Final Salary Schemes under Threat?

Part 1
Alexander van Stee and Alex Jungman
Alexander van Stee has been working for Hewitt since 1993 and is a Retirement and Financial Management Consultant. He is currently based in London, having joined Hewitt Bacon & Woodrows International team last year. His experience includes working on projects in the areas of benefit design, valuations and cost projections, international pension accounting and mergers and acquisitions. Mr van Stee has a masters degree in Mathematics from the University of Leiden in the Netherlands. He qualified as an actuary in 1997 and is a member of the Dutch Society of Actuaries. Leading the Retirement and Financial Management practice of Hewitts operations in the Netherlands, Alex Jungman is based in Amsterdam. He has worked in the employee benefits and actuarial areas since 1967 helping clients redefine their pension strategies and redesign their pension plans and providing advice on international benefits, mergers and acquisitions and international accounting standards. A member of the Dutch Society of Actuaries, Mr Jungman qualified as an actuary in 1968 and has assisted the Society for 15 years in teaching courses and managing the educational side of the organization.

In this article we reflect on the future of final salary pension schemes in Europe and on the impact of the fall in financial markets. We will focus on several European countries where occupational final salary schemes are prevalent. The article is divided into two parts, Part 1 being published this month and Part 2 next month. Part 1 will focus on a country the Netherlands where occupational retirement benefits are traditionally funded externally and which has the second-largest pensions market in Europe (after the UK) and the highest pension asset value relative to GDP* in the world. The Netherlands has a longstanding tradition of funded final pay schemes and employers are facing difficulties as a result of the plunge in stock prices in a similar way to their counterparts in a number of other countries with such schemes (for example, the UK).

60% of total pension assets are concentrated in these funds. With regard to investment practice in the Netherlands it is important to note that, until 1990, on average just 15-20% of pension assets were invested in equities. Only a handful of company pension funds held a substantially larger proportion of their assets in equities among the most striking examples are, not surprisingly, the Anglo-Dutch companies Shell and Unilever. Currently the exposure to equities ranges, on average, between 40% and 45% (which is of course still modest if compared with the UK). In particular, pension funds that moved towards a higher exposure to equities in the second half of the 1990s are now most likely to be experiencing funding deficits, as they only partially benefited from the bull market. More or less in parallel with the increasing interest in equities and more dynamic investment strategies, the Pensioen- & Verzekeringskamer (PVK), the Dutch supervisory authority for pension funds and insurance companies, has started to play a more active role as a supervisor. During the past five years the PVK has, among other things, tightened up reporting procedures for pension funds and issued rulings on funding

FUNDING ISSUES IN THE NETHERLANDS Some Useful Pension Statistics

Occupational pension schemes cover over 90% of the working population in the Netherlands. Generally, medium-sized to large companies operate selfadministered pension schemes, which are sometimes reinsured; small companies typically use insurance contracts to provide retirement benefits for their employees. Most of the pension assets in the Netherlands (around 500 billion in total) are held by occupational pension funds. Assets for directly insured pension schemes constitute roughly 10% of the total. There are around 900 pension funds in the Netherlands, almost 90% of which are single-employer funds. Only 10% of all pension funds are in respect of industry-wide schemes but over

* gross domestic product All the statistics in this article are taken from various publications of the Pensioen- & Verzekeringskamer. 1 = 1.51; US$1 = 0.92 as at 7 February 2003

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requirements. As a result, a number of previously selfadministered pension schemes were directly insured. Consequently, the number of pension funds in the Netherlands has slightly decreased. As funding levels, i.e. the ratio of assets to pension liabilities, of Dutch pension funds have continued to decrease from an average of 150% at the end of 1999 to 125% at the end of 2001 the PVKs concerns have increased accordingly. At the end of the third quarter of 2002, the PVK announced tougher funding requirements for pension funds and reported at the same time an average funding level of 100%.

The PVK letter identifies three instruments that a pension fund board generally has at its disposal to control the funding level: the contribution rate, the suspension of pension increases, and investment policy. Pension fund boards were given three months to produce a recovery plan if all the funding requirements were not met, thereby including pension funds that meet the 105% requirement but fail to meet the solvency buffer requirement. As suspending pension increases only prevents the funding level from deteriorating further and changing the investment policy will in the short term only lower the required solvency buffer (for example, less exposure to equities will generally result in weaker solvency requirements), pension funds failing to meet the 105% requirement have no choice but to increase the contribution rate in order to increase the funding level. On 14 January 2003, the umbrella organizations of occupational (industry-wide and company) pension funds pointed out that pension contributions would, as a consequence of the new requirements, increase to such a level that the macro-economic effects would be very serious. The umbrella organizations subscribe to the PVKs view on the required funding levels in the long term but propose a more flexible approach to temporary situations of underfunding. At the moment it is unclear whether the new funding requirements will become fully effective in their present form. The anticipated PVK ruling has encountered strong opposition which is not surprising, given the expected effects on contribution levels. It remains to be seen whether the PVK is prepared to concede to this opposition and weaken the requirements. If this happens, we would expect the PVK to take a more flexible approach to the period over which funding levels have to meet the requirements, which should result in less dramatic increases in contribution rates. If not, we expect that the Governments assessment of the macro-economic impact of the requirements will be decisive. If the impact is as serious as is suggested by the umbrella organizations, the Government will surely dispense with the PVK ruling.

Technical Basis for Dutch Funding Guidelines

In this article we frequently use the term funding level. Clearly, this is not an absolute concept. It is defined by whatever funding requirements are set by national supervisory bodies or by law. For example, both the UK and the Netherlands have funding requirements with respect to pension schemes, but there are important differences between the funding level definitions. A brief description of the funding regime of selfadministered pension schemes in the Netherlands follows:

Assets are determined at market value. Liabilities are calculated using a 4% discount rate, current salary and no allowance for future pension increases, unless they are guaranteed. Normally the liabilities will be inclusive of an allowance for administration costs and longevity. No allowances for future decrements other than mortality are made. If the assets are equal to the liabilities, as described above, the funding level is 100%. In addition to assets covering 100% of the liabilities, buffers are required by the PVK to counterbalance the effects of poor investment returns and other risks.

This is just an outline but it should convey enough about the Dutch concept of funding to give an understanding of the import of the PVKs recent letter.

The PVKs Recent Letter on Funding Levels

On 30 September 2002 the PVK issued a letter to all Dutch pension funds announcing tougher funding level requirements, which would come into effect on 1 January 2003. In brief, any self-administered pension fund is required to have a prescribed funding level that can never be less than 105%. In addition to this 5% buffer, which is intended to cover risks that are not explicitly quantified, a solvency buffer is required to cover depreciation in the value of the assets, the size of this depending on the asset allocation. A further buffer may be required to allow for future pension increases, even if they are not guaranteed, if the conditional nature of increases in the past was not explicitly communicated to the beneficiaries. All pension funds must meet the 5% requirement within one year; the period allowed for building up the additional solvency buffer will generally vary between two and eight years. Furthermore, future contributions to the pension fund must in each year cover all actuarial costs, i.e. the cost of benefit accrual and past service*, plus the cost of administration and that of building up the solvency buffer.

Will the Ruling Change Pensions Practice?

Over the last decade, Dutch companies have been amending or replacing their pension schemes for a number of reasons such as cost containment, the need for a more flexible benefit structure or new legal requirements (tax related or other). Although the number is decreasing, over 50% of the Dutch workforce still has retirement benefits linked to final pay. The

* As no allowance is made for future salary increases under Dutch funding guidelines, the actuarial cost in any year will include a past-service element as a result of salary increases in the current year.

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incidence of schemes operated purely on a defined contribution basis is very small less than 5%. While there is a distinct trend for companies to move away from final pay schemes mostly in favour of career revaluation schemes* or hybrid schemes it should be noted that the cost of funding these schemes is often only one of a number of drivers for change. A companys benefits strategy is or should be at least as important as financial considerations when it comes to balanced decisions on changing the pension scheme. An employer considering dramatic changes to the pension scheme for financial reasons would have many rivers to cross (unless there are extreme circumstances, e.g. company insolvency). Changes to the pension scheme often require the approval of the pension scheme members council. Closure to new entrants of an existing scheme and setting up a (less costly) scheme for new employees a practice that is commonly found in the UK would still require the approval of the pension fund board or of the works council if the scheme is directly insured. Changing the scheme may not even be the solution to the problem. It is important here to discriminate between long-term and short-term effects. An employers concern with pension scheme funding issues in the long term could very well be a driving force for changing or replacing the pension scheme. However, in the short term, changing the scheme rules is not likely to affect the funding level of the scheme as, under Dutch funding practice, the pension liability, i.e. the present value of the accrued benefits, is based on current salary and will not change if the scheme is changed. By law, accrued benefits cannot be taken away from the beneficiaries. Dutch legislation allows accrued benefits to be transferred to a new scheme, but the present value of the accrued benefits cannot be touched the scheme change will only be reflected in future pension costs. In other words, the short-term effects of changing the pension scheme would not normally result in the company being able to meet the PVKs requirements if these requirements were not met before the change.

Contrary to current Dutch funding practice, effects of future salary and pension increases will be reflected in the size of the pension obligation under the new guideline, which means that changing the pension scheme rules will have an immediate impact on the companys balance sheet and profit-and-loss items**. This is probably a far more compelling reason for corporate management to terminate a final salary scheme and is thus more likely to be the financial driving force behind the decisions on pensions than (national) funding requirements. Interestingly, many UK employers identify the introduction of FRS 17 (the UK accounting standard) rather than funding requirements as a main reason for moving from defined benefit to defined contribution schemes.

SO, ARE FINAL PAY SCHEMES UNDER THREAT?

Are final salary schemes in the Netherlands under threat as a result of the tougher funding requirements by the PVK? We do not believe they are, although employers might be inclined to raise the issue when negotiating on employee benefit packages. However, as mentioned above, changes to the pension scheme will not settle funding difficulties in the short term and the PVK appears to have adopted a short-term view. Accounting issues are more likely to challenge the existence of final salary (or, more generally, defined benefit) schemes, at least from 1 January 2005 onwards. However, companies that reconsider their retirement schemes to improve the balance sheet and the profit-and-loss account will have quite a battle on their hands at the negotiating table. Decisions on pension benefits should not be entirely financially driven. A well-thought-out benefits package will reflect a balance of numerous factors and should be competitive as well as affordable. * * *

Part 2 of this article to be published in next months issue will also deal with the future of final salary schemes, focusing this time on a number of other European countries where final salary-related retirement benefit schemes are also common.

What Else Is in Store?

It is unlikely that the PVKs new funding requirements will act as a trigger for companies to revise their pension schemes on a large scale. Many Dutch employers were already considering a move away from final salary schemes before the market started to fall. Employers may be inclined to speed up this process due to current funding difficulties, but as explained above this will not resolve their funding issues in the short term. On 1 January 2005 a new Dutch accounting guideline on pensions (Richtlijn 271 par. 3) is expected to come into effect. The draft guideline is very similar to that covering pension accounting under IAS 19. If the latest draft of this accounting guideline is adopted in its current form, it will apply to all (limited or public) companies. This will not only affect Dutch-based companies but also Dutch subsidiaries of parent companies based outside the Netherlands. Note that IAS 19 will be the prescribed accounting standard on employee benefits from the same date, but only for listed companies in the European Union.

* In around 90% of career revaluation schemes the indexing of accrued benefits is conditional. The most prevalent hybrid schemes in the Netherlands use a combination of defined benefit and defined contribution formulas (for example, a retirement benefit based on final or average pay on earnings up to a ceiling and defined contribution on earnings above the ceiling). By law, at least half the pension fund board members must be employee representatives. International Accounting Standard No. 19 Which types of company are covered by the guideline is a question on which parties still have to agree and which may change before the guideline becomes final. It is not inconceivable that smaller companies, for example, will be exempted from the accounting requirements. ** A decrease in the size of the pension obligation as a result of a scheme change will, under IAS 19, be immediately recognized (as a gain). Financial Reporting Standard No. 17

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