Saturday, January 7, 2012

The sustainability of pension schemes

The sustainability of pension schemes, by Srichander Ramaswamy
BIS Working Papers No 368


Poor financial market returns and low long-term real interest rates in recent years have created challenges for the sponsors of defined benefit pension schemes. At the same time, lower payroll tax revenues in a period of high unemployment, and rising fiscal deficits in many advanced economies as economic activity has fallen, are also testing the sustainability of pay-as-you-go public pension schemes. Amendments to pension accounting rules that require corporations to regularly report the valuation differences between their defined benefit pension assets and plan liabilities on their balance sheet have made investors more aware of the pension risk exposure for the sponsors of such schemes. This paper sheds light on what effects these developments are having on the design of occupational pension schemes, and also provides some estimates for the post-employment benefits that could be delivered by these schemes under different sets of assumptions. The paper concludes by providing some policy perspectives.

8  Summary and policy issues (edited)

A weak macroeconomic environment and unusually low real interest rates in many countries have put the funding challenges faced by occupational and public pension schemes in the spotlight. This paper took a simple actuarial model to quantify how the cost of funding DB pension schemes increase as the real rate of return in asset markets falls. If real returns on pension assets are assumed to be lower by 0.5% compared to their historical averages, service costs of DB schemes would be 15% higher than in the past for the same benefit payments. Converting final salary pension schemes to career average schemes (and not altering the percentages applied) would lower pensions by 20–25% assuming that real wages grow at the rate of 1–1.5% per annum.

Declining mortality rates will put further upward pressure on the contribution rates needed to fund these schemes. When the expected increases in longevity are priced into the actuarial model for computing the service cost, this cost is likely to be 10% higher than estimates presented in the paper. Increasing longevity as well as demographic changes that point to a rise in the old-age dependency ratio poses challenges to the sustainability of PAYG schemes. The projected increase in old-age dependency ratio suggests that in many countries the contributions to PAYG schemes have to increase by 20% from current levels in 2020 to pay pensions. But as PAYG schemes that service current pensions from employee contributions and taxes do not report the contractual pension liabilities, estimating the funding shortfalls these schemes might face going forward is a challenge.

In contrast to PAYG schemes and some funded public pension schemes, occupational DB schemes have to comply with accounting standards to report the market value of their pension liabilities and the assets that back them so that potential funding shortfalls faced by these schemes can be quantified. Unusually low real interest rates and poor financial market returns in the past decade have had an adverse impact on the coverage ratio of these schemes through the valuation effects on liabilities and lower returns on pension assets. Estimates of the coverage ratio of occupational DB schemes based on these returns would point to a funding deficit of 10 to 20 per cent against their pension liabilities. The size of any deficit that eventually materialises over the long lives of these schemes, however, would depend on future returns – which are unknown.

For occupational DB schemes that face large funding shortfalls, employer contributions will have to rise to improve the coverage ratio of these schemes. At the same time, increasing longevity and falling real yields against the backdrop of a weak macroeconomic environment are raising the service costs of DB schemes and adding to the upward pressures on required contribution rates. Recent amendments to pension accounting standards, which require companies to provide more disclosures in their financial statements on the risks the DB scheme poses to the entity and to report the net gains or losses from their DB pension plans on their balance sheet, are likely to accelerate the shift out of occupational DB plans into DC plans. This is because DC plans limit the contractual liabilities of employers to the contribution rates to be paid for the current service period of the employee.

A progressive shift from DB to DC schemes can have material implications for post-employment benefits because it exposes employees to the investment risks on the pension assets. In addition to this risk, beneficiaries of DC plans will also be exposed to the principal risk factors that determine annuity payments, namely level of real interest rates and the projections of mortality rates into the future when the actual annuity payments will be made. Using a simple model to estimate the retirement income from DC schemes, the numerical results presented in Table 2 showed that when contributions to DC schemes are 18% of salaries over a 30-year period and the returns net of administrative expenses on plan assets are 2% higher than the rate at which wages grow, post-employment benefits from a DC scheme would roughly be 43% of the final salary. The excess return assumption of 2% is based on the following input variables in the model to compute retirement income for DC plans: real yield on long-term bonds is 2%; equity risk premium over the returns on long-term government bonds is 3%; plan assets have an equal share of bonds and equities; administrative expenses are 0.5% of plan assets; and the annual real wage growth rate is 1.25%.

The quantitative analysis presented in this paper provides some insights on the possible trade-offs that may be available for public policy on the design of sustainable pension schemes. For example, the internal rate of return on the notional assets of PAYG schemes will be approximately equal to the rate of real GDP growth of the local economy, which is expected to be 2% or lower in advanced economies. The actuarial model showed that service cost of a pension scheme will be high when the rate of return on the pension assets is low. A funded public pension scheme, on the other hand, will be able to raise the level of return on pension fund assets by investing them in higher growth markets. Estimates using the actuarial model suggest that a 50 basis points increase in real returns lowers the service cost of the pension scheme by 15%. Funded pension schemes therefore offer the prospect of lowering service costs and to be able to better align the pension benefits offered by these schemes to the contribution rates received.

Public policy may also be needed to develop efficient markets for pricing annuity risk as occupational DC plans become the preferred post-employment benefit scheme offered by employers. Efficient markets for pricing annuities will in turn depend on how the market for managing and hedging longevity risk develops. As more employers progressively shift towards DC schemes for providing post-employment benefits, regulatory policies might be needed to restrict the range of permissible investment options available for plan assets to avoid unintended risks being taken by the plan beneficiaries, and to set mandatory minimum contribution rates for participating in DC schemes. Finally, considering that plan beneficiaries in DC schemes are exposed to interest rate risk at the time of converting plan assets into an annuity, the pros and cons of providing insurance policies that guarantee a minimum real yield at which these assets can be converted into an annuity will have to be examined.