Global financial crisis uncovers Defined Benefit time bomb
What impact has the global financial crisis had on the pension funds industry? FAnews Online recently attended the Actuarial Society of South Africa 2009 Convention to find out. The first presentation in the Pensions stream at the convention was titled Pensions and the financial crisis – an international perspective. Tommie Doubell, managing director of Genesis Actuarial Solutions, spent the best part of an hour describing how plummeting equity values impacted retirement systems in various countries around the world.
A mixed bag on the global pension front
Pension funding differs significantly from country to country. Doubell looked at the models applied in a number of European countries (including Ireland, the United Kingdom, Germany and the Netherlands) and the United States to demonstrate the fundamental differences in each region. We’ll look at some of these differences to gain insight into the relative health of the industry in each region.
The German pension funds industry survived virtually unscathed. “Germany is very different to South Africa – mostly DB – because pure DC funds aren’t allowed at all,” said Doubell. The market is highly regulated and companies make what’s known as a “direct pension promise” to employees. Fund liabilities are carried on the companies’ books. Conservative investment strategies result in 80% to 90% of pension fund assets being held in fixed interest investments. The Netherlands follows a similar conservative pattern using DB funds. Many funds in the country are industry-wide, very large and managed by full-time professional asset managers.
The UK and Ireland operate less conservative strategies. Both countries are dominated by the older DB funds (which account for approximately 70% of all funds) and sponsoring companies struggle to exit these arrangements. The system is trust based and assets are generally between 60% and 70% invested in equities. Unlike Ireland, the UK has a Pensions Protection Fund which assists insolvent funds. Both countries operate huge DB funds with high equity weightings. And it’s these funds that get under water very quickly.
“The United States still has a large DB component to their industry too,” said Doubell. Approximately 62% of Fortune 1000 companies operate DB pension funds, with 73% of these funds still open. Doubell notes that around 60% of US DB pension fund assets are in equities. Recently the US has shifted to DC funds through the 401K pension plan. This gives US employees more freedom in saving for their retirement. The 401K creates additional risks to individual retirement savers with many employees pouring all their funds into the company they work for. When Enron collapsed so spectacularly (in late 2001) many employees lost their retirement savings too!
International funds go to the wall
How bad is the problem internationally? We can answer this question with a quick look at a graph of funding levels in the US DB pension fund industry going back to 2000. In 2002, shortly after the dotcom bust, most US DB pension funds had clawed back to funding levels of around 97%. As the financial crisis unfolds these funding levels have plummeted to just 67%. Another way to look at the situation is to consider the number of funds at 90% or better funding levels. At end 2007 63% of Fortune 1 000 companies DB pension funds achieved 90% funding levels or better. Just 12 months later only 6% of funds could say the same! The situation is equally poor in the UK, where 95% of all DB funds are under funded, and Ireland, where 90% of DB funds are in poor shape.
The US Pension Fund Guarantee Corporation reported $11bn in liabilities at end September 2008 – and that’s when the market crash began in earnest. And the UK already has 100 schemes in the Pension Protection Fund with another 290 funds on the shortlist. An example of how serious company sponsored DB shortfalls can become is the £12bn deficit at the UK postal service, the Royal Mail.
Pension fund consultants and actuaries sit with a major headache. They have to decide what to do to remedy these industry-wide funding shortfalls. “If you’ve suddenly got a fund with a 67% funding level the picture changes dramatically,” said Doubell. Do we just hope for equities to provide for a recovery from the 65% funding level or do we do something else to nurse these funds back to health? It can be done when markets perform strongly; but it’s going to be difficult if we enter the so-called U-shaped market recovery so many predict. And there are plenty of other challenges in rebuilding these DB funds. These include generally lower interest rates, reduction in asset values, guaranteed pension increases, mortality improvements and long-term inflation expectations. Each of these factors lumbers the DB fund with additional commitments, prolonging recovery, and in some instances resulting in fund insolvency. The companies sponsoring these DB funds end up in serious trouble and may not be able to meet larger financial obligations due to the poor business environment!
Meanwhile, in South Africa
“The impact on South Africa has been less severe than worldwide,” said Doubell. We can confidently say that the domestic pension funds industry is in much better shape than most of the developed world. There are a number of reasons for this. The first is the bulk of our pension funds were 100% solvent as we entered 2008. We’d also just come out of a period of surplus redistribution which forced most funds to reassess their risk profiles. Many funds had taken unprecedented steps to adjust the risk profile downward. The second is the recent shift from defined benefit to defined contribution. It’s important for the industry to acknowledge the risk the member takes in this scenario. There’s a need for comprehensive communication with fund members through difficult economic times.
Editor’s thoughts:
The extent of the equity market sell-off caught many in the pension industry by surprise. Through the boom years we’ve been shifting to higher levels of equity exposure with scant regard for the additional risk involved. Fortunately markets have made up some of the losses and the worst appears behind us. Are you happy with how your client’s retirement savings endured the financial crisis? Add your comments below, or send them to [email protected]
