As defined benefit (DB)pension plans increasingly shut their doors—not just to new members, but also to further contributions—scheme sponsors face tough choices about how to cut their financial losses.
Pension plans that were once tools to attract and retain key employees have become financial millstones, as the combined impact of low inflation, low equity returns and people living longer has saddled DB schemes with an expensive price tag. However, closing a final salary scheme to new members can even create division in the workplace, between the long-standing employees still benefiting from a DB regime and more recent staff signed up to a less generous alternative.
“Some members of final salary schemes in the UK effectively benefit from contributions of 30%, whereas someone starting on a defined contribution (DC) scheme might effectively only be getting a 3% contribution,” says Bob Scott, Senior Partner at actuarial firm LCP. “Such a wide gap is unsustainable, and we have recently seen a wave of closures of final salary schemes even to existing members, to restore more uniform pension provision across the workforce.”
In the UK, only 21% of DB schemes in the private sector remain open to new members, according to the National Association of Pension Funds (NAPF). The number of schemes that no longer allow deposits from existing members has jumped from 7% in 2009 to 17% in 2011.
Meanwhile, across Europe, 60% to 70% of company-funded DB schemes are now closed, according to calculations by Matt Wilmington, Principal at Aon Hewitt: “We have seen quite a lot of closures to new members and plan freezes, but at a lower level than in the UK.”
Countries with significant levels of private DB schemes such as the UK, Germany, the Netherlands, Ireland and Switzerland all face issues around lessening their liabilities, even if the regulatory environments, funding and relationships between employers and employees may vary. Wilmington continues: “The tools to manage risk are all very similar across the different countries, although a lot will be driven by where the focus has been traditionally.”
For a plan sponsor, the closure of a DB pension scheme usually represents the first step in a process of winding up the scheme and shedding risk.
Emma Watkins, Director of Business Development at MetLife, points out that even those with schemes closed to new members and further accruals still need to “make provision for escalating benefits, allow for investments that may not be doing what they need to do, and may need to continue making contributions”.
The ultimate objective of nearly two-thirds of plans in Europe is to be self-sufficient, without relying on their sponsor to pay the benefits, or to use an insurance company to buy out the benefits, according to the European findings from Aon Hewitt’s Global Pension Risk Survey 2011.
A traditional ‘buy-out’ occurs when a company shifts its pension liabilities entirely under a bulk annuity contract with an insurance company. Alternatively, a synthetic buy-out generally uses a combination of derivatives and swaps to enable a pension plan to offload risk without necessarily parting with the assets.
Adrian Boulding, Pensions Strategy Director at Legal & General, explains: “Once they have paid a premium to the insurance company, the liabilities come off their balance sheet, and the employer can walk away knowing that their employees will get the benefits they have been promised.”