Building a better safety net

Addressing funding deficits in pension funds is the paramount concern in Ireland, with defined benefit schemes facing a deficit of €30bn and 90% of schemes failing to meet funding standards, according to statistics by The Pensions Board. However, in the last few months the Irish government has taken positive steps to address some of the major issues faced by pension funds, and is progressively paving the way for recovery.

On April 27, Irish minister for social and family affairs Mary Hanafin published measures intended to support workers of DB schemes which were included in the Social Welfare and Pensions Bill 2009. The measures involve a pensions insolvency payment scheme - PIPS - which is designed to provide cheaper annuities to help former and current employees of insolvent companies with pension schemes in deficit. The initiative requires scheme trustees to pay a sum to the Exchequer, thereby transferring the responsibility of paying pensions to the government instead of buying annuities. These savings will then contribute to members yet to retire, in order to reduce some of the pension deficits.

The initiative has been largely welcomed by pension funds, industry bodies and trade unions, although many acknowledge this as an initial measure which needs to be developed further. Waterford Crystal, for example, recently became insolvent and has a pension in deficit, rendering it eligible to benefit from the PIPS initiative. However, the company SR Technics recently decided to relocate out of Dublin, and despite being a solvent company, is winding up its pension scheme in deficit.

"SR Technics is a profitable company, yet as the company is relocating and has a pension in deficit, members with 40 years in service, for example, will receive little or nothing," says Loraine Mulligan, economic and social policy analyst at trade union SIPTU. Although many companies have a covenant, there is nonetheless no legal obligation to resolve the pension deficit, said the Irish Association of Pensions Funds (IAPF) director of policy Jerry Moriarty.

Indeed some players concede PIPS and other initiatives do not assist enough pension schemes, as the SR Technics case highlights. The measures were based upon papers on defined benefit funding compiled last December by the Society of Actuaries in Ireland (SAI) and the IAPF, as well as an investigation into state annuity options by the SAI. While most of the recommendations were adopted by the government, it omitted the need for protection in a scheme wind-up by a solvent employer, and the proposal for some form of employer guarantee or debt.

"We also suggested that on a scheme wind-up only pensions in payment up to a certain level be given a higher level of priority, as we felt there isn't an urgent need for someone on a pension of €200,000 a year to hold this preserved," said Moriarty at the IAPF. "We thought it would be better if there was a floor and ceiling, but this wasn't brought in - I don't think the government felt it was equitable in terms of the rights people have."

Pioneer global head of institutional business Paul Price also explained that extending the scheme coverage at this stage is unlikely to be economically viable. He said: "I'm uncertain as to whether they should extend it to all companies. You can only extend what you can afford and in the current state of affairs, I'm not sure if it would be prudent for the Irish government to commit to a greater level due to the cost. This is not feasible today."

The state annuity option offered by PIPS is estimated to be up to 20% cheaper than an annuity purchased from an insurance company, leaving more assets for deferred and active members, according to the SAI. Mercer actuary Michael Madden commented: "Should the state get involved? If it offers a cheaper option than market annuity rates - and there'll be an 8% to 18% annuity cost saving with this plan - then yes." Yet he added that it would, ideally, make more sense to offer this to more pension schemes.

SAI president Philip Shier explained that since its proposal in December, the yield on Irish government debt relative to Eurozone bonds in general has increased substantially. "The possibility of using this higher yield is another factor which makes using the state annuity option more attractive," he said. This yield is the result of the government having to pay a premium to borrow money in the international markets, relative to German and French bonds, he explained.

However, Shier questioned the extent to which the scheme will be cost neutral for the government. "PIPS is supposed to be cost neutral but how this works will be interesting in terms of how this is priced." For example, the cost neutrality is subject to the correct pricing of longevity risks. The annuity is calculated based on the cost of government borrowing and mortality assumptions. The funds are then transferred to the Exchequer and the annuities delivered on a pay-as-you-go basis.
Shier added: "The important element for pension funds is that there is a form of annuities which are guaranteed in so far as they're government backed, and they're cheaper to provide, leaving more assets for members lower in the pecking order." In response to the scheme, Watson Wyatt questioned via its E-Advisor tool whether the higher theoretical Irish government bond yield used to provide the cheaper annuities is sustainable for future pricing.

An Irish PPF?
Despite the provision of the PIPS for certain schemes, there is still no pension protection fund in Ireland to help schemes such as SR Technics. "A green paper on pensions published by the Irish government in October 2007 outlined ways to address this issue among various others and is due to be followed up this summer," said The Pensions Board assistant head of information services Andrew Nugent. Yet Moriarty at the IAPF also said that as the DB population is relatively small in Ireland, comprising 1,000 schemes, a pension protection fund would be hard to sustain and would consequently place further financial burdens on continuing schemes.

The green paper also outlined the possibility of introducing a mandatory pensions system, a move which would certainly be welcomed by some industry players. Mulligan at SIPTU commented: "We want a mandatory system with enhanced payment based on contributions from employers, where workers are guaranteed these entitlements. Yet this will be a large transition from where we stand at the moment - around 50% of the population don't even have a pension fund." She added that unless people have an occupational scheme, there is only a minimum state pension which falls below average industrial earnings.

Rather than develop a mandatory system, other industry players such as Shier at the SAI argue that the current state system should simply be enhanced. The green paper asks whether it is possible to increase supplementary pension coverage to the desired level under the current voluntary system.
Along with the PIPS schemes, minister Hanafin proposed other measures to aid DB pensions, including changes to wind-up priorities and the restructuring of schemes. She explained that if a DB scheme is wound-up with a deficit, future pension increases will not be awarded until workers who have contributed and who have yet to retire receive their portion of the benefits.

Hewitt investment consultant Betty O'Reilly commented: "The recent crisis has thrown up certain anomalies, and this move seeks to ensure that pension scheme assets are distributed more fairly in the event of a wind-up." Similarly Nugent at The Pensions Board said that other active members have seen their pensions fall because of the losses, so while pensioners will continue to get priority in the order of the wind-up, this "spreads the pain, even if the pain is still there".

However, consultants Watson Wyatt stated: "Clearly this will not be a popular change for pensioners who in some cases would have otherwise had their full pension, including guaranteed increases, secured on wind-up." It cites that pensioners who would have received a pension with 3% guaranteed increases may see a reduction of as much as 40% in value terms.

Restructuring plans under fire
Similarly the restructuring measure that was announced has been met with some consternation. The restructure allows for greater flexibility of schemes which fail to meet the funding standard. Under section 50 of the Pensions Act, the Pensions Board could reduce active member benefits to help the scheme pass the funding standard. The new measures allow for all scheme members, including former employees, to have benefits restructured, although current pensioners cannot have their pensions reduced below the current level.

Mulligan at SIPTU commented: "On this front we are not in favour and this will cause concern for deferred and active members. We want to defend the maximum amount of benefit that can be retained for members". However, she added that the government is balking at their proposal to move towards a comprehensive pension system.

The implementation of the restructuring programme may also be met with some difficulties. Watson Wyatt senior consultant Brian Mulcair said "it's likely to be fraught with difficulties" and trustees of DB pension schemes may not be able to facilitate dramatic changes to the accrued benefit entitlements of members. He said: "The key area that will need to be reviewed will be the balance of power held within the scheme, between trustees and sponsoring employer." He added that when doing the due diligence process there will be key positions under trustee rules which will have significant bearing on whether these changes can be made.

Indeed trustees face significant challenges aside from this. The most pressing debate for trustee boards is how to address the pension fund deficit, in terms of increasing or reducing risk, said Bank of Ireland Asset Management head of customer group Mark McNulty. "Increasing risk might faster close the deficit, but it may also further widen it, whereas decreasing the risk means expected outcomes are lower," he said. He added that trustees must focus on the most important issues and be able to rely on others to perform less strategic investment issues. "The fund manager's role is to provide solutions, such as selecting asset classes, to free up trustees time."

Tax issues
Despite these positive moves, potential tax changes which could impose tax on the currently tax-free lump sum may further deter people from contributing to pensions. In the recent emergency budget, the minister of finance Brian Lenihan announced a new scheme to encourage early retirement for public sector employees. However, he did not - as was expected - introduce a tax on lump sum gratuity payments, although he has signalled this could be reviewed in the December Budget, according to Watson Wyatt. Shier at the SAI commented: "This could be difficult and cause political outrage - people plan pensions on the tax free lump sum."

There is also concern that tax relief may be reduced. Watson Wyatt highlighted the government might amend the tax treatment of pensions, despite only around 1% of pension scheme members earning in excess of €100,000. AIB Investment Managers senior business manager Oliver Fahy commented: "There is a lot of debate that tax relief on pension funds is a fat-cat perk, which the IAPF argues against. Yes, there are some high earners that may utilise pensions as a tax planning device; but the tax relief is just tax deferral." Madden at Mercer added: "There's a substantial level of tax relief for higher rate pension contributions - if this is limited, there would be less incentive to save."

Nonetheless, the government's initial measures such as the PIPS have been largely welcomed to aid company pensions in immediate trouble. Yet as Paul Price at Pioneer said: "We need to move back to longer-term thinking with regards to how we assess funding issues. A year and a half ago when the markets were on the bull run, the deficits were south of €10bn. If these markets go up another 35% in the next 6 months, the deficit will be less of a problem."

Ultimately, the measures introduced by the minister should be viewed in the context of aiding long-term recovery as opposed to delivering an instant short-term solution to the deficit and provide the basis for further legislative development.

Investment in the Irish pensions market
One of the primary concerns for defined contribution pension schemes in the Irish market is the suitability of the default option offered to investors. Although levels of contributions into DC funds are low and while encouraging people to save in the current environment remains a challenge, the construction of a viable default option should be immediately addressed.

Rubicon managing director Fiona Daly commented: "Around 90% of scheme members just enter the default option, so the challenge is how to construct a viable default that is suitable for all members." A lot of DC schemes have an inappropriate default option as it has a high exposure to domestic equities, she said.

Indeed many Irish pension funds are considered to be "over-exposed" to the Irish equity market, which has declined significantly due to a large exposure to financials and a high concentration of stock specific risk, said Mercer actuary Michael Madden.

Lifestyle funds are being considered by the industry as an appropriate default option. Bank of Ireland Asset Management (BIAM) head of customer group Mark McNulty said: "The default has traditionally been a managed fund, but now it's becoming more diversified with better risk and return characteristics." He explained that managed funds no longer meet the specific needs of pension funds as they are designed for out-performance, which does not match pension scheme objectives. "Schemes are now adopting scheme-specific benchmarks - a portfolio of assets moving in line with liabilities," he said.

Hewitt investment consultant Betty O'Reilly similarly supports the lifestyle approach, in order to invest in growth assets and then move to bonds and other safe-haven assets to protect value nearer retirement. She added: "As most members don't take an active part in decision making when choosing a pension, it's vital that the default option is decent."

Aside from the default option, the prevalent concern for all pension funds is the effect of the market environment, which is exacerbated by increasing longevity and the general slowdown of the economy, said AIB Investment Managers senior business manager Oliver Fahy. He added: "The challenge is how to provide products for pension funds to meet long-term expectations in a tough environment." He said DB schemes require more diversification within the fund and that long only equities still have a role to play in this. "People are looking for diversifiers that are still linked to equities, such as tangible alternatives including commodities or infrastructure type products."

Other investment avenues
The Irish government recently proposed the idea of an infrastructure bond, whereby pension funds invest in infrastructure projects, and is currently in discussion with pension industry bodies to explore this as an investment. Fahy at AIB said this is certainly an alternative to funding if the government is stretched but adds that "every pension fund has to make a decision as to its merits."

BIAM's McNulty said the infrastructure bond would be useful for growth and liability matching as an alternative asset class, because there is potential for an inflation link. "Irish pension funds would invest in infrastructure because it has low correlation to equities, and improves risk and return characteristics."

As infrastructure is a long-term investment, it is also arguably suited to the long-term nature of pension investing. Pioneer global head of institutional business Paul Price commented: "The infrastructure bond that the government has proposed is an absolutely fabulous idea for the Irish pensions industry." He said pension funds must consider what level of yield they would get, and are perhaps looking for 2.5% which roughly reflects the credit default swap (CDS) spread on Irish government debt. "Infrastructure is a long-term investment, pension funds are long-term investors - this is the perfect match to have as part of a diversified portfolio."

Despite these potential initiatives, pension schemes are still under pressure to deliver decent returns without taking too much risk. Hewitt's O'Reilly said: "The aim is to find sources of return that won't increase levels of risk - traditional managed funds have high exposure to equities and properties in Ireland." She said that while there is value in corporate bonds in order to diversify and enhance returns, she questioned whether it is appropriate to move out of certain asset classes. For example, property is difficult to move out of as an asset class with low liquidity.

Similarly Madden at Mercer commented: "There is strong direction from The Pensions Regulator that it's not appropriate for trustees to invest highly in equities. In principal, it's better to guarantee less rather than promise benefits." He added that some schemes have de-risked and invested more in bonds, although many schemes still have more than 60% allocated to equities, largely due to inertia.

A matter of timing
Yet as Watson Wyatt senior consultant Brian Mulcair highlighted, timing is crucial for de-risking. "Some clients might see this as the wrong time to start de-risking because there's an affordability point - if you move to de-risk a scheme you're taking away potential market rebounds and any returns that may be achieved." He explained that with funding levels at such poor levels, de-risking is effectively locking in deficits at the current time. "We would expect clients that want to de-risk to design a journey plan and look to achieve this over a longer period of time."

Rather than remain in equities, Price advocated investing in European corporate bonds. He said: "With the current yields on European corporate bonds, there is an opportunity to swap out some of the equity exposure into these bonds, which effectively shifts the investor along the risk curve." Pioneer stated in a letter issued in February that by swapping along the risk curve, DB schemes could potentially annualise double-digit returns over the next five years.

However, in order to allow this reallocation of assets, Price said a more "realistic" attitude towards mark-to-market needs to be adopted, to prevent pensions going into "forced sale mode" and instead encourage a buy and hold strategy. "As pension funds are long-term investors, they will hold the bonds until maturity, rather than sell today at the reduced mark-to-market value," he said.

Another factor pension funds must take into account is inflation-linking. BIAM's McNulty said pension scheme liabilities can be inflation linked and unrewarded risk can be addressed by this link, as well as by extending the duration of bonds. "However the challenge for the Irish pensions market is the ability to access Irish inflation investment products." He added that BIAM is making this available through a link to the Irish retail and consumer prices indices, rather than European inflation. "We provide this to larger schemes at present, but we're working on making this available to a large number of smaller schemes."