How safe is your pension?

Government attempts to soothe worries about the 'hole' in pension funds have only added to the confusion, writes Dominic Coyle

PENSIONS ARE big news this week . . . but for all the wrong reasons. A leaked memo to Cabinet from the Department of Social and Family Affairs warns of a hole of between €20 billion and €30 billion in pension funds. It states that some high-profile funds could fail and that more than 90 per cent of private pension funds will this year fail to meet the funding standard required of them by the regulator, the Pensions Board.

It didn't take long for commentators to point out that the "hole" in pension funds puts into the shade the possible financial commitment required to restore to health the State's troubled banking system - a subject sufficiently serious to dominate the news for much of the past three months.

Within 24 hours, the Minister, Mary Hanafin, came on radio to try to reassure people about their pensions. But, far from putting concerns to rest, her comment that, regardless of what happens to someone's private pension plan, there will always be the State pension to fall back on, served only to escalate the worry of people who may be approaching retirement.

The prospects of living on what is designed to be "subsistence" income of €230.30 a week is little comfort to someone who may have been paying into a pension scheme for up to 40 years in the expectation of a comfortable retirement.

Unfortunately, Hanafin's interview also served only to muddy the waters as she meandered from pension funds' problems in meeting the "funding standard", to addressing constraints about buying an annuity when one retires. These are two serious but very separate issues. One affects only the more traditional defined-benefit pension schemes; the other is a specific concern for the growing number of people on what are called defined contribution schemes, which are rapidly becoming the norm in the private sector.

So what is the funding standard and why is the likely failure of so many companies to meet it seen as a crisis with the Department of Social and Family Affairs? And why should we worry about the time at which we buy an annuity? In plain English: Will my pension be there when I retire and will the amount I receive be affected by the slide in the markets?

The funding standard is a measure laid down by the Pensions Board. It applies to defined-benefit, or final salary, occupational pension schemes. These are pension schemes that promise to pay someone in retirement a set percentage of their working income based on the number of years' service they have with their employer.

Although there are variations, usually such schemes pay 1/60th of final salary for each year of service up to a maximum of 40/60ths, or two-thirds.

While declining in popularity with employers due to their high cost, defined-benefit schemes continue to account for the largest number of people in occupational pension schemes - largely because it is the type of scheme that applies in the public service.

In general, employers and employees will both contribute to the scheme but, importantly, the liability for the eventual pension rests with the employer. They commit to pay the predetermined sum regardless of the investment performance of the funds. If there is not enough money in the pot to meet that commitment, the employer is burdened with topping it up. The funding standard is designed to ensure that these defined-benefit funds have sufficient resources to meet their commitments. It is designed to protect employees against careless or reckless employers who might divert money from their company pension scheme to meet other spending priorities they consider more urgent, or those who plunder their scheme in emergency.

The standard is extremely rigorous. It says the fund must have sufficient resources to meet all liabilities if it were to be wound down unexpectedly now.

Employers and many in the pensions industry argue that it is unfair and unreasonable to expect a fund to meet today pension commitments it may not incur for decades. This is especially so as funds are subject to the vagaries of the market.

"In trying to make the world safer, post-Enron, we have become victims of the controls we have put in place and have almost inadvertently created a problem for companies," says Deborah Reidy, a director with pensions consultants Hewitt. "Relaxing the standard is what is important at this time."

However, Mercer partner Liam Quigley calls for more innovative approaches. "There is already a 10-year window to get back to funded status," he says. "If you are going to simply water down the funding standard, that means individuals' pensions will be less secure."

The majority of almost all pension funds are invested in equities - stocks and shares. Equities are seen as the strongest performing investment asset class but carry higher risk. That is evident in the current bear market where the Irish stock market is down almost 60 per cent this year. Other global stock markets are also badly affected and, unsurprisingly, pension fund performance in the past 12 months has been dire - with the average Irish fund losing almost a third of its entire value.

A fund that might have met the funding standard this time last year is now 33 per cent smaller but its commitments will have risen. Inevitably, many will fail to meet the standard.

Ray McKenna, a partner and managing consultant at Watson Wyatt, said that while the intent of the funding standard was good, it was "simply too prescriptive". "The funding standard was never designed for the perfect storm that defined-benefit pensions now face - with people living longer, investments dropping through the floor, low interest rates and salaries that in recent years have outpaced normal assumptions. Nothing could."

Funds that fail to meet the standard must present a plan to the Pensions Board to explain the actions they will take to bring it back into line within three years. This might include raising contributions by the employer and/or the employees or reducing benefits under the scheme.

They can't simply suggest they will wait for the stock market to emerge from the crisis. Funds that have been particularly badly hit can apply to the Pensions Board for 10 years, rather than three, in which to get their affairs back in order.

In her interview, Hanafin said the board would not grant schemes an extra six months to present their recovery plans as they battle to cope with the scale of the market collapse and as the economic downturn places other pressures on business.

"We have funds facing very significant deficits and they are not going to hang around," McKenna adds.

Many companies are facing the choice between preserving their business or their company pension, he argues, and they will simply move to close down the defined-benefit schemes. "Pension schemes are not all bad and we need to protect them because, ultimately, these are all voluntary."

Hewitt's Reidy agrees: "At the end of the day, that will do far more damage to members of the pension scheme."

But that is only if companies survive. Given the current economic situation, companies could be long out of business by that time and their pension funds may have to be wound up without being able to fully meet liabilities.

"If 90 per cent of companies are failing to meet the funding standard as the economy is entering a recession, the likelihood is that some of the companies that will go out of business during that recession will have defined-benefit schemes," says Mercer's Liam Quigley. So what happens then? Anyone already retired takes priority over those still working. Thus someone of 55 who took early retirement will have his full pension entitlement protected before a former colleague, aged 64 and still in employment, receives anything.

Once all retirees have had their pensions protected - generally through the purchase of annuities - what is left is distributed among existing employees. Again, according to Quigley, those nearing retirement fare poorly, being treated identically as a colleague of, say, 24.

However one tinkers with the funding standard, prudent management of pension assets is essential. "The funding standard is, in this case, the messenger and people are shooting the messenger," says Quigley.

"Some of these funds have very significant deficits and these have to be faced."