Creative solution needed before pensions crisis gets any older
OPINION:An alternative to annuity purchase is required for pension schemes that wind up, writes MICHAEL WALSH
IRISH DEFINED-benefit pension schemes are at tipping point. Over the past 10 years, the cost of funding defined-benefit pensions has doubled, due to increases in life expectancy and lower interest rates. Over the same period, the average annual investment return has been close to nil, due to large losses in 2003 and 2008. The Pensions Board extended its deadlines to give schemes more time to develop plans to address funding deficits. Now, a further crisis – this time in euro-zone bond markets – has hit pension schemes, just as the deadlines approach for submitting recovery plans to the board (with the first group due on November 30th).
The key factor for pension schemes is the exceptionally low yield on German government bonds. While the yield on Irish government bonds has risen, the German yield has fallen and this drove up annuity prices significantly over the summer. This has a direct impact on pension schemes’ liabilities for current pensioners.
It is simply not sustainable to fund pensions on the basis of a yield of 3 per cent per annum or less. As matters stand, however, pension schemes are required to buy annuities on this basis for pensioner members if they wind up. And they must therefore make provision for this cost in setting their contribution rates. Most pension schemes have spent many months building recovery plans, negotiating contributions and benefit changes with employers, employees and unions. Now, literally at the 11th hour, those recovery plans may no longer work. Without time or appetite to go back to the drawing board, employers could now decide that there is no option other than to wind up.
The Society of Actuaries and the Irish Association of Pension Funds have put a proposal to government to address this issue. It would involve insurers being allowed to sell, and pension schemes being allowed to buy, a new kind of annuity. These so-called sovereign annuities would be directly linked to Irish government bonds. They would therefore be much cheaper than conventional annuities. This would increase the chances that pension schemes can continue to operate and make good current funding deficits over time.
We understand the Department of Finance is considering this proposal but has yet to make a decision on it. With time rapidly running out for pension schemes, this decision is needed urgently. Sovereign annuities are one potential solution; if they are not introduced, Mercer’s view is that an alternative to annuity purchase is needed for pension schemes that wind up. What might this involve?
Our proposal at Mercer is that pension schemes that wind up be permitted to pay lump sums to pensioners instead of buying annuities. The lump sum would be the capital value of the person’s pension calculated on a prescribed basis. The calculation would allow for current life expectancy and expected future mortality improvements together with a specified long-term rate of interest or a rate linked to average euro-zone bond yields. Pensioners could then put the money in an Approved Retirement Fund from which income could be drawn down. Alternatively, they could use the money to buy an annuity, although if this is done at the current time it would likely be for a lower amount than their previous income from the pension scheme.
This approach is already embedded in pensions legislation for current and former employees who have not yet reached retirement age. Our approach would result in a fairer distribution of a scheme’s resources in the event of its winding up. It would also reduce schemes’ funding obligations, making it less likely that they will have to wind up.
The Government has committed to removing the requirement for people who retire from defined-contribution schemes to buy annuities. Instead they are to be allowed to move their retirement savings to an Approved Retirement Fund. Our proposal is consistent with this policy. For defined-contribution schemes, it is proposed that retirees would have to have a minimum lifetime income of €18,000 per annum to avail of the Approved Retirement Fund option in respect of the balance of their retirement savings (ie a State pension of about €12,000 per annum and an annuity or other guaranteed income of €6,000 per annum). The same approach could be used for defined-benefit schemes that are winding up, ie the scheme would buy annuities for up to €6,000 for each pensioner and pay the capital value of the balance of members’ pensions.
We acknowledge that our proposal involves significant challenges and potential pitfalls; the devil, as always, is in the detail. But, as is the case with the banking crisis, there is no ideal solution.
Challenging times call for imaginative measures. The world has changed radically since the current legislative framework for pensions was established. The current approach is not the only one possible. The industry is keen to support the regulator and Government in working out the detail. The status quo is a tipping point that all stakeholders surely wish to avoid. A solution is needed urgently.
Michael Walsh is head of retirement practice at Mercer