Paying for pensions

 

INSURANCE COMPANIES will soon sell sovereign annuities to pension funds in what will be a major attempt by the Government to tackle the pension crisis, as it affects private sector defined-benefit (DB) pension schemes. This will involve using Irish or other EU government bonds, which the National Treasury Management Agency will issue as sovereign annuities, in order to achieve a number of different policy goals. The new annuities should help pension funds to reduce their funding deficits, help the Government to meet some of its borrowing needs, and so ease the State’s return to the international debt markets next year.

Most defined benefit schemes, where an employer promises an employee a pension linked to final salary, are in severe financial difficulty. Four out of five such schemes – with some half a million members – are in deficit. Their liabilities greatly exceed their assets and the schemes, if wound up, would be unable to meet all their financial obligations. Pensioners, who under current legislation have prior claim on the scheme’s assets, would find themselves best protected. That would leave existing employees, as active members of the pension scheme, to share the remaining assets. In such circumstances they would lose out heavily, with their accrued benefits greatly reduced.

Most companies have already closed their defined-benefit schemes to new members while pension benefits for existing members have been cut. Less than a decade ago, four-fifths of DB schemes met the minimum funding standard, a legal requirement. Today four-fifths do not. The reasons are clear: since the onset of the financial crisis Irish pension funds have performed badly, and delivered poor investment returns. As more people take early retirement from work and live longer in retirement, pension costs have risen. And as interest rates have fallen sharply with the recession, the cost of buying annuities to fund the pension payments of retirees has soared. Low rates mean that ever-larger capital sums are required to buy more expensive annuities

A sovereign annuity invested in and priced off high yielding Irish bonds at 6 per cent would be far cheaper than conventional annuities that are now priced on their low-yielding German bond equivalents. The change would alleviate the funding difficulties of most defined benefit schemes, and help them to meet their minimum funding obligations. And, where schemes were wound up the reduced cost of securing pensioner liabilities would leave more assets available for active members. But the introduction of sovereign annuities will also have important consequences for the trustees of pension funds in making investment decisions, and in striking a balance between risk and reward. Stated simply, a conventional annuity based on a AAA-rated asset (a German bond) is seen as risk free. Its lowly rated Irish equivalent is not. Given the major changes now proposed, their full implications for members of defined-benefit schemes and for retirees deserve greater scrutiny and a wider public debate than they have so far received.

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