How to fit a pension scheme into a controlled budget?

6 September 2012


Article appeared in CFO Magazine on 6 September 2012

How can you fit your pension scheme into a controlled budget?
A pension basically consists of deferred wages and is vitally important to virtually every employee. The pension scheme helps the employee to meet his living expenses after retirement and, during employment, provides security in the event of death or occupational disability. A pension is therefore an important employee benefit, and also a costly one.

Rising costs
Due to the falling interest rates, contributions for many traditional pension schemes have risen sharply in the past years. These days, the total cost of contributions can run up to 30% of the wage bill. Other cost-inflating factors are unexpected additional contributions relating to pension value transfers, the rising life expectancy and requests from pension funds to top up funding shortfalls. Finally, the new IAS 19 standard may also have major reporting consequences. The abolition of the method for spreading losses over several years may lead to lower profits and more volatile balance sheets.

Due to the developments outlined above, companies have recently shown a growing interest in ways to make their pension schemes IFRS-proof. More particularly, they want to eliminate the risks attached to defined benefit (DB) schemes. A defined contribution (DC) scheme caters to that need. With a DC scheme, their full and sole obligation consists of paying the agreed annual contribution. This contribution is almost entirely predictable and can be easily fitted into a controlled budget. Added to this, current DC schemes are transparent and can be administered at extremely low costs. The fees and charges for DC schemes are clear in advance and so competitive that they are often demonstrably lower than the administration costs incurred by the largest pension funds.

Emergence of PPIs
DC schemes were once the preserve of insurers and pension funds, but since 2011 they can also be carried out by a premium pension institution (PPI). The PPI is gaining in  popularity and, apart from the advantages of a DC scheme over traditional schemes, also offers a few other benefits. For one thing, the administration process is relatively simple, which keeps costs low. Some PPIs have even set up a modern infrastructure based on an investment accounting system to operate even more efficiently. Finally, the governance requirements for a PPI are lower than for a traditional pension administrator, as the PPI is not allowed to run any insurance and investment risks. The result is a highly efficient organisation.

How do you control the risks?
The surviving dependant’s pension and risk of occupational disability are insured collectively and are thus borne by the group as a whole. By contrast, the retirement pension is not based on any form of solidarity. The prudent investment approach and long investment horizon mean that the individual member can comfortably bear the risk himself. Investments risks, for instance, can be limited by means of a responsible age-dependent investing strategy, also known as Life Cycle Investing. By taking a little more risk in the initial period, the employee has a chance of generating a good return. The investment risks are then steadily reduced in a sensible manner. By investing in pension stabilisation funds, the interest rate risk is also limited as the employee’s retirement date draws nearer. Thanks to this approach, both the equity prices and the interest rates have steadily less effect on the level of the actual pension as the retirement date approaches.

Give employees influence
The employee is the one who runs the risk, so it is important he has insight into and influence over his own pension. Clear communication is vital in this respect. And an online pension account is an ideal means of informing employees of what is happening with their pension.

Clear advance communication about the effects of choices, such as additional savings, early retirement or changing the risk profile, enables employees to make the right choices. You can even let employees select their own pension investments, naturally within certain limits.

By doing so, you can let them determine their own optimal risk/return ratio.

Switching over from a DB to a DC scheme is still often seen as a major, and even insurmountable, hurdle. But it doesn’t have to be. Many fears about DC schemes can be removed through good support and clear communication during the implementation phase. Several in-between options are also available. For instance, an employer can opt to limit the DC component in their pension top-up scheme for high earners. Another alternative that is increasingly applied involves setting up a DC scheme for new employees. Using a graduated table based on an actuarial interest rate of 3%, the ambition of a DC scheme is comparable to that of an average-pay scheme.

So it is clearly interesting for companies to place their employees’ pensions with a PPI. Besides being affordable and transparent, pensions from PPIs can be added into a controlled budget and can thus help companies achieve IFRS compliance. Employees can keep track of their pensions online and influence the progress of their pension accrual. Clear communication and the option of taking control of their own pension also makes employees more aware of their pension scheme.

Folkert Pama, BeFrank CEO.