The cost of a pension plan: need for more transparency
In the current competitive market environment and these financially challenging times, increasingly more private organisations and government institutions are finding it difficult to keep their heads above water. These difficult circumstances often make deep cuts and restructuring necessary in order to be able to survive. Every cost factor within the organisation is then scrutinised and employees’ non-statutory benefits do not escape this process.
However, determining the cost price of these benefits is already simpler for one plan than the rest. The supplementary pension plan generally falls under the category of ‘complex cases’ because pension plans are frequently not very transparent and their cost price is dependent on various factors.
The major element in determining the cost price is obviously the content of the pension plan: a defined contribution of 5% of the salary will be more expensive than the same plan where the contributions are only 3%; a defined benefit of 300% of the salary costs more than a commitment of 200% of the salary, a pension plan on the basis of the full annual salary, including the thirteenth month salary, holiday pay and variable allowances, will require greater effort than the same plan on the basis of only twelve fixed monthly salaries, and so on. If the nature of the pension plan does not change, these cost price determinants are clear. It becomes more difficult when a defined benefit plan, in which the final pension benefit is defined, has to be compared with a defined contribution plan where the pension contribution is fixed. In order to dispel the great uncertainty about future contributions in a defined benefit plan, many companies are switching such plans to defined contribution plans, but at which level must the new contributions then be set in order to award equivalent benefits and avoid labour law problems in the company? It is clear that such an exercise must not only take account of current contributions and costs, but also future developments.
Of course, the complete lack or discontinuation of a pension plan is always the least expensive solution, but other arguments, such as salary optimisation for tax purposes (e.g. variable bonuses), attracting and retaining personnel in a tight labour market, providing extra social protection, etc. obviously play a role in addition to cost price determinants. The vision of your company in this regard would also have to be reflected in the content of your pension plan.
As soon as the substantive rules and formulas of the pension plan are defined, the major part (around 80%) of the total cost price is fixed. The other part of the total cost price is made up of the ‘derivative’ costs for administration, suppliers, insurance risks, brokers, consultants, etc.
Many of these derivative costs are underestimated or not fully appreciated because they are often not charged separately: the internal administrative work in following up the pension plan is additionally performed by personnel managers and the external management costs are included in the overall contributions or allowances that are paid for the pension plan. It is moreover almost impossible for a non-specialist to be able to identify these ‘hidden costs’ in this complex and technical material.
A recent legislative bill of 7 June 2013 on the protection of buyers of financial products and services (Twin Peaks II) therefore provides for greater transparency in relation to commissions and other management fees. European legislation is also developing in the same direction of further transparency and a recent legislative amendment in the Netherlands caused a total revolution in the financial services market. It remains to be seen, however, how this will pan out specifically in Belgium, but according to the last status report, the changes will start to set in quickly from May 2014.
An additional argument for the optimisation of derivative costs is the minimum return guarantees that the Belgian Supplementary Pensions Act [Wet op de Aanvullende Pensioenen – WAP] has imposed on the employer since 2004. The minimum employer guarantees for defined contribution plans are a 3.25% return after a maximum of 5% costs for employer allowances and 3.75% without costs for personal contributions. Due to the recent fall in guaranteed interest at almost all Belgian insurers, employers therefore run the risk of having to additionally finance the growing difference between the obligations imposed by the WAP and the actual returns granted by the insurers. This additional financing risk could then be increased further by the derivative costs.
In conclusion, we provide the following rule of thumb to illustrate the importance of these derivative costs: ‘The accrued reserves in a pension plan equal, on average, 10 to 15 times the annual pension contributions. As such, a 1% reduction in costs on the annual contribution will lead in due course to a 10-15% increase in pension reserves. Conversely, a 1% additional return on the pension reserves will lead in due course to a 10-15% lower annual contribution in order to obtain the same pension capital.’
In short, more transparency and knowledge of the cost price of a pension plan constitutes an element that is not to be overlooked in a sound financial policy.