For some weeks now, the financial markets have been falling freely. Primarily bank shares had originally been under heavy pressure, but after some time the drop in share prices spread to all sectors. To restore confidence, and to keep credit facilities at the required level, governments over the whole world are taking important support measures for banks. The possible consequences for personal savings have been extensively explained in the news media. In this newsletter we investigate the potential risks for company pension plans of the so-called second pillar.
It is not the intention to give a technical overview of the important control mechanisms, which are at the disposal of the Belgian Banking and Finance Commission (CBFA) for controlling the solvency of the pension institutes. These strict and preventive control mechanisms, which may be linked to imposed recovery plans with regard to detected problems, limit the possibility of a bankruptcy of a pension institute to a minimum. Nothing can really be excluded in extreme situations, but, hopefully and probably, intervention by the governments will lead to a protection of the pension capitals of the beneficiaries.
The most important problem at banks is currently not solvency, but actually the liquidity. Due to a lack of confidence, there is a problem on the one hand to obtain sufficient credits from other banks and, on the other hand, there is an increasing outflow of savings that are being withdrawn by worried investors. In extreme situations this can lead to the impossibility of meeting short-term obligations, even if assets are sufficient for covering long-term engagements.
Such an unforeseen liquidity risk is almost non-existent for pension institutes. The pension institutes are assured of a regular inflow, which serves to finance the pension obligations that have been defined for the employer (and the employee) in the pension regulations. On the other hand, pension payments can be claimed at the earliest as of the (early) retirement age (as of 60 years), so that an unforeseen and spontaneous "rush" on the pension funds is excluded. It is of course possible for an employer to cancel a pension plan, thereby also interrupting the "inflow" of pension contributions. Such a discontinuation however changes the labour relations entirely, and it furthermore prevents the implementation of the legal procedures that must be respected in this regard. If, by contrast, an employer wishes to transfer his pension reserves to another pension institute, then he must notify the CBFA in advance, which can refuse such a transfer, if this operation should "threaten the balance of the pension institute".
The preceding shows that the possibility of a bankruptcy of a pension institute is rather small. This does not, however, mean that the financial crisis does not have an impact on the financing of the pension plans. The pension obligations are, in the first instance, determined by the corresponding pension regulations, and by the provisions of the Belgian Supplementary Pensions Act (WAP).
In a pension plan with "fixed performance" (defined benefit, planned objective), the minimum pension reserves are calculated by updating (interest rate of 6% and the mortality tables MR/MF) the acquired pension capitals, on the basis of today's salary and career performance.
In a pension plan with "fixed contributions" (defined contribution; fixed premiums), the minimum pension reserves are calculated with a yield of 3.25%, after a maximum of 5% for costs, and after deduction of the risk premiums for death and disability, the employer contributions and 3.75% special costs for the personal contributions. The minimum obligations or liabilities of the employer are in other words fixed. By contrast, the financing and the value of the assets varies in function of the pension institute and the selected guarantees.
Most pension plans are financed through an insurance company under a so-called "Branche 21". This often means that the insurance company guarantees the interest rate (usually 3.25%), and that it grants a participation in profits, depending on the results of its investments. Due to the interest rate guarantee, the insurance company will primarily invest in bonds, and only for a very limited part in some more risky shares. In the event of a financial crisis, it is possible that the achieved yield is lower than the interest rate guarantee, but such a loss is at the expense of the insurer. The loss or risk for the employers and employees is limited to a loss of the (unguaranteed) participation in profits.
If a pension plan is financed by way of "Branche 23", then no interest guarantee is given at all. The pension contributions are not transferred to investment funds and will receive the actual return of these funds. A choice is usually offered between different investment funds that, to a greater or a lesser extent, invest in shares with a higher or lower financial risk. The insurer here only acts as a fund manager and provides no interest guarantee. In the event of a financial crisis, the entire loss is at the expense of the employer. The difference between the minimum legal obligations and the value of the assets must be compensated by him. The loss for employees is limited to the possible return, which exceeds the above-mentioned minimum employer guarantees for fixed contributions.
Some pension plans are financed via Institutes for Company Pensions (IBP), the so-called pension funds. Larger employers (often) create a legally separate company, for the special management of their pension plans. Such a pension fund will almost always provide a "means commitment" (management of the received pension funds according to best ability) and almost never a "results commitment". The financial risk for the employer can consequently be compared with a pension plan through an insurer under Branche 23.
The immediate effect of a financial crisis on the financing of the pension plans is therefore dependant on the selected manner of investment, and on the existing financing surplus that exceeds the minimum of a legal obligation. The impact on pension plans under Branche 21 will be rather limited, if they have sufficient free reserves.
For pension plans under Branche 23, or for plans that are financed via pension funds, the extent of the "gap" that has developed between the obligation and the assets is dependent on the selected investments and the surplus that existed. In principle, an employer must immediately top up such a deficiency, but a recovery program can be developed for this eventuality under agreement with the CBFA.
The current financial crisis clearly shows that risky investments, in the event of insufficient buffers (a surplus in assets that exceed obligations), can lead to unpleasant and unforeseen financing obligations. It is to be hoped that the financial markets will recover quickly, so that such additional "recovery payments" can be prevented during the difficult period of an upcoming recession.