Occupational Pension Schemes in ireland - A Review of Risk and Investment Strategies.

Occupational Pension Schemes in Ireland – A Review of Risk and Investment Strategies Jim Stewart, Trinity College Dublin, and Bridget McNally, National University of Ireland, Maynooth. E-Mail [email protected] [email protected] Abstract 1/5/03 The pensions industry is a multi – billion euro industry world wide. As at December 2002, Irish pension fund assets under management (not including the Government Pension reserve Fund) were of the order of 50,618.5m. Euro. Recent stock market performances coupled with a number of high – profile corporate failures have focussed attention on the vulnerabilities of funded pension systems. This paper looks at the role of funded occupational pension schemes in Ireland and specifically at the risks inherent in both the investment strategies of these schemes and the institutional structure of pension fund provision. It questions whether pension funds by embracing these risks are serving the objectives of the individual beneficiaries of the schemes, the trustees and the sponsor companies. 1 Occupational Pension Schemes in Ireland – A Review of Risk and Investment Strategies Jim Stewart, Trinity College Dublin, and Bridget McNally, National University of Ireland, Maynooth. 2 Occupational Pension Schemes in Ireland – A Review of Risk and Investment Strategies. Focus of paper This paper looks at the role of occupational funded pension schemes in Ireland, in the provision of pensions. It specifically looks at the risks associated with these schemes, from institutional risk to investment strategy risk. Most academic discussion of risk focuses on market risk, in particular risk from equity investment. This paper however argues that risk also flows from the institutional structure of pension fund provision. The paper concludes that the “secure investment” tag, traditionally associated with pension scheme arrangements may be too simplistic due to a variety of risk factors. Introduction The forecast increase in the cost of old age pension provision and possible future difficulties in funding pensions in many countries, is at this stage well documented. “Rapid demographic transitions caused by rising life expectancy and declining fertility mean that the proportion of old people in the general population is growing rapidly” (World Bank-1994 –Foreword). Changing labour markets, in particular reduced participation in the labour force by males over 50 (Disney, 1996 p. 193, p. 225) due to early retirement and/or disability also contributes to the dependency ratio. In most developing countries, an informal system whereby children care for their aged parents and income transfers flow between generations in both directions, is still the mainstay of provision in old age. But in many countries, economic development has resulted in the informal arrangements giving way to formal market arrangements and to varying degrees, mandatory government programmes (World Bank, 1994, ch.2). The widely referred to report by the World Bank (1994) “Averting the Old Age Crisis – Policies to Protect the old and Promote growth”, identifies in its overview, three functions of old age security systems – redistribution, saving and insurance. The study suggests that financial security for the old and economic growth would be better served if Governments developed three systems or “pillars” of old age security; a publicly managed system with mandatory participation and a limited goal of reducing poverty among the old (social security pension), a privately managed mandatory savings system (a pension plan either a personal savings or occupational plan), and voluntary savings (a personal savings or occupational pension plan). One of these policies, the development of privately managed funded pensions, has also been advocated by Governments, the European Commission and the pensions industry in many countries, including Ireland. In developed countries and most low and middleincome countries, Governments have developed formal pension arrangements to some degree. Key to the type and nature of each system is Government policy on a number of policy issues viz: 3  Whether primary reliance should be on voluntary or mandatory mechanisms;  The replacement rates built into the design of social security and private pension benefits;  The balance to be attained between poverty alleviation and redistribution, saving and income smoothing.  What elements of insurance should be provided.  How the system should be financed – funded or on a pay as you go basis.  Should the system be managed publicly or privately. The current pattern across Europe and the US is summarised in the Table (1) below: Table 1 Ireland Social security old age contributory and non – contributory pension. Voluntary employer provided occupational pension arrangements – largely defined benefit. Private personal pensions also available. UK. Low level of State pension, complemented by voluntary employer provided, defined benefit funded system. Private personal pensions also available. Sweden Minimum State pension, complemented by publicly managed mandatory defined contribution system. Also large and unified voluntary occupational pension and personal pensions sector. Norway Flat rate State pension complemented by mandatory earnings related defined benefit public pension for entire workforce. Fairly large voluntary occupational pension and personal pension sector. Denmark Means tested basic pension. Mandatory small flat – rate contributory pension in the private sector. Large fragmented occupational and personal pensions sector. Netherlands Transition from a mandatory public scheme to a voluntary privatised one. France Compulsory defined benefit pay as you go system. USA Compulsory three tier plan for all federal employees – basic social security, a defined benefit plan and a defined contribution plan. In the private sector defined contribution plans (401(k)) are by far the most popular Source: Reynard et al. eds, (1996 p.16-23, p.40-48, p.127-136, p.154-162, p221-231), Hughes and Stewart,eds, (2000 p.147-160,p.180-192) Currently about one in every four persons and more than one third of the working age population in OECD countries are covered by an occupational pension. In Ireland, coverage of those in employment, aged 20 to 65 stands at approximately 50% (CSO) and is increasing. The pensions industry is a multi–billion euro industry world wide. As at 4 December 2002, assets managed on behalf of Irish pension funds stood at 50,618.5 million euro (IAPF, 2003)). As at December 2000, there were 86,348 pension schemes registered with the Irish Pension Board with a total membership of 629,801. Of this, 180,690 individuals were members of defined contribution schemes while there were 449,111 members of defined benefit schemes. The trend however is towards defined contribution schemes with a significant number of onemember schemes being registered during 2000. Table (2) gives more information on the members of occupational pension schemes. Table 2 Members of Occupational Pension Schemes Supervised by the Pensions Board year Members of all pension schemesa ‘000 D.B. Only ‘000 D.C. Only ‘000 Pension fund assetsb Euro Billion Assets as % of GDP Total at workc ‘000 Estimated pension coverage per cent 2000 630 449 181 53.9 66 1710 36.8 1995 478 405 78 20.8 50 1239 38.6 Source: Connell, P. and Stewart, J. (forthcoming). Notes a - This data refers to occupational pension schemes and includes both public sector PAYG schemes as well as funded or partly funded schemes. The data relates to members of pension schemes monitored by the Pensions Board. Source: Various issues of Annual Report of the Pensions Board. b - Source: Shane Whelan, (2001) Irish pensions Funds: Size Growth and Composition of Assets, Dublin: Shane F. Whelan & Co. c - C.S.O. Quarterly National Household Survey SeptNov. 2000, Feb. 2001 and 1995 National Labour Force Survey, 1996. Occupational Pension Schemes – Structure and Regulatory Framework. Occupational pension schemes are privately managed pension schemes offered by employers to some or all employees as part of an overall remuneration package. Often facilitated by tax concessions and regulated by Governments, their objective is to provide a targeted level of income on retirement in most situations complementing social security. Occupational pension schemes in Ireland are mainly set up as trusts. Accordingly, they are primarily governed by Trust law. However this is supplemented by the Pensions Act 1990, and the Pensions Amendment Act, 1996. In addition, occupational pension schemes are subject to employment law, tax law, insurance law, social welfare law and more recently family law. Many schemes invest their funds and provide benefits through some form of insurance contract. At a minimum, certain contingencies, e.g. death or disability of members are 5 insured by the pension scheme. The standard type of investment structure used is either a unit –linked insurance contract or a with profit contract. In the unit linked arrangement, the scheme would buy units in one of the investment funds of the insurance company e.g. the Irish Equity fund, the fixed interest fund or perhaps a managed fund incorporating a broad mix of assets. The value of the scheme’s units would fluctuate with the value of the underlying fund. The assets in the underlying fund remain the property of the insurance company, the scheme’s assets are the units it holds in the fund. A with profit contract will to some extent guarantee a benefit at retirement equivalent to a specified rate of return. Where investment performance exceeds the rate guaranteed, the insurance company may declare an additional bonus, assuming assets invested earn above this minimum rate. However, in 2002 and so far in 2003 many with profit contracts have either not declared an additional bonus, or reduced projected payouts.(Prudential, Norwich Union, Standard Life, Legal & General and Scottish Widows.). The pension scheme could however manage it’s funds itself and not go the insurance route. Typically, in this situation, the scheme would place its funds with one or more fund managers having agreed in advance, investment strategies and key performance indicators. Accordingly the investment route might be represented as in Figure (1). Figure (1) Cash flows for pension Pension Fund Irish Govt Bd Irish Property North American Equities Irish Equities Fixed Int. Fund Irish Equity Fund Managed Fund II Managed Fund I ENRON AIB Eurozone Bond AIB BOI Invests via fund manager Invest through managed funds * Invest in specific sector / mkt * Pensioners Insurance Company Pensioner Pays pensions directly Purchases annuity *May incorporate an insurance contract Pays pension 6 RISK FACTORS Institutional Risk Pension contracts are long term, a contract written now may not be exercised for 40 years and last for a further 20 years. For many pension contracts risk is merely a function of investment policy, but for those pension contracts that involve indirect investment via an insurance company or a fund manager(s) or indeed where the members pension is funded by the purchase of an annuity, there are other third party risks. For instance, the outcome of a contract taken out with an insurance company is in no small part dependant on the continued existence of that company’s business (albeit in perhaps a different legal form). It is difficult for those entering contracts with an insurance company to know the nature of other contracts which may (in distress situations) take precedence in the distribution of investment returns (as in the Equitable Life Case), or whether contracts are written based on assumptions about longevity which are false (as in the Britannic Insurance case (Guardian Newspapers, 7/1/03). Insurance companies are also exposed to uncertainty where the statistical distribution of outcomes is not known. Indeed given uncertainty the long run survival of insurance companies is puzzling. Profitable insurance contracts cannot be written for something that is certain, but equally so for an event that is uncertain. While pension fund trustees may consider direct investment using a selected fund manager or a number of fund managers a more “hands on” approach which gives them greater involvement and control, counter-party risks remain. Consider the situation where the primary fund manager invests scheme monies in a fund operated by yet another third party fund manager (e.g. an Irish fund manager might invest in Far East equities via a Far East equity fund operated by an overseas fund manager). The pension scheme now has in addition to the counter – party risk associated with the primary fund manager, the risk associated with this additional third party. Many schemes whilst using the direct investment approach, fund members pensions on retirement by purchase of an annuity rather than paying the pension directly out of the scheme. Until the difficulties of Equitable Life the inherent risk in this for the members would have been seen as theoretical only. That view is changing. Perhaps the greatest risk, which scheme trustees have to contend with, is likely to arise from the quality of management in both the primary insurance/fund management providers and the various subproviders. It is very difficult to judge the nature of these risks but they nonetheless exist. 7 Investment Strategies: As at end 2001, the portfolio of assets invested in by pension funds was as shown in Table (3). This table shows that little more than 25% of the total funds under management were invested in fixed interest stocks and cash instruments. Less than 10% was invested in property whilst over 60% was invested on the stock market. Given recent financial history – three years of falling stock markets and market volatility stock market investments have proved very risky. It would be interesting to survey pension fund members on what their preferred investment choice would be – the low risk return with little or no surprises (pleasant or unpleasant) on retirement, or stock market speculation with the consequent highs and lows that this entails. It is probably fair to say that few employees, if they thought about it, would be happy to invest as much as 60% of their pension contributions in the stock market and increase the risk of being seriously under provided for at a time when their earnings capacity is nil or at best very vulnerable. Pension funds are concerned with retirement income provision, based on a set of predefined criteria including projected returns on capital invested. They should not be concerned primarily with speculation. It is puzzling therefore why their underlying investment strategies, incorporate practices which could potentially diminish even the original capital amounts invested? 8 Table (3) Asset Portfolios by Irish pension Funds Asset Type Market Value –euro millions % Asset Distribution by Sector Irish Fixed Interest – Government. 1,989.8 3.9 Fixed Interest – Corporate 299.2 0.6 Indexed Linked 137.8 0.3 Equities – quoted 7,862.6 15.5 Equities – unquoted 96.5 0.2 Property 4,318.6 8.5 Forestry 163.3 0.3 Cash and cash instruments 967.5 1.9 Other 364.2 0.7 Total 16.199.5 32.0 Non – Irish – Eurozone ex Ireland Fixed Interest – Government 6,729.3 13.3 Fixed Interest – Corporate 729.4 1.4 Equities 7615.2 15.0 Property 28.4 0.1 Cash and cash instruments 520.2 1.0 Other 89.7 0.2 Total 15,712.2 31.0 Non Irish – World ex Eurozone Fixed Interest – Government 924.5 1.8 Fixed Interest – Corporate 191.7 0.4 Equities – UK 4,312.8 8.5 Equities US 8,240.8 16.3 Equities Europe – Ex Eurozone 1,560.2 3.1 Equities Pacific Basin (ex Japan) 1,488.9 2.9 Equities Japan 1,426.1 2.8 Equities other overseas 91.9 0.2 Property 113.9 0.2 Cash and struments 86.1 0.2 Other 270.1 0.5 Total 18,706.9 37.0 Overall Total 50,618.5 100 IAPF Asset Allocation survey. Industry figures for pension fund performance over the period 1990 to 2002 are even more telling. 9 References: Andersen Pension fund Investment Bulletin –2002 Andrews E.S. and Hurd M.D.(1992), “Employee benefits and retirement income adequacy”, in Bodie Z. and Munnell A.H. (eds) “Pensions and the Economy”: Pension Research Council and University of Pennsylvania press: Philadelphia. ApRoberts L., “Pension Plans and Theories of the U.S. Labor market”, in Reynaud E. apRoberts L, Davies B. and Hughes G., “International Perspectives on Supplementary pensions. Actors and Issues”. Quorum Books Westport: Connecticut London. Blake D (1994b) – “Pension Schemes as options on Pension Fund assets: Implications for Pension Fund Asset Management”, mimeo Birkberk college, London. Bodie Z, Shoven J.B. & Wise D.A. (1987), “Issues in Pension Economics”. The University of Chicago Press. Commission on Public Service Pensions – Final Report. (2000) Connell, P. and Stewart, J. “Income of Retired persons in Ireland: Some Evidence from Household Budget Surveys”, in in G. Hughes and J. Stewart (eds), Reforming pensions in Europe: Evolution of Pension Financing and Sources of Retirement Income, Aldershot, UK and Brookfield, US: Edward Elgar, pp. 140156. Davis, E.P. (1996), “Pension Funds Retirement-Income Security and Capital Markets An International Perspective”, Oxford: Clarendon Press.. Disney R.(1996), “Can we afford to grow older? . A Perspective on the Economics of Aging”; The MIT Press: Cambridge, Massachusetts London. Friedman B.M.and Warschawsky M. (1990)- “Annuity prices and saving behaviour in the US”, in Bodie Z., Shoven J.B. and Wise D.A. (eds) “Pensions in the US Economy”: University of Chicago Press. Friot B. – (Year Published) “The Origins of French Supplementary Pension Plans: The Creation of the General Association of Pension institutions for Cadres (AGIRC)” in Reynaud E. apRoberts L, Davies B. and Hughes G., “International Perspectives on Supplementary pensions. Actors and Issues.” Quorum Books Westport: Connecticut London. IAPF (2003) – Asset Allocation survey – 2002, Dublin: Irish Association of Pension Funds. 16 Lutjens E, (Year Published) “Supplementary Pensions in the Netherlands” in Reynaud E. apRoberts L, Davies B. and Hughes G., “International Perspectives on Supplementary pensions. Actors and Issues”. Quorum Books Westport: Connecticut London . Mercer Investment Consulting – Market Insight report – 2002 (Full Reference) Minns R. and Martin.R – “Pension Funds in the United Kingdom: Centralisation and Control”, in Reynaud E. apRoberts L, Davies B. and Hughes G., “International Perspectives on Supplementary pensions. Actors and Issues”. Quorum Books Westport: Connecticut London . Office of Fair Trading (1997), Report of the Director General’s Inquiry into Pensions, vol. 1, London: Office of Fair Trading, available at http://www.oft.gov.uk/. Overbye E. (Year Published) “The impact of Industrial relations on the structure of Supplementary Pensions in Scandinavia” , in Hughes G. and Stewart J., “Pensions in the European Union: Adapting to Economic and Social Change”. Kluwer Academic Publishers: Boston/Dordrecht/London. Ostrup F. “The Development of Supplementary Pensions in Denmark”in Reynaud E. apRoberts L, Davies B. and Hughes G., “International Perspectives on Supplementary pensions. Actors and Issues.” Quorum Books Westport: Connecticut London . Stewart J. (1999) - “Pension Funds and Capital Markets”. Paper given at Policy Institute Seminar series in Public Policy, November 1999. Tepper. I. (1992) –Comment on Bodie and Papke in . Bodie Z. and . Munnell A. (eds), “Pensions and the US Economy” (Pension Research Council: University of Pennsylvania, Philadelphia). Wadensjo E , “The New Swedish Pension System”, in Hughes G. and Stewart J., “Pensions in the European Union: Adapting to Economic and Social Change”. Kluwer Academic Publishers:: Boston/Dordrecht/London. World Bank Policy report (1994)– Averting the old age Crisis.- Policies to protect the old and promote growth. Oxford: Oxford university Press. 17 Even though returns have on average been negative over the last three years, costs of managing all pension schemes have been positive, as they are partly determined by funds under management not fund performance. For example with the new PRSA scheme management charges can be as high as 5% of funds contributed and a further 1% of funds managed. Charges for what are described as ‘non-standard’ PRSAs can be even higher. Pension management charges can be even higher for individual schemes such as AVC schemes. It is easy to see that with falling or projected stationary equity markets, and low returns on Government debt, the main benefits to pension policy holders comes from the State through tax relief. Although as holders of equity linked Special Savings Accounts have discovered, even with a State contribution of 25% of the amount invested, returns may still be negative. 18 19