ANALYSIS:Current jitters over pension funds underline the need for reform of the whole pension sector, writes Jim Stewart
A RECENTLY leaked document prepared for the Minister for Social Welfare and presented to the Cabinet has aroused considerable interest. It is not the long-promised "framework for pensions policy", but rather it is a frank summary of many of the issues facing our pension system.
The memorandum states that most defined benefit pension schemes are not capable of meeting their liabilities. Many members of pension schemes will be puzzled as to how this could possibly be the case.
Pension fund assets values have fallen in line with all other asset classes, other than Government bonds. Compounding this deficit is a likely reduction in dividend income.
Banks for example, will reduce dividends to increase capital ratios and/or face restrictions on paying dividends as a condition of the State purchasing equity or preference shares. Banks, facing a likely capital shortage, are not in a position to meet any pension deficit.
Many non-financial firms will face a deficit in their pension scheme at the same time as their profits are falling. Those individuals who are members of defined contribution schemes including those with personal pensions such as PRSA's, are in an even worse position than those in defined benefit schemes because of the collapse in equity values.
Current policy emphasising funded pensions such as PRSAs has not proven to be the forecast solution to pension provision.
The risky policy of borrowing by the State to invest in equities is shown by losses of the NPRF of 17.3 per cent for the nine months to September 2008. In the Stability Programme Updatepublished in the Budget statement, NPRF assets were valued in June 2008, at 11 per cent of GDP thus reducing the debt/GNP ratio to 25 per cent.
Market falls since then mean that at current valuation levels the debt/GNP ratio including the NPRF and before allowing for this year's increased borrowing, is likely to be several per cent higher.
Equity values for non-financial firms may recover in time, but equity values for financial firms as in the dot.com case, are unlikely to recover to values before the crisis, because the economic environment for financial firms has changed in a fundamental way. This means that pension deficits can only be removed by increased contributions by employees and employers.
The pensions industry argues that one solution is to change the funding standard. The current standard states that if a pension scheme was wound up, assets should be sufficient to meet liabilities. Employers representative body Ibec and others have argued that this should be changed to reflect the likely continuing existence of the sponsoring firm, hence the implicit guarantee that funding will be provided to meet pension liabilities.
However currently a sponsoring firm has 3 years to make up any deficit so presumably, the proposal is to extend this period. Pension liabilities must necessarily be an estimate as they are based on actuarial assumptions over a long time period.
A more pressing issue is the extent of pension fund deficits of those firms likely to be forced into liquidation or of firms which are restructured through mergers, or takeovers and here the current standard provides valuable information.
Those who are already retired receive priority in the event of a pension fund not being able to meet all its liabilities.
A key issue for the 52,000 individuals (2005 data) who currently receive pension income via an annuity is whether the assets and income of insurance companies are sufficient to meet these liabilities.
In addition to losses on equities and various debt instruments, it is likely that insurance and other companies currently face losses on capital guarantee-type products and on any annuities sold with guaranteed increases in income streams after retirement.
Share prices of life insurance companies have fallen and remain volatile. One reason for falling share prices may be greater risk of insolvency. A collapse of a life insurance company would pose considerable difficulties in the area of pension provision, as evidenced by the problems with Equitable Life.
In addition to the collapse in the value of pension fund assets, many individuals have seen dramatic falls in their wealth through falls in the value of housing. Those with endowment mortgages have suffered a double blow.
Individuals owning shares, especially bank shares, have experienced large losses. The most recent annual reports show that there were 47,652 individuals owning fewer than 1,000 shares in AIB, 41,000 in Bank of Ireland and 125,000 in Irish Life and Permanent. These shares are now valued at 8-10 per cent of their peak values.
Some individuals may have lost substantial sums through the failure of debt instruments based on subprime loans, for example ISTC in Ireland and others through investments in property-related bonds. In short, many individuals who have planned for a reasonable income in retirement will experience a fall in their pension payment and have lost a substantial part of their savings.
Those who considered that the social security pension would form a minor part of their retirement income now realise that it will in fact become a far more important part. This needs to be recognised by policy makers who should consider further developing the social security pension system.
Though likely to provide a smaller share of future retirement income, occupational pension funds are likely to remain an important component of the Irish pension system and the provision of occupational pensions needs to be reformed. Costs of providing occupational pension funds (fees, management charges etc) are too high.
The industry needs to develop new low-cost, low-risk products. For example in Denmark pension fund assets may consist of a cash deposit only account. Charges on such accounts should be close to zero.
Finally, some commentators have advocated using the assets of the National Pension Reserve Fund to fund capital contributions to banks. Policy in a number of countries is switching from a focus on bank rescues, purchasing illiquid and risky debt instruments - the so-called toxic loans - to providing a fiscal stimulus.
Further State contributions to the NPRF should be ended, which would require new legislation. Existing assets should be switched to euro zone government debt issues to minimise risk. These assets should then be drawn down to fund government spending and in addition to stabilise and enhance the real economy in particular the indigenous sector, and those firms most likely to provide a basis for a competitive, innovative economy.
In conclusion, now is the time to reform our pension system and to move away from a high- cost, high-risk strategy of funding pensions through risky investments in equity markets.
• Jim Stewart is a member of the Pension Policy Research Group at the School of Business in Trinity College, Dublin