Address to IAPF Investment conference – 26 March 2009
Brendan Kennedy
Chief Executive
The Pensions Board
Thanks for giving me the opportunity to speak.
These are difficult times for defined benefit pensions. Obviously we are all aware of the investment losses since mid-2007 – 40% is not untypical. What you may not be aware of is that a recent OECD study into pensions losses shows that Irish losses are the worst of the countries examined, and are about 8% worse than the next worse country.
But schemes are also trying to deal with the cost of increasing life expectancy, and all of this at a time when the sponsoring employer’s ability to contribute is in many cases significantly reduced.
As a result, scheme trustees and their sponsoring employers are being forced into a fundamental rethink of their defined benefit scheme and specifically a rethink about what they can afford. What I want to talk about is about the basis on which this rethink is undertaken.
I have heard the argument that it is too early to start this process, and that the markets will to recover. I do not agree with this. Like everyone in this room, I too hope that the markets will recover. However, in the short to medium term, we simply do not know. Operating on the basis that a recovery is inevitable or even likely is not responsible scheme management.
When trustees and employers reassess their scheme, the fundamental issue is what can be afforded, and any rethink must avoid overpromising. Overpromising does not achieve anything in the long run for scheme members, and the efforts to meet unaffordable promises can create additional problems.
Funding, investment strategies and employer covenant are interlinked. There is a sequence which runs
- Affordability
- Employer covenant
- Funding and sustainability
- Investment strategy
In the first instance, trustees must decide whether the scheme benefits are affordable, evenif past service losses are ignored. This is not a regulatory obligation, but is an assessment that the trustees should make themselves.
It is a tradition of Irish scheme funding to assume in the calculations that equities will outperform other forms of investment. We all know that there are studies that show that since 1919, equities have on average achieved this outperformance. But recent experience has shown us that there can be very long periods over which equities do not outperform, and in fact expose the investor to very serious short term losses. Specifically, over the past 30 years, equity returns only just match bond returns. I do not think that it is appropriate, when considering the affordability of scheme benefits, to assume that future equity outperformance is a given. Perhaps over time, the pension scheme will earn better investment returns than have been assumed, as a result of equity investment. However, one of the lessons we can and should take from what has happened since 2007 is that additional returns from investing in equities cannot and should not be relied on. Any assessment of scheme affordability that assumes that this additional equity return is inevitable is not a realistic or sustainable assessment of the scheme.
In making this assessment, a further critical factor is a realistic assessment of future life expectancy. While the level of future mortality improvements is by definition uncertain, the latest available evidence suggests that future pensioners are going to live significantly longer than has been allowed for in the current design of defined benefit pension schemes.
If the scheme is affordable, the next question, on the same basis, should be whether the past service deficit can also be afforded.
If current benefits plus deficit can be afforded, are they sustainable? Put another way, can the scheme withstand a bad year? Could the scheme afford the consequences of, say, a 25% equity loss at the same time as a 0.5% fall in yields? There are much more sophisticated investment risk models that trustees and their advisors may wish to explore. However, if a scheme does not satisfy the kind of simple test I describe, these more sophisticated approaches are not relevant.
This stress testing is the question that gets to the heart of the employer covenant. How much, if any, increased contribution can your sponsoring employer bear?
The investment strategy will determine the vulnerability of the scheme to bad years. For the typical Irish defined benefit scheme, investment risk translates into a risk that the level of contributions cannot be afforded. If your investment strategy puts the scheme at risk of costing more than the employer can afford, I don’t see that the scheme is affordable or sustainable. In the first year of poor equity returns, the scheme may have to reduce benefits. This is not a firm basis for pension provision.
I am saying that trustees and their sponsoring employers should explore how much investment risk their investment strategy exposes them to, and how well placed the scheme and the sponsoring employer is to withstand the possible outcome of this strategy. This is not an original statement or particularly sophisticated approach. But it is disappointing that I should feel the need to have to say it today. From our dealings with defined benefit schemes, we in the Pensions Board do not have the impression that exploring sustainability is a common approach. Too often, we see schemes whose only goal is to keep contributions to a minimum, and which give no thought to risk.
It is a cliché that pensions are long-term: this is often given as a reason why short-term issues are not important. The truth is the other way round. Pensions are long term, and therefore they must be able to survive what will happen in the short term in order to deliver on their long-term promise. Trustees have a clear responsibility to think about this and to consider what the short term may bring.
None of this should be interpreted as being an attack on DB. There has not been enough notice taken of how badly DC schemes have performed. However, if DB is to be a viable alternative to DC, it must be managed in such a way to have long-term viability and affordability.
As you know, the Government plans to publish a pensions framework in the near future. It is a reflection of the importance of pensions that the Government remains committed to producing this despite the very difficult financial issues that it has to deal with. Like everyone else involved in pensions, I look forward to this publication and recognise its significance. But in the long term, the most important influence on whether a pension scheme can meet its obligations is not regulation, not the funding standard, but the prudent management of that scheme by its trustees and the support of the sponsoring employer.
Before I conclude, I want to talk briefly about compliance. The Pensions Board has seen an increase in the number of employers who are deducting money from employees’ pay packets but not passing it on to the pension scheme. We are also investigating cases where monies may have been diverted from the pension scheme. The Board sees this as about the most serious offence it is possible to commit, and we will do whatever it takes to pursue these cases where the money is not reimbursed to the pension scheme. Last year we secured a High Court order against an employer for over €180,000 and there is an arrest warrant outstanding for an individual in respect of a Board prosecution. We will be issuing further summons shortly.
The Pensions Board sought and was granted powers to seize records not just from employers but also from scheme advisers and relevant professionals, such as employers accountants, and we can, if necessary, enter offices in pursuit of those records. We have already had a number of cases where professional firms have decided to cooperate with us after we pointed out the powers that we have. I have no doubt that the great majority of those involved in these situations will be cooperative, but the Board will have no hesitation in bringing professional complaints or criminal charges where needed.
Thank you for your attention.