OECD/ IOPS Global Forum On Private Pensions. Reforming Private DB Plans. Istanbul, Nov 2006 Brigitte Miksa, Head of AGI International Pensions

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1 OECD/ IOPS Global Forum On Private Pensions Reforming Private DB Plans Istanbul, Nov 2006 Brigitte Miksa, Head of AGI International Pensions

2 Private pensions of key importance in pension reforms Copyright Allianz Global Investors International Pensions/ BM Nov

3 Pensioners receive their income from different sources in the industrialized countries Sources of retirement income [%] 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Germany France NL UK US CH First pillar Second pillar Third pillar Source: Börsch-Supan 2004: Mind the Gap Copyright Allianz Global Investors International Pensions/ BM Nov

4 The ageing societies urgently require pension reforms Pension Reform Pressure Gauge, May India Greece Spain China Thailand Italy Belgium Portugal Austria France Japan Germany South Korea Taiwan Finland Sweden Netherlands Denmark Singapore Norway Switzerland Hong Kong United Kingdom Australia Ireland No reform need Minor reform need Persisting reform need Urgent need for reforms pressure to reform increasing Source: Allianz Group Economic Research Copyright Allianz Global Investors International Pensions/ BM Nov

5 Drivers of pension reforms Cutting back on the generosity of the state pension system - Increase number of contributors - Reduce number of beneficiaries - Reduce level of benefits Privatising pensions shifting responsibility for old age provision from the state to the individual - Occupational (employment-related) pension provision to achieve expeditiously comprehensive coverage of labour force - Strengthening supplementary private pensions by mandatory or voluntary, tax-sponsored schemes - 2nd and 3rd pillar private pensions as coexisting or intertwining systems Extending the coverage of funded pension systems - Introduction of defined contribution schemes (DC) Copyright Allianz Global Investors International Pensions/ BM Nov

6 The coverage of occupational pensions varies considerably Coverage rates of the second pillar [%] ,0 10,0 15, Source: Center for Research on Pensions and Welfare Policies Turin (CeRP) / EU Germany France Italy NL Sweden UK Copyright Allianz Global Investors International Pensions/ BM Nov

7 Reforming DB plans shift to DC Copyright Allianz Global Investors International Pensions/ BM Nov

8 Occupational pensions - the distribution of DB and DC plans across countries is inconsistent DC and DB plan assets distribution [%] 2004 Country Australia Canada Germany Netherlands Spain United Kingdom United States DC plans DB plans Source: OECD Pension Markets in Focus October 2006 Copyright Allianz Global Investors International Pensions/ BM Nov

9 Germany: from DB to (nearly) DC Defined Benefit (DB) Pre-defined benefit level Pay As You Go - no capital funding guarantee of lifelong pension provision financial risks lie with provider (state, company) Beneficiary bears no investment risk 1 2 Defined Benefit contribution oriented (Hybrid) defined benefit, based on periodical assignment of contributions financing internally or capital funded guarantee of lifelong pension provision investment risk lies with employer, total risk reduced compared to defined benefit scheme Defined Contribution with minimum benefit guarantee 3 Defined Contribution (DC) 4 Benefit = total of contributions with minimum benefit guarantee (min yield > 0%) (employer s covenant) Benefit = total of contributions invested lump-sum payment possible tax sponsored - benefits as lifelong pension payments occupational old-age-provision - typical for anglosaxon countries and Asia (reforms) capital funded - investment risk lies with provider (guarantee) beneficiary bears investment risks not constituent of occupational pension system Copyright Allianz Global Investors International Pensions/ BM Nov

10 In the UK the shift toward DC is ongoing, but a wholesale transformation will take a long time % of firms with such schemes % closed to new entrants % closed to new entrants and new accruals DB schemes DC schemes Mixed DB/DC Total asset value [ bn] Survey among 390 firms with 2.8m plan members Source: Association of Consulting Actuaries 2005, UK Pension Trends Survey Copyright Allianz Global Investors International Pensions/ BM Nov

11 The number of participants in DB plans in the UK declines in the private sector, but rises in the public sector UK occupational plan participants in different plans [m] Private Sector Public Sector Private Sector Public Sector DB DC Source: Gordon Clark 2006, The UK Occupational Pension System in Crisis? Copyright Allianz Global Investors International Pensions/ BM Nov

12 Department, Branch, Subject of Chapter (optional) Pension fund regulation in the UK and the Netherlands fosters DB schemes differently UK Limits on overfunding encouraged contribution holidays in bull markets Pension protection fund opens up risk of moral hazard Underfunding aggrevated by raising accrued benefit obligation - Compulsory indexation - Compulsory survivor benefits Uniform minimum funding requirements Result: Complex system that discourages DB schemes Netherlands Funding coverage of 105% Cushion of up to 130% Flexibility in increasing funding status No extra capital for indexed benefits, only nominal benefits guaranteed Result: Rigid solvency requirements for nominal pension rights / flexibility for conditional pension rights reduce risks for sponsor and link up benefits and returns Sources: Philip Davis, 2004; Gordon Clark, 2006 Copyright Allianz Global Investors International Pensions/ BM Nov

13 The shift to DC plans has been particularly pronounced in the U.S. Workers with pension coverage, by pension type in the U.S. [%] ,0 61, , ,0 11,0 17,0 23,0 31,0 28,0 0 DB only DC only Both Pension participation of male workers dropped from 55% in 1979 to 45% in 2004, but rose from 36% to 42% for women 88% of assets and 86% of participants of DC plans are in 401(k) plans Source: Center for Retirement Research / Boston College 2006 Copyright Allianz Global Investors International Pensions/ BM Nov

14 How to switch from DB to DC plans in U.S. Freeze DB Reasons for a freeze according to Aon study: -Merger -Amount of contributions for the sponsor (45%) -Volatility of required annual contributions to the plan (39%) -Impact on corporate expense (35%) -Inability to accurately predict future contribution requirements (24%) Three options Hard freeze Soft freeze Partial freeze No additional benefits will accrue to any current plan participants from either additional tenure or increases in compensation Limit to increases for current participants in accrued benefits for additional years of participation, but definition of compensation used in formula may be allowed to increase Plan is frozen for some, but not all participants Hard freezes are quite rare and take place mainly among smaller firms* -10.1% of pension plans with fewer than 100 participants were hard-frozen in 2003 vs. 2.2% of those with more than 5,000 participants (PBGC) -Frozen plans are more likely to be underfunded Source: EBRI 2006, Issue Brief No. 291 *data refer to single-employer program Copyright Allianz Global Investors International Pensions/ BM Nov

15 Only after termination of DB switch to DC plans in the U.S. Options for terminating (single-employer) pension schemes - Procedure of a standard termination - Plan must have enough money to pay all benefits, whether vested or not, before plan ends. - Promised benefits are paid out in the form of a lump sum or annuity - Procedure of a distressed termination - Employer must prove severe financial distress, so that PBGC will pay guaranteed benefits Between 1975 and ,256 adequately funded plans were terminated vs. 3,469 under-funded plans - peak with 48,500 terminations vs. 7,000 in *. Transferability of a DB plan into a DC plan - If participants of a terminated plan choose lump-sum distributions, they have the option of rolling over their accrued benefits to a DC plan (IRA or 401(k) Conversion into a DC plan only possible after termination of DB plan with all standard procedures Source: PBGC / Wikipedia Copyright Allianz Global Investors International Pensions/ BM Nov

16 The trend to DC plans is triggered by six developments The Perfect Storm * - Underfunding of pension plans - Shortfall among S&P 500 companies: $ 442bn** Increased volatility in financial markets makes funding of retirement benefits less predictable New laws and regulations in the areas of funding, solvency, and asset allocation as well as taxation have made DB plans overly complex and costly Labour mobility is on the increase Market-based accounting standards result in funding deficits of DB plans being reflected on balance sheets and volatile pension expenses Higher administrative costs of DB plans *Clark, G.L & Monk, A.H.B., University of Oxford, 2006; **Standard&Poors 2005 Copyright Allianz Global Investors International Pensions/ BM Nov

17 Privatising Pensions DC, individual control and responsibility for old age provision Copyright Allianz Global Investors International Pensions/ BM Nov

18 The shift to DC plans implies a different allocation of risks DB plans Investment risk absorbed by pension plan sponsors or by financial intermediaries in the case of life insurance contracts Longevity risk borne by the plan sponsor DC plans Investment risk borne by households Longevity risk borne by households Whereas households were largely insulated from financial market / longevity risks, they bear them in a DC world financial education critical Copyright Allianz Global Investors International Pensions/ BM Nov

19 Privatising pensions an illusion of control? DC schemes are intended to increase the individual s responsibility and control for pensions - employees are increasingly expected to make financial decisions that will determine their standard of living in old age DC schemes imply the assumption of - rational behaviour of individuals with regard to investment decisions - efficient markets protecting investors from systematic pricing errors But research on Behavioural Economics indicates the homo oeconomicus departures from rational behaviour cognitive biases influence decisions lack of understanding of financial markets impair investment decisions personal discretion people tend to overestimate their abilities Source: Kahnemann et al., 2005 Copyright Allianz Global Investors International Pensions/ BM Nov

20 Implications for the design of DC pension plans Pension plans with an autopilot : Automatic enrollment: participation in corporate pension plans increases considerably. Plans should discourage active trading. If savings rates are optional, default rates should be set adequately high, possibly with an automatic increase of pension savings on a regularly scheduled basis or at prespecified future dates. Plans should offer well-diversified, low-fee mutual funds as default choices. Workers who wish to make other choices may do so but good options should be available to those who do not choose. Choice overload reduces plan participation. If we are going to make people fly their own planes, we should expect them to rely on the autopilot, and it must be designed accordingly.* Source: *Kahnemann et al., 2005; Mitchell / Utkus 2003: Lessons from Behavioral Finance for Retirement Plan Design Copyright Allianz Global Investors International Pensions/ BM Nov

21 Thank you for your attention! Copyright Allianz Global Investors International Pensions/ BM Nov

22 Back up Copyright Allianz Global Investors International Pensions/ BM Nov

23 Definitions OECD (2006) Defined Contribution plans are those where the plan sponsor has no obligations over and above paying contributions. Two main types - Defined Contribution (unprotected): A personal pension plan or occupational defined contribution pension plan where the pension plan/fund itself or the pension provider does not offer any investment return or benefit guarantees or promises covering the whole plan/fund - Defined Contribution (protected): A personal pension plan or occupational defined contribution pension plan other than an unprotected pension plan. The guarantees or promises may be offered by the pension plan/fund itself or the plan provider (e.g. deferred annuity, guaranteed rate of return) Defined Benefit: Occupational plans where the plan sponsor has obligations over and above paying contributions, other than in defined contribution plans. Three main types - Traditional: DB plan where benefits are linked through a formula to the members wages or salaries, length of employment, or other factors - Hybrid: DB plan where benefits depend on a rate of return credited to contributors, where this rate of return is either specified in the plan rules, independently of of the actual return of any supporting assets or is calculated with reference to the actual return of any supporting assets and a minimum return guarantee specified in the plan rules - Mixed: A DB plan that has two separate DB and DC components but which are treated as part of the same plan Copyright Allianz Global Investors International Pensions/ BM Nov