In a period of low or no returns, ideas for cost-cutting can look as attractive as any investment strategy to hard-pressed pension fund managers. So in this month’s Off the Record we ask managers how they think companies and other organisations can control the costs of their pension plans.
The longest bear market anyone can remember has put pension fund costs – both funding costs and administrative costs – under extreme pressure. The cost of meeting liabilities had already been rising as a result of demographic changes like longevity. Now falling equity prices are pushing this cost even higher.
Administration costs have grown with the progressive tightening of pension regulation. As more pension funds find themselves under-funded, regulators are imposing more stringent reporting requirements – which cost pension funds time and money. Other factors driving up costs have been the proliferation of defined contribution (DC) and the tax rules that govern them.
Some employers have tried to gain better control of costs by modifying their defined benefit (DB) plans, for example, by switching from final salary to career average plans.
Others have decided – rightly or wrongly – that the only way to have full control over the cost of their occupational pension plan is to switch from a DB scheme to a defined contribution (DC) scheme. Many companies with DB plans – notably in the UK – are now sealing them off by closing them to new entrants and introducing DC schemes in their place.
But is this the best or only way to cut pension plan costs? Are other less draconian strategies available?
Our poll finds little consensus about the correct course. For a start, there is no agreement about whether companies can cut the costs of their schemes without reducing the benefits. Only a small majority (54%) think it is possible to square the circle. One German fund manager observes: “It is not easy, but it is possible.”
Changing the design of the plan is seen as the most effective way to reduce costs. The managers who responded to our survey think there is greatest scope for cost savings in plan design (76%) followed by plan administration (57%) and funding costs (37%).
Specific suggestions for cost-cutting include moving fund management in-house, reducing administration and service provider fees, and minimising ALM studies and other consulting assignments. One fund manager even suggests scrapping occupational schemes altogether and providing employees with instead with ‘employee-managed’ alternatives based on a similar level of contribution.
A straight switch from DB to DC is the simplest change of plan design. However, this is likely to spark opposition, particularly in those countries where a DC plan is seen as a second best pension. A substantial majority of respondents (73%) think that a better solution would be to modify an existing DB plan. This will be good news for pension consultants, who are developing a useful sideline of business advising companies on alternatives to closing their DB schemes.
The cost-saving benefits of closing a DB scheme to new entrants appear straightforward. Two out of three (67%) think that the principal benefit of closing a DB scheme to new members is the saving in funding costs, in spite of the fact that closure does not remove the existing liabilities from the balance sheet.
However, there is some disagreement. “Oh, that it were that simple” is the heart-felt response of one manager. Some point out that it depends on a company’s human resources strategy and the new needs of a more mobile workforce. Others suggest that better risk management, and a reduction in P & L volatility, is the real benefit of closing a DB scheme.
There is certainly no agreement about the proposition that the alternative – a DC scheme – will generally be cheaper to run than a DB scheme. More than half (54%) of managers think that DC is no cheaper than DB and may be more expensive. Managers point out that, since DC plans require more administration, they are bound to be more expensive.
But higher administrative costs may be offset by lower funding costs in the longer term. One UK pension fund manager points out that “fixing the long term contribution level cuts volatility and invariably will lead to lower long term cost in comparison with the predicted higher funding costs for DB arrangements.”
One solution for reducing the cost of DB schemes is to strip them of their “non-core” elements, such as price indexation and survivors’ benefits.
This suggestions gets short shrift from our respondents Only 42% think that the sponsors of DB plans should consider withdrawing non-essential benefits to ensure the survival of their plans. Some feel that stripping out peripheral benefits goes against the spirit of a DB scheme. “A DB plan reflects a paternal employer approach and withdrawing these benefits is incompatible “ one fund manager points out.
Opinion is divided about whether the effects of any cost-cutting should be spread among active, deferred and retired members of a pension scheme. One in two (50%) agree with the suggestion that that all members of a DB pension plan should be expected to absorb the impact of any cost savings in terms of reduced benefits.
However, managers feel that there should be no reduction of accrued rights: “It’s okay to reduce future indexation for deferred pensioners and retired but not past rights,” one warns.
There is also some doubt whether all categories of members should have to bear all cost reductions equally. One pension fund manager suggests drawing a distinction between deferred pension holders and pensioners in payment: “Those whose benefits are already in payment have them secured in relation to the conditions prevailing before they retired,” he says. “Those in deferment should bear some of the cost in terms that they are likely to live longer and draw a pension longer.”
One possibility, he suggests, is to build an ‘age adjuster’ to reduce the impact on people with deferred pensions and ensure that active members share the additional costs with their employer.
Removing regulatory red tape is an attractive option for cutting costs. Two thirds of managers (67% ) think that less prescriptive pensions regulation would lead to lower costs for pension funds. One idea that gains in attractiveness when times are hard is that small pension schemes be subject to less regulation than large schemes. Some reformers have suggested a two speed regulatory system in which a lighter regulatory touch could be applied to smaller schemes or employers.
However, this idea gains little support. A large majority (79%) feel that there is no case for reducing the regulation of small schemes. “Small scheme members still need protection,” is a common view. “Smaller schemes are more likely to face problems so perhaps they should be more subject top monitoring,” a Dutch pension fund manager points out, while a German fund manager observes wryly: “Aren’t we always told that size doesn’t matter?”
The multiplicity of DC schemes also seems designed to increase costs. Perhaps their infinite variety could be reduced. However, this proposal also wins little support. Only 38% think that a reduction in the number of different types of DC pension products lead to lower pension costs. Some felt that this would have no significantly effects.
Tax is another matter. Complex plans spawn complex tax rules and vice versa. A substantial majority (75%) think that simplifying the tax rules governing occupational pensions would cut pension costs. Finally, would that European dream – a pan-European pension – help companies operating in more than one European country to cut their pension plan costs? Here there is strong support, with three in four managers (75%) in favour. “It would not cut costs by itself, but it would help,” one comments. And at this time particularly, every little helps.