Pension benefit indexation rules

Rachel Fixsen provides an overview of defined benefit pension indexing rules in three European countries

Germany

In Germany, for occupational pensions paid on a defined-benefit basis, there is no indexation for employees during the deferred period, but there is once pensions are in payment.

But while there are regulations governing this indexation, there has traditionally been some flexibility for employers. Eberhardt Froitzheim, head of consulting at Mercer Human Resource Consulting in Frankfurt, notes that a clause in the 1974 Betriebsrentengesetz (Employment Benefit Law) governs the indexation of pensions.

Normally, companies should index pensions in payment to the consumer prices index (Preisindex für die Lebenshaltung), but they can deviate from this if company finances are bad, he says: "They can apply to the authorities to do so, but only for a time."

Klaus Stiefermann, general manager of the German Association for Company Pension Schemes (ABA), says German employers are required by law to check pension payments every three years to see if they should be increased. "It is necessary to look at inflation, and on the other side, at the financial situation of the company," he says.

Stiefermann explains the reasoning behind the law's flexibility on indexation. "They didn't want a situation where the company could get in trouble, or that the increase in salaries for active employees would be lower than for the retirees." But he adds that for decades this legislation caused problems, because many cases ended up in the courts due to the number of factors that had to be taken into account.

Under current law, for pensions financed by deferred compensation - contributions from the employee themselves - the paid pension has to be increased by at least 1% a year, Stiefermann says.

And where a company has a Pensionskasse to manage pensions arrangements, the law requires benefits to be increased by a rate of 2.25% a year, which eradicates the need for the three-yearly assessment.

In practice, Froitzheim says that many German companies used the 1% annual increase method anyway, in order to make their pension liabilities more of a known quantity. "Some companies chose to do that before the law came into force, but that was not a guaranteed situation," he says.

There are moves within the proposed EU Portability Directive to introduce mandatory indexation of benefits in the deferred period as well, Froitzheim observes. But according to Stiefermann, the draft of this directive should ensure that German employers will not have to change current practice.

The lack of indexation can take a big bite out of a pension rights in real terms, Froitzheim points out: "If an employee stays with a company between the ages of 20 and 40, then he has vesting rights, but there's no increase in the vested pension between the age of 40 and 67, so the pension isn't worth that much because of inflation."

In Germany, DB schemes are sometimes based on final salary, sometimes on career average and sometimes on a more fixed pension level.

Netherlands

Rather than offering an outright guarantee that pensions will keep pace with the cost of living, pension funds in the Netherlands offer what is known as conditional indexation on their DB pensions.

Renske Biezeveld, policy officer at the Dutch association of industry-wide pension funds (VB) says there are some provisions regarding indexation in the FTK pensions regulatory framework.

"A pension fund has to make clear what ambition it has and how it is going to finance this," she says. "Indexation can be financed through higher premiums, through investment returns or a combination of both. A pension fund has to have a certain funding level before it can offer indexation."

Pension funds in the Netherlands have to run long-term continuity tests - on a 15-year horizon - which show the likelihood that indexation ambitions will be met.

"The results of this test have to be communicated to participants. As of next year, there will be a so-called indexation label, which shows the likelihood of indexation by a pension fund, compared to other pension funds," Biezeveld says.

"There has to be consistency between the level of indexation a pension funds is aiming at, and the way it will be financed. If from the continuity test it appears that it is very unlikely that a fund will be able to grant indexation, the fund should not communicate that it has an ambition to indexation," she says.

It is the social partners, who form the board of a pension fund, who decide on the level of indexation.

Tobias Bastian, sales and accounts manager at Hewitt Associates in Eindhoven, explains what is behind the practice of conditional indexation.

"The new framework for financial supervision says that solvency levels as well as premium levels depend strongly on the indexation ambition," he says. "Unconditional promises or even the idea that indexation is something that can be considered as ‘granted', lead to much higher levels. Therefore many funds have reworded their ambition level to something that is completely conditional."

As long as boards do decide to grant indexation from year to year, Bastian sees the system existing for long time to come. But as investment returns change heavily from year to year, the funding ratio could also, he says, forcing boards not to grant indexation in some years, or only to index partially.

"If this is offset in the ‘good' years by extra indexation, then there is no problem," he adds. But Bastian does not see funds giving extra indexation. "Boards will decide to use extra investment returns for strengthening the fund's financial position," he suggests.

"Therefore, I foresee more and more conflicts between pension funds and retirees. And since most schemes have changed from final pay to average wage, lower indexation will also affect the pension outcomes for active participants, resulting in time in even more conflicts about indexation."

UK

As they stand now, the UK's rules on indexing of DB pension schemes are among the most generous of all developed economies, believes Michelle Lewis, senior policy adviser at the National Association of Pension Funds in the UK.

In an OECD study of 16 developed economies, only Spain and Finland had a more generous revaluation requirement.

The current rules state that deferred pensions must be indexed to the retail prices index (RPI) or 5%, whichever is the lower. Pensions in payment have to be indexed to RPI or 2.5% - again, the lower of the two.

However, the UK's unique situation makes the country's pension sponsors more vulnerable than others to the proposed Solvency II legislation, according to Philip Shier, chairman of the pensions committee of the Groupe Consultatif Actuariel Europeen, the umbrella group for EU actuarial associations.

"The only country which actually provides indexation both before and after retirement is the UK, so the UK would be very badly hit by legislation such as Solvency II because of the requirement to provide technical reserves," he says.

The Association of Consulting Actuaries (ACA) has made a suggestion that some schemes in the UK at least could adopt a similar structure to the Netherlands. "The conditional indexation [of Dutch schemes] has worked pretty well until the last two or three years, when there were enough reserves," Shier notes.

There has been some cutting back on indexation in the UK, he points out. Up to April 2005, the requirement was for UK DB schemes to increase benefits by RPI up to a maximum of 5% in payment, but the 2004 Pensions Act reduced this to RPI up to 2.5%.

Even so, the relative generosity of the indexation is still a worry in some quarters of the pensions industry. "The concerns surrounding revaluation is that the level of revaluation ultimately drives up the costs for those employers that currently or previously ran a defined benefit pension scheme," says Lewis.

"The knock-on effect is that on top of issues such as overall regulation, longevity and fluctuating investment returns, it is one more issue that the some employers feel is a burden."

Moves are now afoot to ease this burden on sponsors. "The UK Government, supported by the NAPF, is putting through a change in the law - the Pensions Bill 2008 - to reduce the cap on revaluation for deferred members from 5% or RPI, whatever is the lower, to 2.5% or RPI, whatever is the lower.

"This will only apply to future accruals and brings it into line with the ceiling for indexing pensions in payment," Lewis says. "This will reduce the cost burden for employers and transfer some risk to their former employees - deferred members.

"The proposed lowering of the cap is important in helping to sustain defined benefit provision in the UK. It will also help to reduce costs and also means that risk is shared more equitably between the employer and employee. Even with these changes, UK pensions will still have one of the most generous systems of pensions indexation in the developed economies," Lewis continues.

Shier observes that Ireland is the only other country in Europe to have a requirement for indexing benefits in deferred pensions, though it has no such legal demand for indexation of pensions in payment.

Inflation case study: Pensioenfonds Horeca en Catering

Like other Dutch pension funds, Pensioenfonds Horeca & Catering (PHC) has found its own solutions to some of the challenges posed by solvency regulation in the Netherlands, steering clear of guaranteed indexation while still striving to help pensioners keep pace with the cost of living.

The €2.2bn pension fund for the Dutch hotel and catering sector has a policy of conditional indexation, which makes the correction for inflation dependent on its actual financial position.

Late in 2007, it granted participants an indexation of 3% for the following year, which was a one-off payment applying to its 700,000 active participants, deferred members and pensioners.

Explaining the background to the conditional indexation policy, Ernst Hagen, head of investments at the fund says that one of the risks in the current Dutch FTK solvency regulatory system is that it only looks at the nominal value of assets and liabilities.

"This creates a bad situation for pension funds when interest rates go down, because this might reflect lower inflation. From a nominal perspective, your liabilities will go up tremendously because they have a long duration, while assets only go up slightly because they are short term.

"For the central bank, this becomes a signal, whereas in real terms, your situation might have been improving," says Hagen.

There is a conflict here for pension schemes that want to provide indexation for members' benefits, he says, because any scheme expressing that intention is deemed by the central bank to be offering a guarantee which then has to be incorporated into its liabilities under solvency regulations.

"Our external communications are very careful to say it is our ambition to keep pace with inflation, but they will not put any guarantees in writing," Hagen explains.

This has happened across the country in the last two years, he says, with any guaranteed indexation being removed from Dutch pension contracts. There are other risks for pension funds in the new regulation, he says.

"The danger is that those pension funds that have not been well advised want to remove the effect of interest rates on the coverage ratio, and have introduced LDI strategies in the form of swap structures or interest rate hedges, which means they fix their interest rate.

"This results in the nominal interest rate being lower so the solvency requirement goes down, which is seemingly very attractive, but a the same time, if you lock in your interest rate and inflation then goes up, you cannot afford to index your liabilities any more. That is a trap which has happened to a number of pension funds."

PHC chose not to fix its interest rate, Hagen explains. "We implemented a swaption collar. If interest rates go down below 3.75%, then this option will be worth something. We can benefit from interest rates going down, so we have some protection, but we are not forced to enter into the contract."

The new regulations do contain some short sightedness, he says. "And there's a danger that pension funds that pension funds might take too little risk. "Whereas pension funds are unique as institutional investors in that they can think long-term with liabilities that are to be paid out between next year and 60 years hence, regulations are pretty strict about solvency ratios."

Some pension funds have hit the ‘soft floor' of the minimum solvency limit of between 120% and 135%, depending on the risks in the portfolio and hedging steps taken, and there have also been funds that have hit the ‘hard floor' of 105%, Hagen points out.

Those hitting the soft floor have to give the Dutch central bank a plan explaining how they will rectify the situation in 15 years, and those at the lower level have to issue a plan for correcting things in just three years.

"Which typically means that if you're going to rectify the solvency level in three years you have to take on more fixed income. The question is, is this the right thing for pension funds that have a much longer horizon?"

The timing for such a move is likely to be bad too, he observes. "The worst thing to happen after a market crash is to be forced to move into fixed income because then you can't recover," he says.

However, there are benefits in the advent of the new rules, he stresses. "A good development is that both the assets and liabilities are valued similarly; it's a good thing to ensure that liabilities can be paid out in the future."

And pension boards have been forced to be more aware of investment structures and how they work, which is positive, he adds.