This month’s Off The Record is about the expectations of members of occupational pension funds. Were these expectations once too high and are they now too low?
When defined contribution (DC) type plans were riding on the back of ever-rising rising equity prices, and defined benefit (DB) plans were well enough funded for employers to take pension holidays, pension fund members had few worries.
The problem for pension fund managers then was how to interest members in the operation and performance of their plans. Now, after three years of a bear market in equities, the problem is very different – how to handle a growing chorus of complaints about the poor returns that pension funds have achieved.
As pension fund managers prepare their annual benefit statements, they are bracing themselves for a barrage of criticism. Criticism from members of DC schemes who have seen the value of their equity investments fall, and criticism from members of DB plans that have seen schemes closed, replaced or wound up because they are financially unviable.
Press coverage of the ‘pensions crisis’ has fuelled fears further, while labour union opposition to scheme closures has polarised pensions provision into a battle between ‘them’ and ‘us’.
Could this have been avoided if pension fund members had had more realistic expectations? Is this a matter of better member education? Should pension funds do more to tell their members about the downside as well as the upside of pension provision?
In the UK ministers are reported to be considering proposals that would require companies to carry “health warnings” telling members when there is not enough money in schemes and alerting them to the fact that they may get lower benefits than promised. These proposals would require a company to compare promised benefits with a worst case scenario – the benefits that would be received if the scheme had to be wound up and its assets were used to buy annuity contracts.
Would health warnings – as the tobacco industry has argued about its own health warnings – frighten people unduly? Or would they alert people to the fact that a defined benefit is not the same as a guaranteed benefit?
What evidence there is suggests that people may not like what they hear, but they would like to hear it. Market research carried out by the UK Department of Work and Pensions found that although people would be shocked to be told that their schemes were underfunded, they would still want to be told.
We wanted your views – that is, if you could spare a moment from your preparation of reports to plan members. Are people more interested in the operation and performance of their pension plans than they were five years ago? A substantial majority of the managers and administrator who responded to our survey (86%) think that people are more interested. However, there were some dissident views. A manager at one Dutch fund suggest that if the number of people who turn up to meetings about the pension plan is any guide, members of his pension plan show no interest whatsoever. If people are more interested, are they more worried – given the poor press pensions are getting – and are they right to be worried? Again, a large majority agree that members are right to be worried, although some think that “ worried” is too strong a word and would prefer “concerned” or “interested”. Some of you point out that pension fund members are worried about matters other than the investment crisis.
Certainly the fall in the equity markets will only directly affect people with a DC plan and who have a high equity content in their portfolio – typically someone at the beginning of the scheme and some way off retirement. In countries where DC plans do not have a minimum guarantee, the member bears the total investment risk. But are they aware of this? A large majority of respondents (81%) think that pension fund members do not understand the transfer of risk involved in switching from a DB to a DC type pension. This may be changing, however. One manager observes that the current high profile of pensions has made members of DC plans more aware of the transfer of risk.
The corollary to this is that plan sponsors that operate DC type occupational plans should explain to members at the outset that they will bear most or all of the investment risk. Here there is almost unanimous agreement. A very substantial majority (95%) say that plan sponsors should explain the risk. However, one manager makes the point that risk is a two way street, and that the sponsor should explain the upside of a DC type plan as well as the downside. “They should explain the possibility of an enhanced pension should actual returns exceed expectations,” he suggests.
One solution is to provide the kind of health warning that is attached to investments and investment funds in some countries. This idea wins strong approval. A large majority (95%) think that sponsors of DC type plans should be obliged to warn members that the value of the equity investments in their pension plans could go down as well as up. One manager adds the rider that plan sponsors should not limit their warning to equities, but should include bonds as well. People should also be told about what their pension “pot” is likely to buy at retirement, he adds: “The purchasing power of the final fund to buy an annuity is also important, as is the structure of that annuity.”
The growing use of “lifecycle” DC plans, whereby pension plan members are invested in equities early in the stage of pension and bonds when they are approaching retirement, requires some knowledge of the principles of asset allocation. But do members have a sufficient grasp of these principles? Few of our respondents (19%) think they do. One UK pension fund manager points out that “many scheme members do not appreciate the range of differences in the scheme and the potentially significant difference in potential final benefits”.
Members of DB pension plans have other concerns – notably solvency margins and funding levels. But, again, do they understand these concepts sufficiently to know whether they should be worried? worry about them? Again, few managers (14%) feel that people understand these concepts. However, some UK managers suggest that plan members are on a steep learning curve, principally because of pension ‘scandals’ in the press. “These issues have certainly been brought sharply into focus in some high profile cases such as Equitable Life, so understanding is improving,” one UK manager points out.
In other European countries, the press has highlighted various pensions ‘scares’. In Switzerland, it has focused on underfunding and minimum guarantees; in Denmark and Sweden, it has focused on the solvency margins. In the UK, it has turned its spotlight on companies that have closed or plan to close their DB plans.
What effect has all this press scrutiny had? Has it made people more aware of pensions in general and their own pension in particular?
There is a surprising support for the press – a profession now ranked lower than politics. A substantial majority of managers (73%) think that press coverage of pensions crisis has been generally helpful in raising public awareness of pensions issues. However, some feel that press coverage of pensions issues has been “too simplistic and polemical”. And the manager of a Dutch pension fund makes the shrewd observation that press attention to pensions may have raised awareness but it has not increased understanding.
Labour unions have also played their part in alerting members to pensions issues. But has this helped or hindered understanding? On balance, managers feel that their intervention has been helpful. So, in the end, it is up to pension funds to do more to educate their members - something that most of you (89%) agree with. Meanwhile, back to the report….