Defined benefits or defined contributions ?
Does this debate concern the Pension Fund?
Bernard Cochemé, UNJSPF
Not a day goes by without the press
reporting on the funding problems
of pension plans. The most
recent focus was on the pension
plans of American car manufacturers and of
a number of large airline companies. Before
that, the Enron scandal and the
Maxwell affair had shed light not only
on the problems of large-scale fraud,
but also, and more specifically, on the
opaque and questionable financial
relationships between certain companies
and their pension funds.
The company/pension fund relationship
seems to be in deep crisis,
for a number of reasons: a company
experiencing financial difficulties
may, for example, find it difficult to
honour its commitment to its employees’
pension fund, which may result
in the fund being placed under the
supervision and management of
some public guarantee mechanism such as
the Pension Benefit Guaranty Corporation
(PBGC) in the United States. In turn, the
financial difficulties of a pension fund can
lower significantly the rating of a publicly
listed company or even push it to the brink
of bankruptcy.
Invariably, such situations lead to a
sharp reduction in the amounts guaranteed
to employees, resulting in severe
financial deterioration for current and
future retirees. The consequent revision
of company pension plans includes the
abandonment of the income guarantee
mechanisms that characterize defined
benefit plans and a transfer of the risks
from the company to its employees, which
is characteristic of defined contribution
or similar retirement savings funds.
Whenever new cases come to light, the
question that is often asked is whether
similar perils await the UN Joint Staff
Pension Fund, more specifically,
whether the Fund is protected against
such dangers.
The purpose of this article is to attempt
to answer these questions by reviewing
the risk factors for the Fund in the light of
the experiences of other pension funds.
There are three main risks inherent
in the difficulties that may be
encountered by defined benefit
plans: overcommitment, underfunding
of obligations, and failure to meet
the expectations of stakeholders
The risk of overcommitment
What is striking from a review of the
factors that have led pension funds into
crisis is the general recognition that
retirement benefits have continued to
increase, including periods when pension
plans were already experiencing
serious difficulties. The explanation lies
in the fact that retirement benefits are
more often than not components of a
broader negotiation on conditions of
employment or wages. Thus, when
employers, public or private, are faced
with difficulties in balancing their budgets,
which are particularly severe during
periods of economic recession characterized
by tax losses or lower
revenues, decisions are easily taken to
increase future retirement benefits,
since they have no immediate impact on
the budget, unlike an increase in wages.
This arbitrage mechanism in favour of
the present and against the future is
reflective of the reality that the ultimate
responsibility for respecting the commitments
given in a defined benefit plan
lies wholly with the employer. If the
employer guarantees it, who then can
oppose it? History has shown that this is
an illusion, since this fragile protection
is easily brushed aside in the face of
severe economic difficulties.
What is the situation of the United
Nations Joint Staff Pension Fund? We
should note first that the Fund manages a
multi-employer plan and that, moreover,
the plan itself is managed by
the Board of the Fund (United
Nations Joint Staff Pension Board), a
collective and tripartite deliberative
body on which the member organizations,
the governments and the participants
are represented. Furthermore,
the decision-making process
involves a number of different
authorities. The process is a rather
complex one and also relatively
slow, but has the advantage of not
being subject to the decision of a single
member organization acting
under the pressure of an event that
is extraneous to the Fund’s objective.
The Fund’s history has also shown that
when a financial imbalance develops, as
disclosed by periodic actuarial calculations,
the Pension Board will examine various
scenarios for redressing it using a
combination of measures that involve both
contributions and benefits. The same indepth
review even happened in a surplus
situation. The most recent example of the
implementation of this regulatory review
mechanism is the tripartite working group
established by the Board in 2000. The
report submitted in July 2002 reviewed the
regulations and entitlements and proposed
changes involving a number of scenarios
for the Fund’s long-term health. In
other words, the cost of each proposal was
quantified and prioritized and the conditions
for its implementation were linked to
anticipated developments in the actuarial
situation. The fact that these economic and
actuarial aspects are taken into account
and that care is taken to ensure consistency
with social and human resources management
policies undoubtedly reflect a
robust approach to the problem and
demonstrate a concern for accountability
over the long term.
Evidently, this approach is made easier
by the very nature of the activities and
statutes of the international intergovernmental
organizations that are members of
the Pension Fund. They have long-term
mandates which, while not obviating the
need for periodic adjustments, at least do
not make them directly subject to fluctuations
in the economic situation or in the
financial markets.
Risk of underfunding
It should be recalled here that the main
objective of defined benefit plans is to
guarantee their obligations with adequate
funding. Otherwise, the burden for paying
future retirement benefits would fall to
future generations or the benefits would
have to be reduced significantly.
Capital funding is derived from contributions
in excess of benefits payable
and/or income from investments in the
financial markets. The financial difficulties
experienced by a pension fund may be
attributable to a variety of factors: too low
contribution rates, lower than anticipated
performance of investments or a combination
of the two. With regard to contributions,
it is not unusual for companies in
years of high returns on investments to
decide to go on a «contribution holiday», in
other words to pay only a part of their contributions
or quite simply to decide to suspend
temporarily the payment of contributions.
Experience shows that it is never
easy to resume the payment of adequate
contributions after a period of interruption,
especially if the economic situation
has deteriorated or if the company’s performance
is improving more slowly.
Investment performance fluctuates as
does investment income. Performance
must be compared against a previously set
target, which must be consistent with the
rates of return used for the long-term valuation
of liabilities. In any case, the choice
of a yield target must credibly match the
rates of return sought by the financial markets.
Some latitude exists in this area and a
number of techniques are employed in
selecting an average rate of return or in
aligning the market value of financial
assets. The problems begin to arise when
performance falls below expectations,
which generally means that the target
yield was set too high or that the management
of the investment portfolio was below
par. It is clear that the choice of a long term
rate of return has potentially enormous
consequences for the amount of capital
coverage that would need to be maintained,
since a high anticipated rate
requires significantly less immediate
funding than a lower anticipated rate. Conversely,
a low anticipated rate requires the
maintenance of higher reserves.
The choice of a high anticipated rate of
return for the future, coupled with
mediocre current financial performance,
presents companies with an intractable
dilemma: increase their reserves to an
appropriate level or reconsider the level
of their commitment. Faced with this kind
of situation, which often arises during periods
of economic downturn, many companies
opt for changing their retirement
plans into defined contribution funds. The
company disengages by transferring the
risks, including the investment risks, to its
employees, who thereafter must rely only
on their own investment strategy to build
up the capital sum that will replace a guaranteed
regular pension.
In the case of the United Nations Joint
Staff Pension Fund, the rates of return
used for actuarial calculations are fixed
after wide consultations involving the
Committee of Actuaries, the Investments
Committee, and the UN Joint Staff Pension
Board or its Standing Committee. The final
decision seeks to reflect a number of concerns:
ensure the credibility of the rate of
return selected as the target rate by comparing
it with current rates; verify that on
average this rate of return has been
achieved by the Fund in previous years;
and confirm that the rate for future years is
realistic under prudent and agreed upon
economic scenarios. Credibility, consistency
and realism are the three pillars of the
method used by the Fund. It goes without
saying that the rate of return thus selected
should not be subject to frequent change.
With regard to the financial performance
of the Fund’s investments, particular
emphasis is placed on the asset allocation
strategy, i.e. the allocation of investments
among the various principal investment categories, since this is critical to the achievement
of a defined performance target. The
fact that the Fund continues to enjoy a positive
cash flow, with income from contributions
and investments substantially exceeding
benefits paid, allows us to pursue a
long-term strategy that emphasizes stocks,
while mitigating the volatility and risks
associated with stocks by also holding such
complementary assets as bonds, real estate
related or short-term investments. This
approach has yielded very good results in
the past. For the future, a deeper analysis
will be undertaken of the constraints and
risks using for the first time a structured
comparison between commitments of all
kinds on the liability side and the Fund’s
financial holdings on the asset side. This so
called asset/liability management technique,
which is commonly practised by pension
funds, should contribute to better management
and decision-making on, to cite but
one example, how to manage the risks of
change. This prudent approach is necessary
for the healthy and sustainable management
of the Pension Fund. By placing
emphasis on the most important parameters
and on the conditions required for the
long-term balance of the Fund, they help to
increase familiarity with and the predictability
of the costs of retirement plans.
Failure to meet the expectations of
stakeholders
This is without doubt one of the most difficult
risks to determine and also to address,
since expectations may be multiple, contradictory
and changeable. This risk arises from a
number of factors. It is often present when the
breakdown by age develops in such a way as to
create a sort of inter-generational conflict,
when the concern to preserve a system built up
over many years leads to a rigid conservatism
that becomes a barrier to the introduction of
necessary changes, when economic constraints
clash with social goals or quite simply when
expectations reflect the fashion of the day.
There are examples of companies that terminate
a defined benefit plan even though it is
actuarially balanced in order to create a
defined contribution plan, following the example
set by their more recent competitors. Similarly,
a population of low average age and high
mobility will probably be less interested in
delayed access to their retirement benefit preferring
the payment of a lump sum much earlier.
Temporary situations, such as a very good
performance of the financial markets, may
also give rise to pressures for the «financialization» of retirements in favour of retirement
savings plans. The emphasis on individualism
and individual initiative is also reflected in
retirement solutions.
It is clear that the Pension Fund must
never lose sight of the expectations of its
stakeholders (participants, retirees, Governments,
boards) if it wishes to continue to fulfil
its role. That necessarily requires governance
mechanisms that allow the expectations
of stakeholders’ representatives to be
expressed in the Board or in ad hoc working
groups, as well as an open attitude towards
the study of different scenarios or proposals
for change. From this perspective, the reform
proposals currently under discussion in the
United Nations common system concerning
human resource policies should be closely
monitored because of their possible impact
on the pension system, which is one of the
essential components of the employment
conditions.
One of the conclusions to be drawn is that
the future of a defined benefit pension plan,
such as that of the United Nations Joint Staff
Pension Fund, requires disciplined management
that gives priority to the long term while
retaining the necessary flexibility for adapting
over time the parameters of the retirement
system to new demographic and economic
trends. I believe that, thus far, the
management of the Pension Fund has done
so successfully.
The author is Chief Executive Officer, UNJSPF.
© 2006 UN Special |