Redesigning
pensions
PwC view on trends in Dutch pensions, based on the annual review of the IAS 19 pension disclosures of companies in the Dutch AEX25
September 2013
Redesigning Pensions
Dutch companies are at the eve of fundamental
changes to their pension situation. The 2014 changes
in pension accrual and pension fund governance need
to be implemented. And more changes to pension
accrual and pension funding are announced for
2015 in the Netherlands. The pension challenge for
multinational companies goes beyond these changes as
their footprint does not stop at the Dutch border.
The design of your pension situation sets the scene:
Your system of providing pension benefits to employees
in the end determines HR, financial and risk related
consequences for your company. Before redesigning
the structure of pension plans, companies should set
clear strategic objectives and ensure that all different
stakeholders within the company are aligned.
Two years ago we reported about the Pension winds of change. And in those two years pensions acted indeed as a hurricane, without sparing any party involved: proposed changes in the Dutch pension system by the government were turned down, accrued benefits were cut or not compensated for inflation and employers were confronted with continuously increasing premium levels, deficit payments and higher and more volatile pension deficits.
Everyone knows that things need to change! But how? The upcoming pension challenges for Dutch companies could be reduced to two basic questions: What benefits do we want to provide to our employees? And how are we going to fund these pension benefits?
As simple as these questions may appear, finding answers may not. Within a company, several stakeholders will look at these questions from their point of view. They have different, and
sometimes conflicting, interests. The preferred answer from one angle could have dramatic and unexpected consequences from another point of view. This will be illustrated through our annual AEX25 survey.
Our view
The design of your pension situation sets the scene. This determines the contribution levels, your pension liabilities, P&L charges and employee satisfaction. Legislation, accounting and compliance requirements are the consequence of your plan design and funding, not the other way around
The following steps should help you to come to an optimal new pension system.
€33bn
47%
The total IFRS deficit for the AEX25 is now around €33bn.
Gross pension liabilities are, at 47% of market cap, still significant.
76%
3 out of 4 AEX companies consider pensions as a main company risk. These companies are currently considering adjustments in the pension situation that go beyond required 2014 legislation.€5bn
Almost 50% of AEX companies already moved or announced to move to a DC construction. Based on current contribution levels this would result in €5bn higher AEX company pension cost.
57%
57% of pension liabilities are outside the Netherlands. For more than half of the AEX companies foreign liabilities exceed Dutch liabilities
Main findings of our investigation
If you would like to discuss the issues and findings included in this report or their impact on your business, contact details can be found at the back.
Define
Pension strategy should be linked to general company strategy. Define what you want to achieve with pension plans around the globe.Align
Parties involved look at pensions fromdifferent angles and have different interests. Combining global HR, financial and risk driven stakeholders offers you a broad perspective, increases acceptance and avoids unexpected outcomes.
Design
A new pension plan should fit within the aligned pension strategy. A newly designed pension situation also involves funding, risk management, governance and member communication. And the focus should also be related to the legacy liability and to non-Dutch pension plans.The pension challenge: understanding how pension developments interrelate and affect your business
Event Company consequences Gradual increase in state pension (‘AOW’)
retirement age. Increases are linked to life expectancy.
Until 2012 state benefits were provided from age 65. This age will increase gradually; we expect that state pension retirement age will equal 71 for employees born in or after 1984.
As state pension is a (significant) part of employees’ total pension benefits, they could postpone the retirement date. Employers should prepare for longer working employees or find alternatives for retirement at a date that the company prefers.
Increase in company retirement age to 67, decreasing accrual rates
As per 1 January 2014 pension accrual is based on a retirement age of 67. Past accrual will remain at age 65. As state pension retirement age also increases, employees need to determine a new desired retirement age resulting in sufficient retirement benefits.
The maximum accrual rates for 2014 will decrease slightly, from 2.25% to 2.15% for average pay plans. More decreases are expected as from 2015: the government has announced decreases down to 1.75%. The 2015 adjustments are still subject to discussions.
Changes in retirement age and accrual rates have consequences for company’s Balance Sheet, P&L and cash requirements. Changes in accounting: IAS 19R IAS 19R replaced IAS 19 (2004) as per 1 January 2013. The main changes are:
• Eliminating the Corridor method resulted in immediate recognition of actuarial losses of €31bn for AEX25, significantly lowering company equity as per 1 January 2013. Future balance sheet positions will be more volatile.
• Company profits are affected as expected return on plan assets is replaced by the discount rate (impact AEX25: TBD) and administration cost need to be separately recorded in P&L
• Less clear cut items are the liability cap and risk sharing, but these can have significant impact for specific companies
• Companies should reconsider how pensions are disclosed in annual accounts Interest rates remain low, life expectancy
to increase further
Regular contributions levels are higher than ever before as a result of current economic and demographic developments. Renegotiating new contracts, in particular with insurance companies could increase cash levels up to 50%.
Several pension funds in deficit. 31 December 2013 is a crucial date for possible further benefit cuts.
Pension funds of some employers will have to cut pension benefits, resulting in lower benefits for (former) company employees. Other employers will have to pay additional lump-sums to improve funding levels and avoid cutting benefits.
Funding rules for pension funds will be updated. Choice between a ‘nominal’ and a ‘real’ contract.
Both options have different consequences for the employer and employees. In general: under a nominal contract, contribution payments are volatile, while benefits are more secure. Under a real contract pension contributions are more stable while pension benefits are less certain.
Pensions remain a significant risk for companies
19 AEX25 companies have identified pensions as
a major company risk. Companies marked that
pension liabilities and cash payments are volatile and
dependent on market movements which are beyond
their control. Not surprisingly, these companies provide
generous guaranteed pension benefits that are funded
through company pension funds.
Analysis
Company’s observations are well reflected in the movement of the AEX deficits in company’s balance sheets during 2012. Despite considerable cash payments of €7.8bn, pension deficits went up with €9.5bn to €32.5bn ultimo 2012. Pension deficits consist of the difference in gross pension liabilities and plan assets. Market effects are reflected in the remeasurement component.
The positive investment return of €21bn in 2012 pushed the asset values close to €200bn. This large gain could not compensate for the increases in gross pension liabilities, mainly caused by decreases in market interest rates. These liabilities reached a new milestone by largely exceeding the €200bn threshold. The gross pension liability of €229bn equals 47% of the AEX companies’ market cap.
Avoiding strong fluctuations in pension deficits is challenging as long as pensions remain significant. A perfect match between assets and liabilities is in practice very difficult to achieve. Pension funds invest in risk-bearing assets in order to gain additional returns for indexation. In addition, pension funds have to deal with funding requirements, which differ from IAS 19.
Our view
Current pension risk is in general caused by pension promises made in the distant past. Consequences of pension design and funding agreements are difficult to measure over a longer period.
Companies should be aware what the consequences are of pension design: not just for the coming years, also for the long run.
Make sure you have a clear vision on the benefits you would like to provide to your (former) employees, your risk appetite and what part of your budget you would like to spend on pensions. This can only be achieved by alignment between HR, Finance and Risk related disciplines.
Figure 1. Movements in the total AEX25 IFRS pension deficit
23 3 (8) (1) 16 33 0bn 5bn 10bn 15bn 20bn 25bn 30bn 35bn Net deficit
1-1-2012 Pensioncost contributionsEmployer Specialevents surementsRemea- 31-12-2012Net deficit
Steering the results?
During FY12 average Eurozone and UK AA corporate bond yields decreased by 1.3%. The overall discount rate of AEX companies decreased by only 0.8%. Following market movement would have resulted in a deficit of over €50bn (versus €32.5bn reported).
Discount rate setting is complex and partly biased. One needs to choose which bonds to include and how to extrapolate for longer durations. Different methodologies result in different discount rates which could all be acceptable. Adjusting your parameters could resolve issues in the short run, but will not solve the underlying risk.
The Dutch tax law on pensions will change in 2014.
Pensionable age moves to 67 and maximum tax
deductible accrual rates will decrease. This is just a
first step as more significant changes are proposed
for 2015. Discussions are still ongoing on the latter
changes. Many companies are currently reconsidering
their pension situation.
HR is generally the party that drives benefit design. Traditionally AEX25 companies provide defined benefit pension plans, which are funded through company pension funds. Benefit levels provided are generous and at the top of tax maximum levels. In addition, accrued benefit levels have been secured so far as none of the AEX25 companies cut accrued benefits. Companies paid additional lump-sums to guarantee accrued benefits and to provide unconditional pension increases.
Analysis
Since tax maximum levels will be reduced, companies are forced to adjust their pension plans. The majority of companies have already announced to reconsider the current pension situation. These reconsiderations go beyond the minimum required adjustments that need to be implemented as per 1 January 2014. Based on initial announcements it appears that AEX25 companies will breach with the past: more risks will be shifted to employees and less guarantees (including unconditional indexation) will be provided by the company.
€33bn 47%
The total IFRS deficit for the AEX25 is now around €33bn. Gross pension liabilities are, at 47% of market cap, still significant.76%
3 out of 4 AEX companies consider pensions as a main company risk. These companies are currently considering adjustments in the pension situation that go beyond required 2014 legislation.€5bn
Almost 50% of AEX companies already moved or announced to move to a DC construction. Based on current contribution levels this would result in €5bn higher AEX company pension cost.57%
57% of pension liabilities are outside the Netherlands. For more than half of the AEX companies foreign liabilities exceed Dutch liabilitiesCompanies consider significant changes
to their pension benefits
Our view
Before HR directors design a pension plan they should first have clarity on what they want to achieve with their pension plan. What is a realistic outcome? How much do you want to pay for that? Is it in line with company strategy? In addition, the design of the pension plan determines the financial, accounting, tax and other consequences, not the other way around. The company should be fully aware of these consequences before the plan is actually implemented.
Most AEX companies have to deal with unions. Moreover, companies have a large public exposure and are not simply able to make adjustments to their pension plans unnoticed. HR directors have to maneuver carefully in this playing field. It is not surprising that changes implemented previously have been rather limited.
It seems that the AEX25 companies are at a turning point. 87% of the companies announced considerations that go beyond adjustments required by law. Also almost half of the companies either already introduced a partial (C)DC plan or have announced to explore this further. Other changes include decreases in accrual rates (14), efforts to cancel guarantees in the plan (5) and transfers to other pension carrier (2).
The trend to de-risk pension plans also reached the
AEX25 companies. Pensions hit companies in their
balance sheet and create volatile cash payments. Many
companies consider a move to (Collective) Defined
Contribution plans ((C)DC), but they should be aware
of the consequences of such a move, both from an HR
and a financial perspective.
Analysis
Company results are under pressure. Economic turmoil forces companies to cut cost and to critically look at their financial health. Shareholders, analysts and supervisors are critically following company results. Despite cost saving programs, pension contributions increased further during FY12. Increasing cash contributions were caused by deficit payments and further decreases in interest rates. The volatility in cash contributions and balance sheet positions, raises interest in (C)DC plans. For companies reporting under IFRS, the P&L charge for defined benefit plans is not equal to the cash contributions. P&L charges are mainly driven by the service cost. Although service costs have always been significantly lower than cash contributions, we
Moving to DC plans could have
unexpected consequences
Our view
Companies should clearly understand the financial consequences of moving to DC plans. Risks might be reduced, however to what extent and at which price? In addition, the company should be aware of the potential benefit consequences for its employees, and indirect risks for the company.
DC markets develop rapidly. New carriers have entered the market and new generation products have been introduced, with lower costs and more advanced features.
The design of a DC plan should not stop once the contributions ladder is determined. Benefit levels are mainly determined by investment returns and cost and the efficiency of life cycles. These elements should receive more attention in the future.
4 2 3 3 3 3 3 6 5 6 10 6 6 8 0bn 2bn 4bn 6bn 8bn 10bn 2006 2007 2008 2009 2010 2011 2012 Service cost Employer contributions
Figure 2. Comparison of AEX25 service cost and employer contributions
notice that the difference continues to increase, reaching a level of €4.6bn in 2012.
If companies would move to DC, this ‘benefit’ will be lost; resulting in significant increases in P&L charges and therefore lower profits.
In addition, in our winds of change review we already concluded that 70% of liabilities were related to employees not in service anymore. Moving to DC only for current employees, or even only for new employees, will not solve the legacy (and often most significant) issue.
Multinationals, like most AEX companies, face
additional challenges: their pension situation abroad.
Differences in local legislation, funding rules, culture
and historical agreements add even more flavors to the
spicy pension meal. For AEX25 companies, the foreign
influence is particularly significant.
Analysis
We estimate that gross pension liabilities outside the
Netherlands are over €130bn, or 57% of the total gross liabilities of AEX25. As shown in the graph, these numbers are not just caused by a few companies: 14 out of 25 companies have foreign pension liabilities exceeding their Dutch liabilities.
AEX25 multinationals historically have strong roots in North-Western Europe and in the US. These countries traditionally offered defined benefit plans. Although changes to defined contribution systems already have taken place in these
countries, companies are still liable for significant legacy defined benefit liabilities and liability implies for most foreign plans that
the employer is ultimately on the hook for all benefit payments. And often, these benefits are unconditionally increased based on consumer or retail price indices.
We observe that foreign pensions are in general managed by local management. This seems trivial since local management is aware of local legislation, funding rules, culture etc, all crucial factors that needed to be understood carefully.
On the other hand, if a company really wants to lower its pension risk, it cannot ignore the magnitude of foreign plans. Companies should therefore be aware of local situations including legislation and the way pension business is done.
UK pensions as an example
The major part of the AEX 25 foreign pension liabilities arise from the UK. Although the UK pension system appears very similar to the Dutch system, it works fundamentally different. Pension benefits are unconditionally increased. Cutting benefits or conditional indexation do not exist.
The global challenge
Our view
So far we notice that globalization has hardly influenced the way pensions are managed.
If companies want to lower their pension risk exposure at group level, they should first have a clear understanding of their global employee benefit situation and corresponding risks. Alignment between HR and Finance is crucial. This will help identifying risks and enables group to set clear cut standards for local companies. And thus contribute to the overall company strategy.
0%-25% (7) 25%-50% (4) 50%-75% (4) 75%-100% (10) 0 5 10 15 20 25 Foreign pension liabilities
Number of AEX25 companies
Figure 3. Foreign pension liabilities of AEX25 companies as percentage of total pension liabilities
And, more importantly, (tough) funding negotiations take place between two financially independent financial parties, and not in a ‘poldermodel’. On the other hand, because of these strong liabilities, other solutions such as longevity hedges, are more common than in the Netherlands. Addressing the UK pension challenge requires thus a completely different approach than the Dutch pension challenge.
Contact details
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© 2013 - PricewaterhouseCoopers Pensions, Actuarial & Insurance Services B.V. (KvK 54226368). All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for further details.
PwC has a successful track record in addressing corporate pension challenges given our breadth and depth of commercial, financial, legal, HR and pensions expertise. If you wish to discuss the information contained in this document or how we can help you, please call your regular contact or alternatively:
Mischa Borst +31 (0) 8879 27457 [email protected] Alfred Lagendijk +31 (0) 8879 26350 [email protected] Marc Bout +31 (0) 8879 26068 [email protected] Adriaan Smits +31 (0) 8879 26306 [email protected]
