The potential impact of continuing failure to resolve the eurozone crisis on companies’ defined contribution (DC) pension schemes has been highlighted by the consulting and investment services group Mercer.
The firm focuses on four risk areas that could develop if the crisis is prolonged that have direct implications for DC plans. Mercer acknowledges that the resulting uncertainty makes planning difficult, but recommends that trustees and scheme sponsors nonetheless review the following issues:
- Investment risk: Continued market volatility could severely impact those schemes that are over-reliant on growth assets such as equities. And after witnessing historically low yields, many government bonds are no longer seen as the safe haven assets they traditionally were.
Tony Pugh, European head of DC consulting at Mercer, says: “Schemes should review their long-term investment strategy on an on-going basis to ensure it is appropriate. Risk mitigating strategies such as increased diversification, for example to non-traditional asset classes, and communicating to members the importance of diversified portfolios, should be considered.”
- Annuity pricing risk: Low bond yields have contributed to the steep rise in annuity prices which, in turn, will translate into lower incomes in retirement for DC scheme members. In many markets there are significant price differences between providers, putting the onus on sponsors and trustees to consider how they can help members secure the best possible deal, such as through an open market adviser.
- Risk of inadequate benefits: As the eurozone crisis shows no signs of abating, sustained low contribution levels coupled with poor investment returns, high annuity rates and falling state benefits translate into inadequate benefits for many employees upon retirement, who as a result are more likely to opt to carry on working. Delaying retirement is, in turn, likely to create challenges for employers including higher cost of insured benefits, blocking of promotion opportunities, as well as internal and external reputation damage. Over time, employees could start to place a higher emphasis on the level of employer contribution to DC plans when choosing which firm to work for.
- Provider risk: As the crisis is particularly impacting financial institutions, companies must consider whether their DC provider might be at risk and what safeguards and compensation plans are in place were a provider to become insolvent. The task is not helped by lack of clarity and a dearth of case studies to demonstrate what would happen in practice should a provider collapse. Nonetheless, trustees and scheme sponsors should investigate this aspect as well as a potential exit plan if their provider is considered at risk.
“There has been much analysis of the current problems in the eurozone and it’s becoming clear that the path to resolution will be bumpy with a series of dangerous episodes,” says Pugh. “Outcomes will be contingent on a combination of many factors, such as bank or insurer stability, politics and market responses, and are impossible to forecast with absolute certainty. Risks are likely to be on the downside and market relief short-lived.
“As the period of the crisis extends without a near-term solution in sight, companies are becoming increasingly interested in the potential risk exposure of DC pension funds and what measures they might be able to take to protect their employees’ retirement savings. Each scheme will have different risk exposures so a thorough analysis based on potential outcome scenarios is the best place to start.”
Mercer’s advice is principally addressed to pension scheme sponsors and trustees, and in some companies the DC scheme lies outside treasury’s remit. However, the firm notes that corporate treasurers’ ownership of pension issues has steadily increased in recent years and the trend is extending to smaller and medium-sized enterprises (SMEs) as well as major corporations.
In an interview with gtnews, Julien Halfon, principal in Mercer’s financial services group, said: “Treasurers are involved through their work with HR departments and in various ways through internal committees and investment boards. For those that work in companies that still retain defined benefit [DB] schemes, the resulting problems are likely to be keeping them awake at nights.”
Currency Risk and Negative Returns
In addition to the four risk areas highlighted by the firm, Pugh and Halfon say that two more can be added. The first is currency risk, although they admit that the potential for taking effective action to mitigate this is limited in all but the very largest schemes.
The second is the increasingly meagre returns being offered by cash funds where, in some cases, the actual return is negative once fees have been factored in. This could lead to a number of the funds closing if eurozone interest rates stay low, or are cut even further. Several large money market funds (MMFs) restricted or closed their European funds to new investments after the European Central Bank (ECB) reduced the rate on its deposit facility to zero in July and Germany, France and the Netherlands have been able to sell short-term debt at negative yields.
On the issue of provider risk, Pugh says that Mercer so far sees little evidence that European corporates are moving schemes away from providers whose financial security appears shaky. US companies are more alert to the threat, transferring to providers they regard as more robust and also acting to remove exposures to eurozone economies from scheme investments.
“Look at the many banks that have provided pension solutions; their credit ratings have been downgraded and their credit default swaps [CDS] have gone up,” adds Halfon. “A provider regarded as safe in 2007 may, in many cases, no longer be so in 2012. Some have changed their structures in order to ring-fence their providers and a number of insurance companies are very shaky financially.”
At the same time the issue has provided a bargaining chip for some corporate treasurers, who have taken the opportunity to re-approach their company’s pension provider and secure lower fees and/or improved services in return for not transferring the scheme elsewhere.
“Both North American and Nordic corporates are ahead of the game in thinking about the various risk exposures of their pension schemes worldwide,” says Pugh. “UK and European multinationals tend to be preoccupied with the problems on their doorstep and are less organised when it comes to thinking of their exposures further afield.
“Pension scheme trustees tend to adopt a cautious approach and understandably so, although it can often give them the appearance of rabbits caught in the headlights. On the other hand the eurozone crisis has been dragging on for so long – and looks set to continue for some time to come – that companies can’t put off tackling these risk issues indefinitely.”
Edwin Bolton, manager, mergers and acquisitions (M&A) and commercial finance for Shell International UK says that it was easy for complacent about DC schemes, but although less of a risk than DB schemes they could not be ignored.
He adds: “Mercer rightly mention the limited investment opportunities and a possible move into non-traditional fields to achieve return; however this should be caveated by the risk inherent in non-traditionals such as relatively inefficient markets and volatility, and also be put in the broader context of inflation, with mention of the fact that relatively few inflation-proof asset classes.
“Inflation also means that with salaries diminishing in real terms contributions are also dwindling, thereby compounding poor returns as you are investing less and earning less.
“Ultimately it is the corporation’s role to make transparent its pensions arrangements and educate employees accordingly, particularly in relation to DC schemes whereby the employee suffers the direct impact of poor performance.”
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