Global Opportunities

Regulation and risk sharing

in occupational pension

systems 

Juan Yermo is a pensions expert who observes the market closely for the OECD. In this article, he outlines developing trends in the wide field of pension plans.

Traditional, final-pay defined benefit (DB) plans are a dying breed. The latest OECD inquiry into risk sharing in occupational pension plans has found that in countries where the move to pure defined contribution (DC) arrangements is being resisted, the private sector is increasingly covered by pension plans of a hybrid or collective defined contribution kind. Hybrid pension arrangements and other plans with risk sharing features offer greater flexibility in regards to pension promises. Risk sharing makes pension promises less onerous, which increases the affordability and sustainability of DB-like promises for sponsoring employers. For employees, risk sharing avoids the move to “pure” DC arrangements where the individual shoulders all risks.

However, for risk sharing to function, its features need to be carefully designed and disclosed to all stakeholders. In a recent publication, the OECD distinguishes between four types of hybrid plans:

Conditional benefit plans: Benefits are calculated as in a traditional DB plan but there is an element of conditionality tied to the performance of the fund, the member’s longevity expectations or other factors.

Cash balance plans: Benefits are calculated based on a notional individual account that earns a specified rate of return, which can be a fixed percentage, the return on an index tracker fund or the return on several funds selected by participants. Benefits may be paid as a lump sum or converted into an annuity.

Nursery plans: Benefits are calculated on a DC basis up to a certain age and on a DB basis afterwards.

Floor or underpin plans: Benefits are the higher of a DC and a DB formula.

Of the hybrids, conditional benefit plans may present the highest degree of risk sharing between companies and employees as benefits can be adjusted according to the plan’s financial situation.

Cash balance plans also lower risks to sponsors relative to traditional DB plans, since the interest credit is generally modest and the initial pension amount is normally adjusted for longevity and interest rates at retirement. The risks that are borne by sponsors are even lower when participants choose lump-sum rather than annuity-like payments.

In collective DC plans, risks are shared among workers and pensioners, while the sponsoring employer simply commits to a fixed contribution. However, collective DC plans turn pension funds into stand-alone entities resembling insurance companies. It remains to be seen whether such plans will remain under their own regulatory framework or whether they will be treated as insured DC arrangements.

Risk sharing can be further enhanced under any of the arrangements if employees are required to make contributions, which can vary depending on the plan’s solvency. Pension plan regulations can alter risk sharing arrangements and shift risks in one or the other direction. Two main types of regulations are member protection and funding rules. In some countries, like Italy, occupational DB plans are no longer allowed. At the other extreme, unprotected DC plans are prohibited in Belgium, Germany and Switzerland.

The revaluation of accrued or deferred pensions and the indexation of pensions in payment are also subject to regulation in some countries, while only in the United Kingdom are both revaluation and indexation mandatory. Elsewhere indexation is common when part of collectively bargained agreements, but is not required by legislation. Meanwhile, pension funds in some countries have explicitly tied indexation to the fund’s solvency position (conditional indexation). Regulations also affect the type of benefit offered, and by implication, whether employers will be exposed to longevity risks. In half of the countries, benefits can only be paid as annuities. Of the rest, two impose limits on the portion paid as lump sums. The rest do not impose regulations.

Risk sharing in pension plans is also affected by funding rules. For example, in the United States, the high tax on excess assets in case of plan termination (50%) is a main reason why employers prefer to convert them into cash balance plans. A conversion into DC arrangements would be treated as a termination of the DB plan and trigger the 50% tax on excess assets.

Minimum funding requirements can also drive plan design. Some countries regulate pension funds like insurance undertakings, effectively ignoring any possible recourse to capital from the sponsoring employer in case of underfunding. This means plans become DC from the perspective of the sponsor, as it commits only to a fixed contribution rate over time, shifting risks to the pension fund or insurer.

The OECD risk sharing study also considers the trend towards risk-based funding regulations. Well-designed funding regulations help promote high levels of benefit security at a reasonable cost to members, sponsoring employers and other stakeholders. By taking into account the nature of benefit promises and, in particular, the specific risks guaranteed, as well as the way those are shared between different stakeholders, risk-based funding regulations may help better address the balance between benefit security and cost.

The three main risk factors are: the nature of risks (market, biometric, operational) and the guarantees offered under different plan designs; the extent to which benefits are conditional or can be reduced; and the extent to which contributions may be raised to cover funding gaps. In addition, the strength of the guarantee from the sponsoring employer(s) and of insolvency guarantee arrangements should be assessed when designing funding requirements. 

One important implication is that plans with strong risk sharing features (conditional indexation, nominal benefit cuts as last recourse, and flexible contribution policies) may have lower funding needs than traditional DB arrangements with mandatory indexation. Given the value of risk sharing in occupational pension provision, funding regulations should be adjusted to reflect the nature and distribution of pension risks.