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IPE Views: Is There a Future for Defined Benefit Schemes?

The GRI Managing Director Of Research, Catherine Lubochinsky, Discusses The Future Of Defined Benefit Schemes With Investment & Pensions Europe

The viability of defined benefit (DB) pension schemes in both the public and private sectors has been a subject of discussion for many years in the developed world, not least because of the significant numbers of private sector organisations that have been closing these schemes, and the ongoing debate about the affordability of these schemes in the public sector.

Working with the Policy and Economic Analysis Programme (PEAP) at the University of Toronto’s Rotman School of Management, the Global Risk Institute (GRI) has developed four macro-economic scenarios for the next 15 years in Canada, as the world recovers from the major crisis experienced in 2007-2008. Observations from this study may be of benefit to DB schemes in many countries.

The four scenarios established using PEAP’s proprietary model were, briefly, as follows: Scenario 1 – interest rates remain low through 2014, but then rise significantly as global economic recovery finally takes hold in 2015 and successive years, with relatively strong economic growth and improving corporate and government balance sheets; Scenario 2 – as per Scenario 1, but with somewhat lower ultimate levels of interest rates than Scenario 1; Scenario 3 – low interest rates continue for an arbitrary five years longer, owing to relatively weak economic growth and demand, before rising to the relatively high levels seen in the first scenario; and Scenario 4, in which low rates for another five years eventually rise to the lower levels seen in Scenario 2. In our view, the most likely outcome based on present data is Scenario 1, with the other scenarios listed in descending order of probability.

Before examining the effect of these scenarios on DB schemes, it’s worth reflecting on how the enrolment profile for these schemes has changed in Canada in recent years, especially since this profile is mirrored by other markets in the developed world, such as the UK and US.

In Canada’s private sector, enrolment in DB schemes has declined from 1.9m in 2008 to 1.5m in 2011 due to scheme closures. By contrast, enrolment in Canadian public sector DB schemes has increased by 300,000 over the same period to 2.9m. This increasing DB enrolment in the public sector may be seen in the light of concerns that, because most of these schemes do not ‘mark to market’ their liabilities, the impact of low interest rates for a long period has yet to be recognised.

Broadly, this research demonstrates that a prolonged low-interest-rate environment could potentially exacerbate funding pressures on public DB schemes and further accelerate the move away from these schemes in the private sector. Lower levels of employment and wages imply lower interest rates, as well as having the knock-on effect of lower contribution rates to pension schemes. Additionally, if the interest rates used to calculate the liabilities of DB schemes remain low for an extended period, the consequences – in terms of higher contribution rates or lower benefits for the scheme’s future members – may be postponed but not eliminated.

Figure 19 from the report illustrates the gap in interest earnings for public sector DB schemes between a near-term return to ‘normal’ levels of interest rates (Scenario I above) and a much longer period of low interest rates (Scenarios III and IV). The gap, in terms of interest earnings, between Scenarios I and IV by 2030 amounts to CAD15.5bn (€10.2bn), with lower long-term rates accounting for CAD10bn of this difference, and the delayed recovery in rates a further CAD5bn.

Figure 21 shows a similar situation in the private sector, but with important differences based on the relative size of components. The share of interest earnings as a proportion of total funding is lower than the share of contributions.

For both public and private sectors, a lower long-term real interest rate has a greater negative effect on earnings than a five-year period of low economic growth before recovery. A high level of real interest rates will only be achieved with strong economic growth, which, at the same time, supports contributions to pension schemes – making strong economic growth a priority.

For the public sector, questions will arise in the event of a continued low-interest-rate environment and concomitant decrease in plan solvencies. For the private sector, the continued shift away from DB schemes to defined contribution schemes has led to a transfer of risks from employers to employees, which leads to questions not covered by this research about how pension schemes can be designed with more balanced risk-sharing mechanisms.