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Balance Sheets Best Practice

How to Manage Pension Costs

by Edmund Truell

Executive Summary

  • The financial implications of rising longevity, in particular with regard to pensions, pose significant challenges to society. The re-allocation of the financial burden among governments, businesses, and individuals will significantly affect pension systems.

  • The upward trend in life expectancy and the consequent aging population has led to large unanticipated retirement costs for businesses and governments, particularly in developed countries.

  • Governments have increased the long-term sustainability of the public finances by reducing the future generosity of state pension entitlements and encouraging greater private sector involvement.

  • In response to government initiatives, corporate sponsors have closed their defined benefit pension schemes, and moved employees into defined contribution schemes—thus shifting investment and longevity risk onto individuals.

  • To deal with the legacy of previous commitments, managers have created a range of new solutions for the financial markets, from hedging liabilities to passing all or part of the risk and responsibility to specialist third-party providers.

Introduction

A huge increase in life expectancy is one of the great achievements of the human race over the past two centuries. Increased longevity has transformed both individuals’ lives and their societies, with the most marked changes taking place in the developed world. Actual increases in life expectancy have been far more substantial than previously projected, with the result that governments, businesses, financial markets, and individuals must radically readjust their plans.

Moreover, the current trend shows no sign of leveling off. For example, between 1981 and 2000 the life expectancy for 65-year-old males in the United Kingdom increased by approximately three months for every year, and future life expectancy is widely expected to continue to increase. Therefore, it is increasingly important that governments, businesses, and individuals consider the economic, societal, and financial implications of an aging society in diverse but important policy areas such as pensions, health care, and long-term care provision. For example, pension liabilities increase by 3% or more for every added year of life expectancy.

Changes to the Pensions Landscape

Pension reform has been high on the political agenda in most Organizations for Economic Co-operation and Development (OECD) countries during the past decade. In most instances the key objective of reform has been to increase the long-term sustainability of public finances in the light of an aging population. Governments have frequently reduced the future generosity of state pension entitlements through several means, such as indexing future pension increases to inflation rather than earnings growth, increasing the official pension age to compensate for expected longevity increases, and, in some cases, developing new measures to automatically reallocate the financial burden of unexpected future increases in longevity between the state and the individual.

To compensate for planned reductions, most reform packages also include measures aimed at encouraging greater private sector involvement. This shift has led to a reallocation of risk, including longevity risk, away from the state and onto businesses and individuals. However, shifting the responsibility of future pension provision to businesses or individuals does not solve all the problems.

Countries such as the United States, the United Kingdom, and the Netherlands, with traditionally larger private sector involvement in pension provision, face unique challenges due to the defined benefit (DB) nature of their pension schemes. In these countries, DB pensions are linked to the salary earned by the individual, and are often index-linked and passed on to dependents in the event of death. Although DB schemes are attractive and arguably help to foster employee loyalty, they have become increasingly onerous for companies to maintain. The United Kingdom, the United States, and the Netherlands have all witnessed an accelerated closure of DB schemes, as businesses respond to new accounting standards and recognize more clearly the substantial longevity risk borne with DB schemes.

Some firms have opted for defined contribution (DC) schemes, in which a contribution of salary is paid regularly into the scheme by the individual and typically is matched by an employer contribution. The contributions are then invested, with the assumption that the compounded return on these investments over time will be sufficient to provide a pension in retirement. The shift from DB to DC schemes places more risk on individuals. Taken together with less generous state pensions, this move raises the question: Will future pensioner incomes be sufficient to meet the expectations of future pensioners? There is an additional danger for companies in some countries, where planned compulsory pensions for all employees are likely to lead to large costs because of the significant increase in employer contributions.

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