Pensions:Investment market volatility and bad press over defined contribution schemes led companies to revise their approach, writes Raymond McKenna
The last year has been a turbulent one for pension funds. Companies, trustees and members have seen significant volatility in investment markets and significant changes in the approach to pension provision by a number of leading employers.
We have also seen the publication of the long-awaited Green Paper on pensions in November. All in all the apparent "sleepy" world of pensions has again proven to be a hot bed of activity.
Pensions have received considerable attention in the Labour Court and in union discussions. Following intensive negotiations, 2007 witnessed landmark decisions by AIB, Bank of Ireland and others to reintroduce an element of defined benefit (DB) pension provision as part of a hybrid pension scheme design.
At one level, this is simply part of a wider trend by companies adopting new innovative pension designs that share the costs and risks of pension delivery more fairly. However, it is notable in AIB's case that the move was away from a defined contribution (DC) scheme - the type preferred by employers because of the degree of cost control available using the DC format.
This is not unexpected as Watson Wyatt's internal research shows that about half of large employers who embark on a pensions review retain some DB aspects in their final pension design, at least for existing employees. The devil is in the detail here, because the study also suggests a real appetite to adopt the innovative forms of DB "career average", "cash balance" and "hybrid" designs.
This may come as a surprise, given the control DC plans give to employers over costs and various risks. So why are employers open to retaining DB formats? Several factors are at play. DC schemes are suffering poor press over the extent to which employees are taking on unknown risks and there are fears of future benefit inadequacy. It is rational for employers to consider these factors in seeking designs that will appeal to employees, and some of the solutions involve incorporating aspects of DB provision in the pension scheme design that is chosen.
As to the future Watson Wyatt believes that momentum is building in favour of, albeit bespoke solutions, some form of hybrid arrangement, particularly among larger companies, and 2008 should see that trend continuing.
The performance of investment markets is a key factor in the success of pension funds, whether defined benefit or defined contribution. Volatility of investment values causes great concerns for companies from a budgeting and accounting perspective. Increasingly, trustees are fundamentally reviewing their investment strategies in an effort to minimise this risk.
One particular area of focus is the historic bias towards Irish-based asset classes. While this is a phenomenon found in most markets around the world, Irish pension schemes have been historically wedded to a very substantial overweight position in local equities and domestic property. While the advent of the euro in 1999 sparked a move to increased global diversification, the process has been gradual and many schemes have retained a large Irish bias.
In recent times this has paid handsomely in the form of strong returns. However, events this year have given renewed reasons to revisit this concentration of investments.
The increased volatility in financial markets during 2007 was more pronounced in Ireland than elsewhere and the concentration in the local equity market, heavily tilted towards financials, property and the construction sectors, has had a significant impact on fund returns. Total returns on the Iseq index were -25 per cent and this compares very unfavourably with the -4 per cent earned on a global equity portfolio over the same period.
Recent events, and in particular the so-called "credit crunch", should prompt pension schemes to reconsider the value of maintaining such a bias and accelerate the movement towards more globally diversified holdings.
While the end of 2007 sees pension funds operating once again in difficult investment market conditions, increases in bond yields mean relief overall for finance directors contemplating their year end balance sheets, in which pension costs are playing an increasingly important and volatile part.
Returns on typical managed funds from the start of the year to mid-December are averaging in the region of -3 per cent to -4 per cent. However, Watson Wyatt observes that bond yields have risen by 0.75 per cent over the year, and they expect that accounting liability values for most schemes at year end may well be down by about 10-15 per cent, more than offsetting the investment losses.
Neil Herlihy, a senior actuary at Watson Wyatt, notes that, for mature schemes, "the adjustment to liabilities can be expected to be lower but many schemes in this category would invest more defensively than the norm and those that do should also be in good shape in terms of pension accounting results".
The much awaited Green Paper on pensions was published by the Department of Social and Family Affairs in November. Its aim is to stimulate debate on the future of pensions in Ireland. While posing many questions in relation to the funding of social welfare and public service pensions, as well as funding and taxation issues for occupational pension funds, the paper disappointed many by not putting forward any concrete solutions or roadmap.
Interested parties have until mid-2008 to submit their responses to the questions raised.
As 2007 comes to a close many companies will reflect on the year that was and, if pensions weren't an issue during 2007, they will undoubtedly be on the agenda in 2008. We are likely to see a continued trend towards bespoke solutions being found by companies undertaking pension design reviews.
Continuing turbulence in investment markets will remain a key issue with employers and trustee boards reviewing their investment strategy and diversifying into global assets classes to reduce risk.
Raymond McKenna is managing consultant at Watson Wyatt
