Pension Plans: a focus on Defined Benefit Pension Schemes

1.2 Single-Member, Group Pension and State Pension Plans 6
state pension systems to a subsidiary pension system ( individual plan or group plan). For
istance in UK, in 1949 there were approx. 4 million pensioners, There are now 10.5 million.
They are expected to rise to 12.5 millions by 2025 and to 14 millions by 2050. The ratio
between workers and pensioners is now 4.5 and by 2025 it is expected to be 3.5.
1.2.2. Second Pillar: Group Pension Plans. A group Pension Plan is a cluster
of personal pension set up by an insurance company or pension company on behalf of an
employer. The employer sets up a individual pension plan for each employee, then all these
plans are grouped together under a Group Pension Plan. Pooling reduces management
costs and members can invest in diversified funds; when a member retires he uses his final
account value to buy a whole-life annuity. The employers will required to enrol employees
into a qualifying workplace pension scheme, therefore this sort of complementary pensions
will no longer voluntary but will become mandatory and the employers will required to make
a minimum contribution based on member's pay.
Group Pension Plans can be either Defined Contributions or Defined Benefits. The
last are usually common for large employers and the current trend shows a movement from
define benefit plans to defined benefit contribution plans. In both cases the employer usually
pays most of the required contributions or, in minority of schemes, he pays the whole fund
accumulating costs.
In DC plans, each member purchase a whole life annuity with the fund accumulated at
retirement. These plans are called money purchase plans. Sales of group personal pensions
by insurance companies to employers are booming, in the past years the increase was around
50%. In DB plan there is a common fund and no separation into members' accounts. They
use several fixed formula to compute the benefits. The costs of a DB plan are not predictable,
and they may vary over the time. In this way, the employer pays for the uncertain part of
the costs whereas the employee pays just a fixed part of his salary.
1.2.3. Third Pillar: Single-Member Plans. In a Single-Member Plan an employee
periodically pays a certain amount into a personal fund; there are no other members but
him. At retirement, he uses the amount accumulated to purchase a life annuity besides
the state pension. This kind of plan is a funded plan giving rise to a fund with assets
to be invested by the insurance company on behalf of the member1. Single-member plans
are usually defined contribution plans, i.e. the contribution is previously settled but the
members can vary the contribution rate. It will be cleared in Section 2
The value at retirement is based on:
• returns from investments up to the end of service;
• management fund expenses;
• terms and conditions on which a whole-life annuity is bought on;
• the cost of other insurance benefits2
Single-Member Plans allow the member to interrupt his contributions for a period of time
and then restore it without penalties (even if it depends on contract) or consequences.
Moreover everyone can have this sort of plan, even people such as students or housewives,
who are not currently working. Other two advantages are tax benefits and tax relieves.
1.2.4. A possible Fourth Pillar: income from a part-time work. During the
last years the Geneva Association3 has been promoting a fourth pillar, that is, an additional
income to support the first three pillars with supplementary resources. This is income from
part-time work for some years after reaching retirement age. From the retirement age, this
fourth pillar income is accompanied by a partial pension. It would help the State to handle
the growing problem of pension financing in years to come, and may offer society solution
1The accumulated fund can be invested in a range of managed fund with different risk return charac-
teristics
2For instance life insurance benefits, providing income to relatives
3The Geneva Association is the international think-tank and research institution supported by the
insurance industry
1.3 Reforms and Forecasts in Europe 7
Figure 1.3.1. Evolution of life expectancy at birth in some EU countries
Source: Eurostat (2007)
Figure 1.3.2. Average exit age from the labour force
*EU25 - Source: Eurostat (2007), Structural Indicatory; OECD
that is appropriate for contemporary service economies, affected by the increasingly flexible
nature of employment and the life-cycle.
1.3. Reforms and Forecasts in Europe
1.3.1. Trends in the retirement age. Between 1950 and 2000, the percentage of
people over 65 years of age in EU25 increased from 9.1% to 15.7%. By 2025 this group will
represent 22.7% of the entire population. Between 2010 and 2030 the expected increase in
EU25 of older workers (55-64 years) is 15.5% and of elderly people (65-79 years) is 37.4%.
The chart 1.1 is about longevity trends in Europe. These demographic shifts are due to:
• decreaing birth rates, due to the social trend in developed economies;
• increasing in longevity (and reduction of death rate), due to better health condi-
tions.
The result of these demographic trends imply that we will have more pensioners in the
future and enormous problems concerning pension financing (less people who create wealth
and contribute to Pension plans and more people who burden Pension schemes).
Since 1950, as we see in the table 1.2, the increase in early retirement for older employees,
in order to help younger people finding a job, has contributed to a reduction in the average
effective exit age from the labour market. In this way, while the number of years spent in
receipt of pensions has been growing during the decades due to this trend and better health
condition, the number of contribution years has decreased. Obviously this has affected the
pension system of every Country and made necessary essential reforms.
1.3 Reforms and Forecasts in Europe 8
Figure 1.3.3. State pension spending per person
Source: Hughes and Stewart 2000
In 2000 the Lisbon European Council set up an ambitious plan concerning employment
rate in Europe: the employment rate should reach 70% by 2010 and moreover the employ-
ment rate for women should be more than 60% by the same year. In the following year, the
Stockholm European Council set a new target for the average EU employment rate for older
men and women (aged 55 to 64): 50% by 2010. The Barcelona European Council in 2002
focused on the average labour market withdrawal age, which was targetted to rise by 5 years
by 2010. Looking at the most recent data (from the European Commission's employment
report 2007), the European Union is still short of the targets previously mentioned. In 2007
the overall employment rate in EU15 was 66.9%, the female employment rate was 57.1%,
while the employment rate among older workers was 46.6%. The average exit age from the
labour force rose to 61.2 years in 2006. In 2006 Sweden, Norway and UK had the highest
average retirement ages (respectively 63.9, 63.1, 63.2 years). France and Italy had the lowest
average retirement ages (respectively 58.9 and 60.2 years).
1.3.2. Pension System reforms. During the 1990s the European Council adopted
and promoted pension system reforms to avoid the collapse of the entire European pension
structure. As shown in the chart1.3, state pension spending is expected to decrease over
the next decades (but UK spending set to rise following 2007 Pensions Act) due to reforms
to promote individual or group pension schemes which are supposed to reduce poverty for
older people when they retire. The chart shows forecast and the effects of reform, without
which the state pension spending would increase.
Some Governments (Sweden, Austria) have begun to broaden the eligibility for access
to the public pension schemes. Unlike private schemes, they are allowing people to acquire
pension credits for periods of short-term contracts, part-time and voluntary work as well as
for periods in maternity or parental or education. Other countries plan to introduce such
allowances or have approved measures with a similar effect (UK, Ireland, Germany). There
have also been reforms for workers who frequently change employer. Belgium, Denmark,
UK, Germany and the Netherlands have improved the portability of supplementary pension
rights to remove obstacle to workers' mobility.
1.3 Reforms and Forecasts in Europe 9
Almost all EU15 countries have increased the mandatory retirement age to 65 years for
men and 60 years for women (and some countries are making efforts to equalise the pension
age for both genders) except for France has set the exit age from the labour market at 60
years. In a few countries there are efforts to raise this age to 67 years (Denmark, UK and
Germany). Moreover governments are providing incentives (accrual rates, tax reduction
for salary after a certain age) to those employees who postpone their exit from labour
market, until the statutory retirement age. The early retirement age is raising as well. In
addition, unisex-tariffs in second-pillar provisions or in the mandatory funded part of the
first-pillar provisions have been introduced by some European countries to achieve gender
balance in pension provision (Netherlands, Denmark, Ireland, Sweden, Germany, Greece,
and Luxembourg)
Further reforms aim to strengthen the benefit-contribution link of pension systems. EU
Governments have introduced longer contribution periods for entitlement to a full pension
wich will be based on lifetime earnings instead of final salary. France is moving from apension
measured on the best 10 years to the best 25 years in the public scheme; Austria is extending
the averaging period from the best 15 to the best 40 years, while countries such as Finland,
Sweden, and Portugal are all moving to a lifetime average earnings measure.
. Several countries have switched to price- or close-to-price indexation of benefits, both
for earnings-related schemes and for minimum pension schemes. Other countries (Italy,
Austria), increase high pensions at a lower rate than medium-level and small pensions,
with only the two latter categories receiving full price compensation in order to help less
wealthy people that are more affected by adverse economic conditions. However, to better
protect non-standard workers, some countries have increased the levels of the guaranteed
minimum pensions beyond the statutory index adjustments (Belgium, Spain, Portugal and
Ireland). Spain, as well as other countries has introduced automatic adjustment mechanisms
and periodically required reviews and adjustments to allow for increases in life expectancy.
Denmark has introduced a direct link between increasing life expectancy and the pension
eligibility age. Sweden has introduced national account schemes, which schemes reduces
pensions if life expectancy increases. In 2003 France linked life expectancy to the number
of contribution years required for entitlement to a full pension.
Further reforms deal with pension reserves set aside to guarantee, financially speaking,
the future pensions (Netherlands, Spain, Portugal).
Especially in the UK and Netherlands funded private pension provision has always
been essential (third pillar). Furthermore, several countries have increased provision in
occupational or private schemes that complement public pensions (e.g. Germany, Austria,
Belgium and Italy) due to the forecasted decrease in replacement rates expected to occur
in EU. However, public Pay-As-You-Go pension schemes are expected to be the principal
source of income for pensioners for the near future and this may create problems to the
European countries in keeping a minimum income to pensioners.
In the UK the Pensions Act of 2007 allows employers to enrol employees into a new
occupational pension provision and creates a new pension institution, the Personal Accounts
Delivery Authority (PADA). PADA's job is to set up a national, trust-based pension scheme
called `personal accounts' that would help millions of people on low and moderate incomes,
who do not have access to a good-quality workplace pension, to save for their retirement.
All these reforms have been undertaken due to increase in life expectancy in order to
stabilise pension systems and to safeguard financial sustainability and to reduce pensioner
poverty. Another fact has to be considered: for almost all EU15 countries the gross replace-
ment rates of the statutory pension schemes is expected to decline. In order to counter this
problem, governments and social partners have conceived different kind of complementary
pensions such as occupational and individual pension schemes. Nevertheless in most EU15
countries the aim is still far away, as only part of the workforce is covered by a comple-
mentary scheme as the table 1.4 shows. This problem may lead to social problems such as
poverty in retirement age.
1.4 Possible Future Pension Policies 10
Figure 1.3.4. Coverage rates of private pension schemes
Source: E.C., Adequate and sustainable pensions. Synthesis report 2006.
1.4. Possible Future Pension Policies
The first pillar (the public pension schemes based on solidarity between generations and
financed on a `Pay-As-You-Go' basis) should remain the main pension for older people to
guarantee a minimum level of income once retired and to avoid poverty. The second pillar
should be complementary to the public pensions, moreover group pension plans should be
made avaible to every employee making them mandatory and accessible to non-standard
workers such as part-time workers, short-time workers, etc. Mobile workers should be able
to take full advantage of these supplementary schemes. Legal frameworks are to set (and have
been already partially arranged) for occupational pension schemes: no gender discrimination,
acknowledgement of workers' financial interest and rights, taxation and investment rules.
The management of pension funds should ensure a proper return on their investments as
well as respect for social and ethical standards even if this can't be guarantee.
A huge problem in Europe is the number of workers retiring before the statutory re-
tirement age through early retirement. The employment rates for older workers decreases
sharply after the age of 55. Luckily, due to acknowledgement of latest financial and demo-
graphic forecasts, the EU has been reviewing upward minimum early retirement ages in the
last years. Human resources policies that involve removing older workers from employment
could help younger employment rate but may not be acceptable and sustainable financially
and socially in the coming years. EU policies should exercise influence in order to make the
labour market more flexible on retirement, making it more gradual, even in times of high
unemployment. Moreover governments should undertake new laws and actions to encourage
older workers to keep working or even re-enter in the labour market. One reform (wich has
already been partially undertaken) is to raise the statutory retirement age, but this is not
enough since tax and income incentives are needed as well to induce workers to retire as late
as possible. Moreover good working conditions and flexible work contracts can contribute
1.4 Possible Future Pension Policies 11
to keeping older workers longer at work. Health and safety policies are important as well as
greater autonomy in work (organisation) combined with a reduction in working hours (at
retirement age or when it is getting closer) are also important in order to persuade workers
to stay on board.
An important matter of labour policies should be to keep training older workers as well
as the younger ones and do not exclude them form training programmes. Skills need to
be upgraded throughout the working life to keep workers employable and updated with
new technologies, strategies, informations, etc. Lifelong learning and vocational training are
essential to maintain the employability of older workers as well as the younger ones.
The European Union should use economic growth and job creation for budgetary consoli-
dation, but also for the social protection systems bearing in mind the demographic forecasts.
Several countries set up an annual reserve for public retirement pensions, withdrawing funds
from margins in the state budget under EMU conditions (the Netherlands, Spain, Ireland,
Belgium and France). Governments should also guarantee the financing, on the basis of
general tax revenues, of all non-contributory solidarity measures introduced into the social
security systems. Moreover they should financially guarantee the social protection systems
growth in line with current and future needs. They should promote sustainable economic
growth and the expansion of employment, preserving the rigths of every worker protecting
older people when they exit the labour market.
CHAPTER 2
Defined Benefit Plan vs Defined Contribution Plan
2.1. Introduction
Among OECD countries we can notice the considerably different importance of private
pensions. Indeed in five countries (Australia, Canada, the Netherlands, United Kingdom
and USA), private savings supply more than 40% of retirement income while in other five
countries (Austria, Czech Republics, Slovak Republics, Hungary and Poland) private savings
provide less than 5%. The OECD average is 19,5% as we can learn from the chart (it shows
how much of retirement income comes from `capital', which includes all private savings and
to focus on pension provision, the calculations exclude incomes from work) 2.1
Figure 2.1.1. The role of private savings
Source: OECD income-distribution database; see Figure 2.3 in OECD Pensions at a Glance 2009 and
OECD (2008), Growing Unequal?
12
2.2 Defined Benefit Plans 13
Several countries have mandatory private pensions designed to face new demographic
and financial challenges. Private pensions have been affected by the current crisis, especially
for employees near to retirement. Less effect is noticed into younger employees' pensions
since they have the whole working life to recover the previous worth. Younger employees
have also been affected by the switch to DC provision and lower employer contributions. In
any case, the crisis has affected both Defined Benefit (DB) or Defined Contribution (DC)
schemes with different consequences: solvency and deficit risk for DB schemes and lower
benefits for DC schemes.
As previously mentioned, pension schemes can be mostly classified in two kinds of
scheme:
(1) Defined Benefit Plan
(2) Defined Contribution Plan
Defined Benefit Plans, or final salary schemes, are ones where the benefits are calculated
using a fixed formula based on factors such as earnings history, tenure of service and age. The
contributions are not known before but change over time to meet the changin estimates of
the cost of funding the scheme; moreover both employers and employees pay contributions
into the plan, usually a member pays 5 per cent of his wage. Employer's contribution
varies, employee's one is usually fixed. In this kind of plan they distribute their benefits
through life annuities. In a life annuity, pensioners receive equal periodic benefit payments
(monthly, quarterly, etc.) for the rest of their lives. A defined benefit pension plan provides
reversionary annuities so a surviving spouse can inherit 50 percent of the member's pension.
Defined Contribution Plan, or money purchase schemes, is a sort of retirement plan in
which the contribution are calculated by a fixed formula and the contribution is specified and
doesn't change. Every period, the employees and the employer put a defined percentage of
own salary. Individual accounts are set up for each member, benefits depend on the amount
of the contributions paid into these account. The contributions are guarantee, benefits are
not. They depend on investment returns and the cost of a life annuity.
Beyond these two different schemes, there is a third group: Hybrid Plans. Hybrid Plans
are those which are not either DC schemes or DB schemes but have certain features of both
types of schemes, they can combine the best, or the worst features, of both. Some employers
prefered these plans in order to share the risk with employees.
The obvious forecasts relating to retirement plans include an ageing problem (financially
speaking), life expectancy keeps increasing and this means more people who will survive at an
older age and will keep receiving benefits from pension fund. Moreover the contribution base
is decreasing. Hence if people keep retiring at the same age it will create big issues since they
will receive a pension for a longer time and this generates instability between contribution
and benefits. Indeed two logical solutions appear to be: increasing in the contribution level
or a raise in the statutory retirement age. If these two measures or at least one of them are
not taken, the effects will be decreasing in benefits level or higher employer contributions.
If governments do not introduce reforms, defined benefit systems won't be able to maintain
their promises and defined contribution systems will provide pensions levels well below what
was employees' expectation when they joined in. Both funded and unfunded systems will
be affected with two main differences: rates of returns will affect future benefits in funded
systems, while productivity will affect contribution levels in unfunded systems.
Up to few years ago, DB schemes had the most number of members, but in the last
years we have been watching a move towards DC schemes and few Hybrids schemes. In the
USA DC schemes are the majority as well as Europe, with the exception of few countries
such as UK, Netherlands and Ireland.
2.2. Defined Benefit Plans
In DB Schemes the value of benefits is predetermined when a member joins the scheme
but employer'scontributions can vary over the time in order to be enough to guarantee
the defined benefits. That involves a periodic actuarial valuation to calculate the required
2.2 Defined Benefit Plans 14
funding cost. If a pension fund achieves poor investment returns, as result of wrong portfolio
choices, to avoid the closing down it will have to increase the contributions level or/and
change the investment strategy to bring back the correct actual capital adequacy. This
seems to be particularly true when Solvency II comes into force otherwise it will trigger
autorithies' measures. In the opposite instance, if the fund is in surplus it would decrease or
suspend the contributions level or increase the benefits to maximise members wealth. For
DB plans the uncertainty turns out to be the contribution level to guarantee the prearranged
benefits.
A distinction must be done between funded DB plan and unfunded DB plan.
In a funded plan, the contributions are invested in a fund in order to reach the level
of defined benefits through expected returns on investments. In an unfunded plan (PAYG
schemes), the assets are not invested in any fund and benefits are paid by the employer
(typically the state) raising money needed from active employees' contribution.
There are different kind of DB depending on the allowing of new members or on the
payment of benefits: _Open schemes, as the name suggests they continue to accept new
members and the benefits of existing members continue to accrue;_Closed schemes (by now
the majority of the schemes) do not admit new members but existing members continue
to accrue benefits;_Frozen (or paid-up) schemes do not admit new members and benefits
do not accrue; the benefits of existing members for earlier service, however, continue to
be guaranteed by the scheme;_schemes that are winding up are in the process of settling
benefits in order to close the scheme permanently. These are schemes in the final stages
of closing down completely;_there are also schemes that are sectionalised, that is, some
sections of the scheme have different status types. For instance these schemes could have a
closed DB section and an open DC section.
The main features of DB schemes are:
• knowledge of the future retirement benefits, based on likely proportion of final
salary;
• uncertainty of contribution needed to reach benefit. It depends on investment
returns, the higher they are, the lower the annual contribution will be and vice
versa;
• the level of benefit promised affects the contribution,
• they are more suitable to employees who stay until retirement and especially for
those who gain above average salary growth. Those who leave before retirement
can receive lower benefits,
• their contributions are larger than the DC schemes,
• financial risk is on the employers shoulder,
• the employees' risk arises from the employer's insolvency.
In DB schemes, employees accrue pension entitlements as a percentage of final salary every
year. The liability of the pension lies on the employers' shoulder and take the risk of
investment, while trustees decide investment strategy. They are exposed to the risk of
increasing costs of the schemes, since they have to ensure the funding of liabilities. This
could create troubles for the employer solvency (one of the main issue of Solvency II with
a strong increase in margin therefore of total cost). The contributions are based on the
present value of the defined benefits expected to accrue from future servicet. Normally the
pension is calculated to let an employee reach two third of his final salary when he retires
(if he has 40 years of service), according to the 2.2.1 :
(2.2.1) (service/60)× last wage.
Service means the number of years worked for the employer. Last wage is the final
salary or an average of the last 5-10 years salary (DB schemes are also called Final Salary
Schemes).