Broken PromisesInsolvency in Defined Benefit Funds

Shauna Ferris

Macquarie University, NSW

sferris@efs.mq.edu.au

Presented at

the Annual Superannuation Researchers’ Colloquium

July 2005

The Scope of the Problem

Estimated total underfunding is $350 billion United Airlines (May 2005) :

Fund Liabilities : $ 17 billionFund Assets : $ 7 billion (42%)PBGC cost (other funds pay) $ 7 billionMembers shortfall $ 3 billion (19%)

PBGC deficit is $23 billion and rising Govt is currently attempting (despite political

resistance) to tighten the legislation

USA:

The Scope of the Problem

Estimated total underfunding £60 billion (top 100 companies only)

DWP estimates approx 65,000 workers pension fund members have suffered a significant loss (i.e. more than 20% of their benefits) when under-funded schemes were wound up by insolvent employers.

35,000 lost more than 50% of their benefits. Workers at Allied Steel & Wire (insolvent) : will get less

than 20% of their pension entitlements New legislation coming (Pension Protection Fund)

UK:

The Scope of the Problem

After poor investment returns in 2001/2002 APRA reported that a “significant number of funds” were in an unsatisfactory financial position

ASIC & ICA surveys suggest about 20% of large funds had a deficit (relative to Vested benefits) – very likely a higher proportion for small funds

Press reports of deficitsNAB $252 million; News Corporation $468 million; AMCOR $120 million

Australia:

The Scope of the Problem

One major failure, Ansett: members lost about $150 million in benefits after the 2001 collapse

UniSuper’s actuarial report in December 2002Fund Liabilities $ 5.2 billionFund Assets $ 4.5 billionShortfall $ 700 millionFunding Level 87% of Vested Benefits

As a result of good investment performance, the financial position of many funds has improved (e.g. UniSuper is up to 94%)

Australia continued:

Is the current situation acceptable? Does the solvency legislation provide a fair balance between the rights of the employers and rights of workers?

“Those who favour the retention of the laissez-faire principle in all its vigour argue that the establishment of a pension scheme is a voluntary act on the part of the employer. Since the employer does not have to provide a scheme at all, surely it must have complete freedom to set the terms of any scheme it chooses to provide. Though such a proposition still has its advocates, it is not dictated by either policy or logic. It is perfectly legitimate to insist that if the employer does choose to set up a scheme, the bundle of benefits offered to the employees as an integral part of the remuneration package should be legally protected and financially secure.”1

i.e. Keeping Promises1Journal of the Institute of Actuaries, 1994, Goode

Historically:

Superannuation seen as a privilege not a right

Low levels of vested benefits Willingness of employers to maintain

funding Reliance on the integrity of the employer to

make good any deficits within a reasonable time frame

But now:

Super is seen as deferred remuneration Much higher levels of vested benefits Barriers to withdrawal/ownership of surplus Reduced levels of funding (PUC vs Aggregate)

Possible shift in ethics ? -responsibility to shareholders is only

responsibility (James Hardie)-“if you don’t have a legal responsibility,

then you don’t have any responsibility”

In the USA and the UK:

Many employers have deliberately underfund to the extent allowed by the law

And then close the fund and walk away Leaving members and guarantee funds (funded by

other employers) to pick up the tab

SO : Suppose that you are a member of a defined benefit fund in Australia. Is there anything which will prevent the employer sponsor from reducing the level of funding, allowing a deficit to emerge, and then closing the fund ?

Key questions in assessing the solvency regime:

1. Level of protected benefits?2. Valuation of Liabilities?3. Valuation of Assets?4. Minimum level of funding and/or contributions? 5. Remedial action for deficits (amortisation

period)?6. The fund as creditor of an insolvent employer?7. Allocation of assets among members on wind-

up?8. Well-designed guarantee fund / moral hazard?

A Hypothetical Example: Unisuper

The employer contributions are : 14% into a defined benefit fund3% into an accumulation fund

The member contributions are 7% into the defined benefit fund

Assume : Assets 4.5 billion Liabilities 5.2 billion Shortfall 700 million

Assets = 87% of Vested Benefits.

Is this fund technically solvent (ie does it meet the minimum funding levels required by SIS?

Yes, as long Assets exceed the Minimum Requisit Benefits (as calculated by an actuary).

But:• various methods of calculation• not shown on Member Benefit Statement• total not shown in Annual Report• poor disclosure

My rough guess : • MRB for Unisuper is probably about 70%

?• But the ratio varies for each person from

50% to 100% (pensioners)

Is the employer required (under SIS) to make additional contributions to fund the deficit?

No. The fund is in an unsatisfactory financial position but as long as the fund is technically solvent the employer is not required to do anything about this.

Is the employer required (under the Trust Deed) to make additional contributions to fund the deficit?

No. If the fund is still in an unsatisfactory financial position after 4 years, the trustees can request the employers to pay additional contributions. The employers do not have to agree. If they do, the employee contributions will also be increased.

What happens if the employers do not agree to make additional contributions?

After four years, the trustees might decide to reduce the future benefits.

How much extra contributions would be needed ?

The deficit is $700 million ($820 grossed up)

Annual employer contributions were $840 million in 2003

So approx 1 year’s extra cont

Will the deficit disappear by itself?

It might, if investment performance improves and other experience is as projected by the actuary.

In 2002 the actuary estimated that there was a 50/50 chance that the deficit would disappear within 8 years. (In fact the funding ratio had improved to 94% by June 2004)

Could the deficit reappear and even become larger?

Yes, a defined benefit fund has a number of risks which could create a deficit

• poor investment returns • higher than expected salary increases• pensioners living too long• more people choosing pensions• higher then expected inflation (indexed pensions)• large number of people resigning when the fund is in

deficit• increased tax on superannuation funds

The risk of a shortfall is increased if the employer can reduce his contribution rates and/or remove surplus from the fund. In Unisuper the contribution rate is fixed and in the past the surplus has been used to increase member benefits.

Worst Case Scenario?

Let’s suppose that the fund is closed to new members. The number of pensioners has increased, they are living longer, and due to tax and social security changes more people are choosing pension benefits instead of lump sums.

• Pension benefits now amount to $2 billion. • Benefits for in-service members are $3 billion.

The long term experience has been worse than expected, and the employer is still contributing at the same rate (as required by the Trust Deed).

Assets are $4.35 billion, So the funding ratio has declined to 87%. For in-service members, the MRBs are just 70% of the

Vested Benefits, so the fund is still technically solvent.

Let’s suppose that in the next year:

investment returns are negative 5% due to a downturn in the education

industry and/or government cut backs, 10% of in-service members are sacked or resign and are paid their benefits

the fund is wound up immediately afterwards

How much would an in-service member receive?

Pensioner priorityFund Assets available to pay in-service

members = 0.95 * 4.35 – 2 - .10 * (4.35-2)= 1.8975 billion

Vested Benefits for in-service members= 3* 0.9 = 2.7 billionFunding Ratio = 70%

Note the “gearing” effect of giving pensioners priority.*A severe problem in UK pension funds, * Especially in declining industries

Assuming that the Universities are still solvent, could the fund claim the shortfall from the Uni?

Probably not• Under SIS, the employers are required to pay

the amount required to fund the MRB but no more.

• Under the Trust Deed, there is no additional liability to pay (? ask a lawyer)

• Any liability under employment contract?

So basically the in-service members bear the shortfall.

Does this mean that everyone in service would get 70% of their Vested Benefit?

Not at all. Under SIS, they would all receive at least their

MRB. Due to the way the MRB is calculated, it may be

higher than 70% for some people (e.g. older members) and lower than 70% for others.

If there is any money left over after this, it is distributed at the discretion of the Trustees (who must treat all members equitably)

Should I be worried?