Pension funds that are financially healthy have a balanced funding ratio, which means that the value of the funds' assets is sufficient to cover the amount needed to pay out benefits. If their funding ratio is too low, pension funds must take recovery measures to ensure that they will be able to fulfil their commitments to members and beneficiaries also in the long term. Examples of such measures include increasing contributions, postponing annual increases in line with wages and price levels (index-linking), and, as a last resort, reducing entitlements. This year, pension fund recovery plans have a maximum term of twelve years, within which the funds must achieve a funding ratio that is at or above the required level. According to the new requirements they may calculate their funding ratio based on the twelve-month average funding ratio, known as the policy funding ratio (PFR). This prevents pension funds from being declared in deficit based on daily rates.
The rules governing recovery plans used to be much stricter. Underfunded pension funds were required to show significant recovery within three years. This often led to lower benefit payouts (curtailments), postponement of index-linking, or increased contributions for both employees and employers.
Assessment of recovery plans
DNB has evaluated a total of 155 recovery plans over the past few months, assessing their compliance with the requirements of the new financial assessment framework. Although the new framework offers pension funds more time and wider policy margins they must be able to thoroughly substantiate their projections for the future.
Pension funds make various assumptions about the future in their recovery plans. On average, they expect to achieve the required funding ratio within 6.5 years. The plans show that the funds expect to achieve recovery almost exclusively on the basis of surplus investment returns – the expected return on investments as a projection of future asset growth. Pension fund recovery plans are bound to maximum with respect to the level of expected returns, however. Their projections are bound to an annual maximum of 7% on equities and 6% on real estate. Some, mostly larger, funds use these maximum levels in calculating their future return on investments. Whether these returns will actually be achieved of course depends on financial market trends.
Contributions have a negative impact on recovery
Pension funds may also use their expected return on investments to set the level of contributions. This is known as contribution cushioning, and it means that the actual level of contributions is lower than the required level. As pension funds must take the required level of contributions into account when drafting their recovery plans, contribution cushioning has a negative impact on recovery. Apart from opting for contribution cushioning, only a small number of the pension funds intends to raise contributions as a recovery measure.
No pension curtailments expected
Pension funds will not have to resort to pension curtailments in the short term. Under the new statutory assessment framework, however, they must achieve a funding ratio of at least 104% within the first five years of the recovery period. If a pension fund is unable to achieve this target within five years, for instance because its projected returns on investment failed to materialise sufficiently, it will have to resort to curtailing pension benefits after all. Such cuts do not have to be implemented all at once, however. The new regulations offer the option of spreading them over a ten-year period, so that the benefits will only need to be reduced in small steps.
Partial index-linking of pensions
Under the new regulations, pension funds may apply index-linking if they have a funding ratio of 110% or more, which means that they are allowed to increase the level of pension benefits with the partial of full increase of wages and price levels. Pension funds must hold more cash in order to be able to increase pension benefits. This is why recovering pension funds are not allowed to apply full index-linking immediately. They are only allowed to do so once they have returned to full financial health and have built up sufficient buffers, so that index-linking does not stand in the way of recovery.
Most pension funds have stated in their recovery plans that they intend to apply index-linking as soon as their funding ratio reaches 110%;20% of the recovering funds are expected to achieve this goal in 2015. Two-thirds of the funds expect to start partial index-linking in 2018.
DNB plans to review the pension funds again next year, taking their funding ratios at that point in time as the basis for the recovery plans. Then we will see to what extent the outcome of the pension funds' recovery plans has contributed to their financial recovery over the first year.