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Retirement funds hit the limits
Turn around and there's another one. Pension guarantees have
been springing up all over the place. Governments the world over
want people to provide for their own retirement either through
personal pensions or, more typically, through company schemes.
Underfunding of company schemes is being discussed with greater
urgency in Europe, where demographic trends portend worsening
dependency ratios, and in many emerging markets. What happens if
companies fail, breaking their promises to pay pensions to retired
workers? Several countries have insurance schemes - some private,
some state-run - to back up pension funds. But is there a financial
disaster in the fine print?
No less than seven studies are in progress or have recently
been completed about creating a guarantee fund in the UK to top up
poorly funded company retirement schemes. The European Commission
recently issued a report: "Rebuilding pension".
Recently, Poland and Hungary have put in guarantees, like
those in Chile, to back up their new individual social security
investment accounts. Some international advisers have even been
telling countries that social-security reform is impossible without
guarantees from the state. But poorly designed guarantees can
defeat the purposes of reform and distort local capital markets.
Against this backdrop, insolvency insurers - existing
guarantee funds came to Washington for their biannual confab in
September. Their experiences - good and bad - deserve a look.
Gone, mostly, was the gloom and doom that hung over these
meetings earlier in the 1990s. The US system had been under siege,
facing huge unfunded liabilities. GM's pensions, for example, were
under water to the tune of $25 billion. But America's Pension
Benefit Guaranty Corporation (PBGC) - a US government agency - says
that it has snapped back, reporting a frothy surplus as the US
economy has surged forward and after a back-door subsidy for GM
worth $4,000 a worker. The Americans also raised taxes for their
programme.
Government guarantees are valuable - something the public
often fails to understand. Several studies have shown that company
pensions in the US are worth upwards of $60 billion more thanks to
the guarantee provided by law in 1974.
Finland also engineered something of a turnround. It
privatized a government-run programme of credit-linked pension
insurance that had piled up enormous losses. And Sweden, with a
hard-nosed business model thriving in the midst of the ultimate
welfare state, has continued to rack up solid results. Only Japan
seemed under a cloud.
Make no mistake. This is banking. Pension promises are a form
of debt for the companies that make them. Insolvency insurance
exists to assume the credit risk and, in most cases, interest rate
risk and other risks as well. It represents the last line of
defence for pensioners and workers in many industrialized
countries, before pensions go down the tubes with failing
companies.
And social security reformers, starting with Chile, use
guarantees to keep investment returns close to some average for
qualified fund managers. The state also stands behind the solvency
of those same fund managers as well as the insurance companies that
sell annuities to participating workers. Chile also guarantees a
minimum pension to any worker who contributes for more than 20
years.
Sweden kicked off the guarantee movement, when it set up its
highly successful and private FPG/AMFK systems in 1960. The FPG
secures white-collar pensions, the AMFK blue-collar pensions. The
same organization runs both schemes.
The Swedes recognized, from the start, that the key to
keeping a guarantee fund healthy is loss control, not reserving.
So, they built in safeguards to make sure that companies can't
expose the guarantee fund to big new risks, as a result of
acquisitions, divestitures or taking on more debt.
Sweden, along with Finland and Germany, allows companies to
use their pension debt in the business. There are no portfolios of
stocks and bonds inside these pension schemes. The principal
pension asset can be a loan to the company. It's called a book
reserve and shows up as debt on the employer's balance sheet. To a
guarantee fund, it represents the problem of securing underfunded
pensions carried to the ultimate extreme.
Sweden's FPG isn't open to all comers. Companies, including
their pension debt, must meet credit standards. If they can't, they
can simply buy annuities for their workers from a Swedish life
insurance company.
The maximum FPG contract runs for three years. And the
premium of around 0.3% of insured benefits has varied only
slightly. And the FPG has the power to step in and cap the growth
of liabilities or demand collateral if the condition of an employer
goes down hill. The guarantee fund can also force the policyholder
to replace its guaranteed liabilities with SPP annuities in even
more dire situations.
Still, there have been some losses. Claims approached SKr500
million ($60 million) a year during the last recession. But the
Swedish system has been able to recover 45% of the face value in
those cases. That's pretty good compared with international
experience.
By all accounts, Sweden's FPG has been a hard act to follow.
For every system that performs well, several have run into trouble.
Austria spilt lots of red ink - about $280 million - in the
mid-1990s with a system that guaranteed only 24 monthly pension
payments or a lump sum of $7,600. The Austrians, incidentally,
didn't show up for the meeting in Washington.
And consider Finland. The government guaranteed private
pensions there when they became mandatory in 1962 - two years after
employer and labour groups joined to set up the FPG/AMFK in Sweden.
Finland's scheme seemed to run smoothly enough until 1989,
when losses started to pile up. Then, the problem mushroomed into a
major debacle, and the government privatized the programme four
years later. Estimates at the time suggested that Finland's 1.4
million workers would be tapped, on average, for $500 each to pay
for the bailout.
Fortunately, Garantia - the private company created to pick
up the pieces - has recovered more than expected from the left-over
bankruptcy claims. But the collapse sent a signal loud and clear.
Using pension guarantees to promote other goals - such as
supporting small business, regional development or powerful
companies - can be a recipe for disaster.
Finland's Central Pension Security Institute - an agency of
the government - priced its guarantees to please politically. They
came with big subsidies, but in the face of the objections of the
finance ministry.
Finland also shows that these systems should have enough
capital from the start to survive a major shock. It's not good
enough to try building up reserves slowly over a long time. Finland
didn't accumulate nearly enough, even after 30 years.
The US, Canada and Japan have meanwhile proven that these
guarantees can seem deceptively inexpensive, until they start
operating. Actual claims exceeded initial projections by a lot. So,
caveat taxpayer.
No guarantee can sometimes be much better than a bad
guarantee. At least one country has shown that sound funding can
provide the best security for pension income. The Netherlands, for
example, doesn't send people to these insolvency insurers'
meetings. The Dutch learnt early the perils of poorly funded
pensions. Over 1,000 workers and pensioners lost virtually their
entire pensions when the Royal Dutch Lloyd shipping company went
bankrupt in the 1930s.
The Dutch government finally changed the law after World War
II. Book reserves - also called party-in-interest investments -
went out, except for tiny amounts. That and other reforms broke the
link between the employer's sometimes doubtful financial strength
and the pension promise.
Funding since has probably been the most aggressive on the
planet. So, the pension funds of little Holland emerged as major
investors on the international scene. And all this in a country
with strong trade unions.
The view from Washington is very different. Weak US labour
unions have, for a long time, managed to thwart effective funding
standards. Cost shifting to non-union taxpayers has been the order
of the day.
James Smalhout
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