Issues in the Treatment of Defined Benefit Pension Schemes

1. Issues in the Treatment of Defined Benefit Pension Schemes Brent Moulton Advisory Expert Group Meeting UN Headquarters, New York 23–25 April, 2012

2. Overview • SNA 2008 treats defined-benefit pension schemes as contractual obligations that result in liabilities towards households, regardless of funding level. • In preparing to implement these changes in the United States, we’ve identified two issues that may need clarification: • 1. Issues arising with partially funded schemes • 2. Treatment of holding gains and losses

3. Treatment under SNA 1993/2008 Production account • Output (autonomous funds) in insurance and pensions fund subsector (93/08) Generation of income account • Actual contributions: employer to households (primary) (93/08) • Imputed contributions to make benefits accrued in current year = total contribution (08)

4. Treatment under SNA 1993/2008 Allocation of primary income account • Households’ (HH) receipt of actual employer contributions to pension fund (PF) (93/08) • Plus imputed employer contributions (08) • PF receives property income (93/08) • Property income attributed to plan participants: • = property income received by PF (93) • = increase in net present value (NPV) of entitlements (08)

5. Treatment under SNA 1993/2008 Secondary distribution of income account • HH total pension contributions (HH to PF): • Employers’ actual contributions (93/08) • Employers’ imputed contributions (08) • HH actual contributions (93/08) • HH pension contribution supplements* (93/08) • Less: pension scheme service charges (93/08) • Pension benefits (PF to HH) (93/08) * pension contribution supplements: • = property income received by PF (93) • = increase in NPV of entitlements (08)

6. Treatment under SNA 1993/2008 Use of income account • Pension scheme service charge recorded in HH final consumption expenditure (93/08) • Adjustment for change in pension entitlements = HH net contributions in secondary distribution of income account less pension benefits: • Based on employers’ actual contributions; PF’s property income (93) • Based on employers’ actual + imputed contributions; increase in NPV of entitlements (08) • Net saving of pension fund: zero (93); depends on imputed contributions & NPV of entitlements (08)

7. Treatment under SNA 1993/2008 Financial account • Change in pension entitlements (PF to HH) as in use of income account (93/08) • Claim of pension fund on pension manager (08): • Allows deficits in funding to be shown as liabilities of the pension manager (usually the employer) • Can be negative if there is an excess in funding

8. Treatment under SNA 1993/2008 Balance sheet • “pension funds are assets of the households entitled to receive pensions.” But, DB pension fund “can have a net worth… if assets of the fund exceed of fall short of the fund’s liability for guaranteed benefits.” (93) • “In the case where the employer retains the liability for any underfunding or the benefit of any overfunding, a claim on… the employer… by the pension fund should be recorded for any deficit or surplus… the net worth of the pension fund remains exactly zero at all times.” (08)

9. Issue: Underfunded plans • BEA (Reinsdorf & Lenze) article in Survey of Current Business August 2009: • Ratio of plan assets to actuarial liabilities for year-end 2004: • Private DB plans 96.4% • State & local government plans 88.2% • Federal government plans 42.0% • U.S. government plans are persistently underfunded, especially at federal level

10. Example (very simple) • Assumptions: • One employee. No uncertainty or variation. • Works for 30 years. Retirement lasts 20 years. • Salary = 1,000 / year. • Pension benefit = 1.5% × years service × salary = 450/yr • Discount rate = rate of return on investment = 5% Case 1 • Employer fully funds plan based on accrued benefits. • Employer contribution = 45 in the first year of employment and increases each year (48, 50, 53,…) until it reaches 187 in 30th year. • Plan pays 9,000 in benefits from 3,017 in cumulative contributions, 5,983 in cumulative property income

11. Example (very simple) Case 2 • For first 20 years, employer provides actual contributions equal to 50% of change in pension entitlement • Employer actual contribution = 23 in the first year of employment and increases each year (24, 25, 26,…) until it reaches 57 in 20th year. • At year 20, plan assets = 1148, plan liabilities = 2295 • Cumulative contributions: 751 actual contributions, 751 imputed contributions; forgone property income = 794 • SNA08 shows liability—claim of pension fund on employer (2295 – 1148), but no interest on this liability

12. Example (very simple) Case 2 (continued) • Year 21: Assume employer recognizes that plan is underfunded and starts making payments covering full change in entitlement (120) plus catch-up contribution of 75 (=57 to cover forgone property income + 18 reduction in underfunding) • Employer liability reduced by 18 • If continues to pay catch-up contribution of 75 per year for 30 years, allows pension to be paid in full. • 18 is financial transaction – but recording of 57 unclear • Not compensation of employees (paid during retirement) • Conceptually, should represent imputed interest on loan by pension fund to employer

13. Underfunded plans: Proposal • While SNA08 correctly recognizes property income payable on pension entitlements and claim of pension fund on the employer (“pension manager”), its treatment is incomplete because it fails to show interest associated with this liability of the employer • Property income is essential to operation of pension scheme, so it shouldn’t be ignored • Recommend recording imputed interest payable by pension manager to pension fund • Calculated as claim of pension fund on pension manager times interest rate used in calculating increase in NPV of entitlements

14. Issue: Pensions funded by holding gains • According to U.S. flow-of-funds data, 2/3 of assets of private pension funds are equities or mutual fund shares. • Holding gains represent a large share of expected returns • Implies gap between saving, change in net worth • Under SNA93, this gap was passed to the household sector • For pension fund, saving = change in net worth = 0, with effects of holding gains showing up in change in household net worth

15. Example (holding gains) Case 3 • Same case 1 (fully funded scheme), except assume that the 5% return represents 2% property income and 3% holding gains • In year 25: • Contribution = change in entitlement = 146 • Property income received by plan = .02 × 3348 = 67 • Holding gains received by plan = .03 × 3348 = 100 • Property income payable to plan participants = 167 • Pension fund’s net saving = –100 • Pension fund & employer’s change in net worth = 0

16. Holding gains • While there is no single right answer about where to show gap between saving and change in net worth: • We usually interpret corporate saving as undistributed operating surplus • Will be difficult for users to interpret persistent negative saving by fully funded pension plans • Plans are operated on behalf of households, which suggests continuing to show the gap in the household sector (as under SNA93)

17. Holding gains - Proposal • Suggest that pension fund’s net saving = change in net worth = zero (as in SNA93) • Could be implemented by recording households’ property income on benefit entitlements as sum of pension fund’s actual property income and imputed interest on pension fund’s claim on employer • Would reduce household sector’s property income and saving and avoid persistent negative saving by pension fund

18. Questions for AEG - Underfunding • Should the claim of pension fund on pension manager include the full underfunding – forgone contributions and forgone property income? • Should change in liability due to forgone property income be recorded as imputed interest payable by pension manager to fund? • If not, how should the subsequent catch-up contributions be recorded?

19. Questions for AEG: Holding gains • Does the AEG agree with Reinsdorf’s suggested alternative approach for recording property income? • would set pension fund net saving = zero • would use pension funds’ actual property income on assets (plus employers’ imputed interest for underfunded schemes) to impute households’ property income on pension entitlements