Broken Promises Insolvency in Defined Benefit Funds

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 USA: • Estimated total underfunding is $350 billion • United Airlines (May 2005) : Fund Liabilities : $ 17 billion Fund Assets : $ 7 billion (42%) PBGC cost (other funds pay) $ 7 billion Members shortfall $ 3 billion (19%) • PBGC deficit is $23 billion and rising • Govt is currently attempting (despite political resistance) to tighten the legislation

The Scope of the Problem UK: • 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)

The Scope of the Problem Australia: • 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 deficits NAB $252 million; News Corporation $468 million; AMCOR $120 million

The Scope of the Problem Australia continued: • One major failure, Ansett: members lost about $150 million in benefits after the 2001 collapse • UniSuper’s actuarial report in December 2002 Fund Liabilities $ 5.2 billion Fund Assets $ 4.5 billion Shortfall $ 700 million Funding 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%)

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 Promises 1Journal 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: • Level of protected benefits? • Valuation of Liabilities? • Valuation of Assets? • Minimum level of funding and/or contributions? • Remedial action for deficits (amortisation period)? • The fund as creditor of an insolvent employer? • Allocation of assets among members on wind-up? • Well-designed guarantee fund / moral hazard?

A Hypothetical Example: Unisuper • The employer contributions are : 14% into a defined benefit fund 3% 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 priority Fund 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 billion Funding 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?

Broken Promises Insolvency in Defined Benefit Funds