Benefit Schemes

Everyone wants to have a better life after their retirement. They prefer saving more than spending in their earlier stage of working. They can afford to invest more when they are still young. Almost every employee will invest in pension fund. However, the changing of financial market in these few years affected the investment in pension schemes.

There are two types of pension schemes. The first one is Defined Benefit Schemes (DB) and the second one is Defined Contribution Schemes (DC). Defined Benefit Schemes is also known as final salary pension schemes. The definition of DB is that the members need to follow the terms set by the scheme rules. The contribution paid by the employees is compulsory and the employers will contribute more. Trustees will guarantee an expected return. Certain level of their money will be kept and the remaining will be invested in the financial market. The main disadvantage of this scheme for employers is that they are responsible for achieving the required level of contribution. Defined Contribution Schemes is also named as money purchased pension schemes. The meaning of DC is that the amount paid by the employees and the employers are vary. All the money contributed will be invested. The difference between DB and DC is that employers are responsible for most of the costs when the investment return is under expectation or the costs rise in DB while employees need to bear the risk in DC. Employees need to maintain their contribution at a fixed level in DC, so they need to increase their contribution rates when there are bad returns from the investment or the increase in costs. It is very obvious that the employer can pay less if they use the DB schemes. As a result, many corporations switched from DB scheme to DC schemes in these few years.

In 2007 and 2008, the pension funds market faced a big challenge because of the financial crisis. The pension funds nominal rate of return dropped dramatically.

For example, the real rate of return of UK pension funds was 3% where the rate was 7% in 2006. The drop in equity markets and the slow economic growth in 2008 affected the return for 2008. The rate of return of 2008 was about -13%.

The financial crisis led to the increase in the risk level of funding gaps for DB schemes. In most of the OECD countries, the funding levels have decreased to 90% or below. For example, the percentage in the Netherlands has dropped to under 95% whereits lowest required level is 105%. The interest rates decreased rapidly because of the financial crisis and the global recession. The return on the newly issued bonds would be lower. Another important point is that the pension fund liabilities increased generally because the discount rate decreased with the interest rates, as a result the present value of liabilities rises. The decline in funding level can result in changes pension fund investment tactics, for example, cutting of pension promises or requiring for supplementary contributions. The cut of pension promises involved ending indexation of benefit payments or only paid part of it. The supplementary contributions from the employers and employees can put the funding level back to the required level. However, it is hard to get money from them during a economic recession.

Government announced some policy to discourage the unfavourable outcomes during the recovery periods in some countries. For example, the least funding level in Netherlands is 105%, managers need to make sure that they need to meet the minimum level within three years if their funding level is less than 105%. In the early 2008, the government decides to extend the period to five years because they do not want to reduce the retirement benefits.

When using the DB pensions scheme, the employers are the one who bear all the risks for the investment. According to the survey done by NAPF, which is described as the ‘leading voice of the UK workplace pensions', the number of employers expecting no changes in the open DB scheme has decreased from 37% to 23%. There is also more employers wishing to switch new employees to DC schemes. Although there are still a 14% of employers expected to keep their pension scheme, they would like to make adjustments to reduce risks and costs to them. This is clearly understood that the employers are less willing to take risks during 2007-2009 since the return of the investment is becoming uncertain and more likely to be reduced.

Similarly in the closed DB scheme, the number of employers who were expected to have no changes in their closed DB scheme has been fallen by 17%. The amount of employers who want to switch employees to DC schemes has risen from 4% to 13%. The employers who wish to keep their current schemes but apply changes to reduce risks and costs have doubled in July 2008 which is 28%. We can see that both employers using opened or closed DB scheme have similar response to the financial crisis. In addition, 25% of DB schemes have a plan to close to future accrual in response to the financial crisis they are facing.

In the view of employees, they used to be confident in the pension schemes. With good economy status, employees were having positive expectation in their investment. In the first two quarters of 2008, from the research done by NAPF, the overall confidence of employees has risen from 3% to 22%. In September, the female group has positive confidence level at first. However in the forthcoming quarter, the confidence level of the employees has fallen significantly. According to the survey, the group which has the most confidence level fallen is the age group 35-44, 45-54, 55-64, with the rate of 32%, 19% and 33% respectively, whilst the age group of 25-34 has the level fallen by 7% only. This may be because of the mid age group are approaching their retirement age, so they will have to care about the current economy. However for the younger people, they can be more confidence and positive since it is still a long way for them to retire, it is somehow believed that by that time the economy should be recovered.

Employees might wish to stop investing into the pension scheme since they might want to reduce expenditure. This is largely caused by the economic crisis, the unemployment has been raised and the costs are likely to increase. 11% of employees said that they are going to cut back their pension saving. Especially for the youngest group, many of them are going to cut their savings or take a pension holiday. This may because they are too young to invest largely into the scheme since there is still plenty of time for them to retire. However, it is believed that although the employees are feeling negative about the pensions at the moment, they still have positive expectations towards the future. Some employees may also wish to increase their contributions in order to make a better return in the future.

During 2007-2009, the financial crisis has largely affected the equity market, where the pension funds holders mostly invested in. Since the equity market was undergoing a difficult situation, most investments in the market had experienced losses. This also includes the pension funds holders, either using the DB or the DC schemes, who suffered during the time with only a significantly low rate of return or even a negative rate of return. In worse condition, some of them using the DC scheme might even have to reinvest more in order to maintain their funding scheme.

The participants of DC schemes bear the outcome directly. The decrease in the asset values lead to the decrease in the retirement assets, as a result, their retirement income will be reduced in the future. Hong Kong and the USA started to use DC system and the participants underwent a severe loss. The USA had lost 1 trillion US-dollars and the Mandatory Provident Fund system in Hong Kong lost about 30%. TheMandatory Provident Fund system includes mixed fund which is the most popular, then is equity funds, capital reservation funds and guaranteed funds, bond funds and money market funds. The 30% losses of the funds are mainly resulted from the loss of mixed and equity funds. Fortunately, the financial market began to recover in 2009. For example, the real rate of return of UK pension funds in 2009 increased to about 16%.

In Conclusion, government should set up some policy to reform the pension scheme. The UK government set up Pension Act 2007 and 2008 which include a policy of auto enrolment with minimum employer contribution. The final target to make sure that the pension fund scheme is on a sustainable basis over a long period.

 

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