Issue: March/May 09
THE FINANCIAL CRISIS, PENSIONS and POLICY
The financial crisis has far-reaching effects beyond its impact on the international banking system. Toyota recently announced it would cut production at 11 of its 12 factories in Japan, and General Motors laid off 2000 workers. The effects of the global “credit crunch” have spilled over into other sectors. So what does this have to do with retirement provisioning and pension reform in SA?
Members of defined-contribution (DC) funds surely know by now the nasty effect the market downturn has had on their fund values over the past year. This is true the world over as markets have tumbled lower. The graph below shows returns (both in local currency and dollar normalised) in 2008 for some of the largest pension markets around the globe:
The worst thing to do in all likelihood would be to cash out now only to try investing later. This would be tantamount to “selling low and buying high” – a sure strategy to becoming a poor investor! The market will recover, and when it does you want to be invested in it.
What about members of defined-benefit (DB) funds and the employers who back them? If one looks internationally, the “global meltdown” has had dramatic effects on the funding level of many DB schemes. The downturn in market values, in conjunction with expected lowering of long-term interest rates (which implies greater DB liabilities), means double-whammy negative effects on DB fund solvency ratios. A recent study by Watson Wyatt indicates that the 11 largest pension-fund markets collectively had asset values in 2008 that were $5 trillion lower than in 2007. This translates to a 19,2% drop in asset values since 2007, with DB funding levels dropping by 29,4%.1 These dramatic falls have naturally made employer-sponsors, members and regulators uneasy.
The Netherlands, which is virtually completely a DB pension system, has arguably the strictest funding regime imposed by regulation. Funds are required to maintain a solvency ratio of 125%. If they dip below that level they are earmarked for regulatory action. At year-end 2007, the average funding ratio across pension funds was 144%. At present however, it is estimated that half of all pension plans in the Netherlands have fallen below 105%.
The Watson Wyatt study indicates an average asset / liability ratio of just over 60% for DB funds across the 11 largest pension markets as at the end of 2008
The picture in other jurisdictions that adopt less stringent, but nevertheless reasonable funding standards, is even uglier with DB funding levels far below 100%.2 Poor DB scheme solvency and poor market returns has prompted calls in some quarters for government intervention, an increase in contributions to improve the financial position of funds, regulatory review, and radically (as well as ridiculously) in the case of Argentina the nationalisation of private sector pension funds.
Where’s the relevance of any of this for pension reform in SA? Firstly, it should be recognised that most of our DB schemes are run by the state or parastatals and are well-funded. We are, in terms of the number of funds, primarily a DC retirement fund market. However, in reforming our system, we need to acknowledge that there is no free lunch. Whether the reformed national system is DB or DC in character, you cannot escape the market. The most ambitious DB plan with unrealistic promises might be populist but will not be sustainable in the face of severe financial market and longevity stress. On the other hand, a DC system contains inherent volatility of retirement outcomes for members. The challenge becomes how to smooth these out in a reasonable fashion, recognising that there can be no complete removal of risk from the system.
In terms of pensions policy, further lessons can be learnt from the financial crisis and its knock-on effects which should influence the debate surrounding pension reform. These at the very least are two-fold: