The minimum return guarantee, devised by financial engineers to allow pension providers to offer a handy hybrid between defined contribution and defined benefit schemes, is proving increasingly hard for pension fund managers to ignore.
Interest in the concept has grown following the spectacularly negative returns triggered by the credit crunch. However, a new report from the Organisation for Economic Co-operation and Development warns that the notion of pledging a minimum floor for investment returns can be extremely costly for pension providers and hence for the participants making pension contributions. Of course, much depends on the level of return guaranteed.
Capital guarantees that protect the nominal value of contributions in defined contribution pension plans a 0 percent guarantee have a relatively low cost, protect plan members from worst-case scenarios, and can thus help raise public confidence and trust in the funded pension system, says the OECDs inaugural Pensions Outlook, published Monday. However, the report says, guarantees above the capital guarantee, on the other hand, can be very expensive. As a result, the OECD adds, such guarantees reduce substantially the net-of-fee benefit from defined contribution plans.
The report highlights the German example, where some pension plans provided both by employers and as purely personal pensions offer a nominal-value capital guarantee: the individual will not, when they draw their pension, receive less money than they put in. In Switzerland, pension funds are required by law to meet a minimum average return, over the contribution period as a whole, of 2 percent a year. In Denmark, ATP, the operator of a nationwide, mandatory defined contribution plan, has provided a relative return assurance since 2009, where the minimum annual return is reset regularly in line with long-term interest rates.
The OECD has calculated the cost to pension providers of these pledges by assessing the cost of buying derivatives such as put options that would protect them against the downside risk of low returns. It estimates the average cost of a German-style capital assurance at a fairly cheap 1.3 percent of the total value of the final pension pay-out. For the Swiss-style 2 percent guarantee this cost rises to 5 percent of the payout. For a floating system roughly along the lines of the Danish model, with a new minimum return set for each year that is based on the prevailing market interest rate at the time, it increases to 24 percent a substantial and potentially prohibitive portion of the value of the pension.
The report also warns that minimum return warranties could change the nature of a providers entire investment portfolio. It notes that where the company providing the pledge also manages the pension investment, there is a risk that a guarantee could result in conservative asset allocations, especially under increasingly demanding prudential (e.g. solvency) regulations. The lower risk provided by guarantees would be associated with lower expected benefits.
Pension providers in the United Kingdom and other countries have already complained that well-meaning attempts to minimize investment risk for future pensioners in this case because of regulatory action rather than minimum return requirements have forced them to invest in low-risk, low-return bonds. Still, those complaints have been muffled in recent years by the gap between gilts strong performance and the poor returns of the stock market.
Despite fears over their direct and indirect costs, the OECD report notes that more countries are considering whether to introduce minimum return guarantees in the context of the recent crisis. These floors would have saved pension investors from the spectacular declines in their portfolios caused by the credit crunch.
The Pensions Outlook estimates that in 2008 the peak of the crisis pension funds across the OECDs 34 rich-country member states suffered a negative real rate of return of 10.5 percent, with an average return of minus 1.6 percent from 2007 to 2011. That helped limit the average annual return from 2001 to 2010 to 0.1 percent.
This hit defined benefit schemes badly. Average funding levels in defined benefit schemes fell below 100 percent in the Netherlands and Switzerland at the end of 2011 according to the report, and to 80 percent in the United Kingdom.
When it comes to defined contribution schemes, governments across the world are scratching their heads trying to work out how to incentivize disillusioned investors, caught out by these losses, to continue putting money in pension plans. Minimum return guarantees, in particular the capital guarantee, may help overcome popular fears over saving for retirement in defined contribution pension plans, concludes the report. Surveys highlight that peoples negative feelings about saving in defined contribution pension plans often stem from the fear of losing even part of the nominal value of their contributions.