In the spotlight: occupational pensions

Getting out of the impasse of the ‘right’ conversion rate


The decision on how high to set the conversion rate for an employee benefits scheme (pension fund) has serious consequences. It will have an impact for decades to come on the income of pensioners, the finances of the pension fund, and the situation of the employer. Individual pensioners want as high a pension as possible, while the people responsible for the scheme have to be prudent to safeguard the long-term future of the fund.

Heinz Hartmann

Heinz Hartmann

Chairman of the Board of Trustees of PwC’s pension fund and COO/CFO of PwC Switzerland

So what is the ‘right’ conversion rate? Given that we can’t predict with any certainty whatsoever the basic assumptions – investment returns and pensioner life expectancies – that will apply for the next 20 or 30 years, how are we supposed to work out the right conversion rate? Once you set the conversion rate you can adjust it upwards, but only in certain circumstances can you can adjust it downwards. That means you can’t afford to set the rate too high. As far as mandatory pensions are concerned, the decision lies with the sovereign power, in other words with the people. This could result in a one-sided bias towards the interests of pensioners. The political authorities and business must make due preparations and find ways of assuring the solvency of pension funds.

Complex dilemma

The authority over and responsibility for the extra-mandatory component lies with a pension fund’s board of trustees, which equally represents the employer and the employees. The trustees have to weigh up the various interests carefully.

  • Cutting conversion rates will lead to painful reductions in income for future pensioners, who may well view any cut in the rate as an unnecessary overreaction.
  • On the other hand, postponing the decision to adjust the conversion rate invites accusations of acting irresponsibly, as any delay may result in substantial changes in pensioners' assets, or even put the pension fund’s solvency at risk.
  • The employer wants to ensure that its pension fund remains also attractive for new people joining the organisation. Remedial contributions and low interest rates on retirement capital due to redistribution on the basis of inflated benefits promised in the past are a real turn-off. Subsidising pensioners at the expense of active members is in sharp contradiction to the idea of the second pillar.
  • A reduction in the conversion rate will create apprehension among employees that the employer wants to mitigate reductions in benefits with extra savings contributions and compensatory payments.
  • Reducing the conversion rate will mean that employees will need to work longer to avoid reductions in benefits – which will not always be in the interests of the employer.
  • So-called 1e plans (see 1e pension plans) may be a topic for discussion. These plans allow insured members to choose their own investment strategy and assume the investment and longevity risk.

Seen in a sober light, the fact is that it’s impossible to set the ‘right’ conversion rate. There will always be a conflict of interest, and the circumstances will always turn out differently from what was originally expected.

Figure 1: Complex challenge faced by pension funds
Cross-subsidisationby active members Interest Retirement pension Retirement capital Conversion rate

Farsighted solution

The trustees of PwC’s pension fund have opted for measures to reduce the redistribution that will also be advantageous and understandable for the people already receiving a pension. Their pension income remains plannable. While the model adopted involves a significant cut in fixed pensions, it added a variable bonus component, which is determined periodically by comparing budgeted and actual returns. In other words, the bonus component may be cut if returns are insufficient, but it may also be raised if returns are good. This way it’s possible, to some extent, to adjust the conversion rate on an ongoing basis. The positive side-effect of this approach is that it indirectly links pensions to inflation, as inflation tends to be higher when interest rates are high – and vice versa. At first, PwC’s new model was only implemented for new retirees whose pension started in 2005 or after. Necessary cuts in conversion rates for future retirees, by around 50%, and expectations of low returns, mean that new retirees need more capital to finance their own retirement. For this reason the board of trustees wants to limit the redistribution by also applying the pension model to current pensions (existing retirees). In other words, the pensions of people who have already retired will be adjusted in line with returns. This does not constitute a remedial measure, but rather a switch to a more appropriate system. The result is that all pensions are indexed – and the redistribution effect is reduced.

The system underlying the model and the way it functions are described in part two of this articleDynamic pensions.

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Heinz Hartmann

Heinz Hartmann

Chairman of the Board of Trustees of PwC’s pension fund and COO/CFO of PwC Switzerland

+41 58 792 15 44

Summary

The general outlook for Swiss pensions is not particularly bright. So it’s all the more important to find financially sustainable solutions to the problems faced by the second pillar – solutions that don’t put younger generations of active members at a disadvantage. At PwC we have opted for a dynamic model geared to the reality that takes account of the interests of both pensioners and active members. This is our way of taking responsibility not only for our pension fund, but for the future of our society.