Chapter 5 // Defined Benefits plans : convincing Unions there are other solutions ( Part 2 ) // Analysing the risk of insolvency

There are wide-ranging consequences for Defined Benefit (DB) schemes that cannot match their guarantees. In extreme cases, the fund can go bankrupt and everyone is left with nothing. And in all cases, both employers and employees pay.

Take the recent case of General Motors, which decided to contribute about $570 million – or 35% of the company’s profits in 2019 – to shore up its pension plans (US and non-US) last year. In this situation, the employer took over the refinancing of the company's pension fund, but this is not always possible.

In 2012, after the financial crises of 2008 (junk bonds) and 2012 (Greek debt), the situation was so critical that General Motors theoretically could have gone bankrupt. Even with the 2020 cash injection, the company was forced to offer a total reduction of $26 billion in benefits, impacting 118,000 employees. And for 42,000 of them, General Motors preferred to offer a lump sum rather than continuing to pay annuities.

This represents just one example. In extreme cases, if unions take an inflexible stance and refuse to cut profits, the fund can go bankrupt and everyone is left with nothing.

A false sense of security

According to a 2015 working paper published by the De Nederlandsche Bank, the average of the first 600 pension funds, which were under the supervision of the Central Bank, went from a funding ratio of 144% to 91% after the 2008 crisis (when the minimum funding ratio in the Netherlands was 105%).

In such situations, most funds are designed to return above the minimum requested by adopting one or more of the following measures: 

1.  Contribution rate increase. This means that both the employer and the employee are impacted.

2.  No indexation. This particularly impacts retirees.

3.  Pension cut. This impacts employees and retirees.

In other words, if there is a financial crisis, everyone – employer, employees, and retirees – is affected. So, the feeling of being well protected inside a DB is not, for me, as justified as some people like to think.

A worthless guarantee

In the event of a financial crisis (sound familiar?), it’s true that the employee who is invested in an unsecured Defined Contribution (unit linked) suffers the consequences.

Where a DB scheme is concerned, however, the employer in principle suffers the consequences for hundreds or thousands of employees.

However, there are two things to bear in mind. One, if the crisis is not too serious and the market starts again, the guarantee is rendered superfluous. If, on the other hand, the crisis is prolonged, the employer is left in difficulty or even bankrupt, and the loss is ultimately transferred to the employee.

So, if you think about it, what's the point of having a guarantee?

The only advantage that the guarantee affords to most investment funds is to push the asset manager to reduce risk by investing in asset classes such as bonds (less profitable) or, worse, to buy swaps or hedging options that are extremely expensive and decrease profitability.

In conclusion

There are two other significant advantages in moving from a DB pension fund to a unit linked fund. First, unit-linked funds are less expensive in terms of control and audit procedures. Secondly, a unit-linked scheme (as we will see in my next blog) would remove one of the major blocks to the development of cross-border pension funds in Europe.

So, if we succeed in changing the European culture and nudge the unions toward unit linked, the work would be simplified, the costs reduced, the transparency increased, and the performances boosted.

I don't fool myself that I alone can convince the unions. But it is important that someone starts talking about it all the same.