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In this Watson Wyatt Update:
DNB published the guidelines for applying the Financial Assessment Framework (“the FTK”) to fully reinsured pension funds in June 2007. If a fund qualifies as a fully reinsured fund, the only risk that it runs is the credit risk of the reinsurer. The reinsurer’s credit worthiness can be such that the fund must retain additional resources to keep all its obligations financially covered. In addition, there may be sufficient cause on the grounds of the reinsurer’s credit spread to retain a Required Net Worth, namely if the credit spread is positive when set against the swap curve applied by DNB. Finally, there is a requirement as regards the Minimum Required Net Worth, namely that it must be equal to 1% of the provi-sion, or 25% of the annual management costs, depending on the agreements regarding management expenses. DNB may grant dispensation for the Minimum Required Net Worth, in which case the dispensation applies auto-matically up to 1 January 2010 or even to 1 January 2012. Under certain conditions, an approximation method based on the reinsurer’s credit worthiness may be used. With a rating of AA- or above, the applicable credit spread is zero and DNB may allow the retention of no additional resources.
For more information contact: Wichert Hoekert.
In a letter dated 16 July 2007, Minister Donner of Social Affairs and Employment states that the indexing label has been deferred until 1 July 2008. The letter also states that all pension providers must determine the anticipated av-erage supplement and the supplement in a poor scenario for each pension scheme before 1 April 2008. Although the letter does not explicitly state as much, it could be concluded from the aforementioned information that the delivery date for the continuity analysis has also been deferred. Of course, this does not apply to funds that DNB has asked to perform a continuity analysis on account of a shortage in reserves or coverage or the provision of a premium discount.
For more information contact: Wichert Hoekert.
If the details of a recent decision by the International Ac-counting Standards Board are not properly understood, the result could well be that employers feel forced to keep their pension funds as slim as possible because of the initial impression that there are tight restrictions on the possibility of showing a pension surplus on the company’s balance sheet. We explain below why this is not the case if the fund is set up in such a way that the fund assets act as collateral that sooner or later is charged entirely to the employer’s account. If it can be inferred from the articles and the implementing agreement that this condition is met, there are no limits as regards the pension surplus that can be shown on the balance sheet. Watson Wyatt expressly advises companies to consult the certifying accountant on this subject if and when the subject arises.
IFRIC Interpretation 14 ‘IAS 19 – The Limit on a Defined Benefit Asset, Minimum Funding Requirements and their Interaction’ (July 2007, effective from 2008, earlier appli-cation is recommended) makes it clear that enterprises that have pension obligations in the Netherlands must take account of the Pensions Act when preparing their annual reports according to the International Financial Reporting Standards. The law lays down minimum re-quirements for funding and solvency ratios and the pre-miums that the funds must collect each year; premium reductions and refunds are permitted only under certain conditions (see below for more information). Therefore, a surplus cannot be claimed as an immediate refund and moreover, it still remains to be seen whether a surplus has the effect of reducing future premium expenses. Thus, the question arises if an enterprise is nonetheless permitted to give the impression in its financial statements that it can gather all the economic benefits from a surplus of this kind? No, say the accountants – the balance sheet (amortisation apart) may not show more than the value of future reductions in contributions and refunds. However, if these are never permitted under the law and the funding contract, then the surplus in fact has no value at all for the enterprise. In that case, the pension fund is not a profit centre, but a black hole.
By all appearances, therefore, a proper system of pension financing — such that adequate buffers are maintained and the contribution covers the cost of the pension ac-crual including indexation — will make a loss for the en-terprise. First of all, the cash value of the pension accrual must be taken as a liability each year. This is logical, be-cause the sum reflects precisely the economic cost of the pension as deferred pay. The problem is that the pre-mium, should it be higher than this annual charge, must be written down as a loss, at least if this premium contrib-utes to a surplus that can never return to the enterprise. After all, if that is the case, additional funding is no longer an investment but dead capital and any amounts added to buffers are lost, as it were. It would seem obvious, then, that the contribution should be kept as low as possible, so as not to create a surplus in the fund. Moreover, the funds will then come under pressure to be less cautious with respect to the cutting the contribution level and granting refunds. The losses for the enterprise could then be lim-ited. The other side of the coin is that pension cover and especially future indexing would then be at risk.
What is the nub of the problem? With many pension schemes, the economic ownership position with regard to surpluses is not clearly laid down, such that a surplus ends up in a kind of no-mans land. This surplus may not then appear on the enterprise’s balance sheet; from the perspective of the enterprise, the surplus is at best a form of hidden shareholders’ equity. Looked at in this way, inefficient financing agreements between the employer and the pension fund can therefore result in the enterprise being undervalued. Enormous amounts of money are often involved, such that the enterprise could well become attractive prey for corporate raiders. This issue is topical at present because with the increase in market interest rates and the recovery of the stock exchanges, pension funds are doing well again and pensions are amply cov-ered in nearly all funds.
Now, suppose that the pension fund’s articles of associa-tion (or bylaws) and the implementing agreement be-tween the fund and the enterprise provide for the fund assets to act as collateral that is charged to the enter-prise. Suppose, further, that the indexing obligations are foreseeable insofar as indexing policy is clearly formu-lated and follows a certain system, at least broadly speak-ing. The fund cannot then play Santa Claus and increase pensions as it sees fit. If these conditions are met, then it may be inferred from IAS 19 and IFRIC Interpretation 14 that there are no limitations regarding the surplus that may be placed on the balance sheet (although future taxes must be taken into account). The surplus then re-mains a restricted asset by means of which the pensions are guaranteed and the fund remains the legal owner. But in economic terms, the enterprise is the owner and that is as it should be as long as collateral is concerned.
Remarkably enough, there is no need to keep the plan‘s funding ratio at a low level, since with an efficient pension scheme financed by an efficient collateral structure, no value is lost. It therefore does no harm to agree that direct or indirect refunds may be considered only above a cer-tain safe limit, of course with due observance of all statu-tory minimum requirements and especially also with a view to the desired caution for the long term.
By agreeing that the fund assets must be regarded as resources that the enterprise has used as collateral for the pension fund to guarantee the pensions, including indexing, proper financing can then be prevented from resulting in large-scale capital erosion. If the ownership position is laid down in this way, in both the fund’s articles and the implementing agreement, IFRIC Interpretation 14 will result in more of a reinforcement than a weakening of the financial basis under the pension schemes.
For more information contact: Roland van Gaalen.
Article 129 of the Pensions Act [Pensioenwet] stipulates that premium discounts with regard to the statutory lower limit for the pension premium can be permitted only if the required technical provisions are covered, the required net worth is present, and the envisaged conditional sup-plements policy can be put into effect. The Explanatory Memorandum [Memorie van toelichting] to the original bill explained that this means that pension entitlements, pen-sion rights and the conditional granting of a supplement must be guaranteed. For refunds, moreover, the statutory requirement is that arrears accruing in the previous ten years with regard to the conditional supplements must be made good and that all reductions in rights that were ap-plied as an emergency measure during that period must first be undone. In addition, further rules (such as the Supplements Matrix Policy Rule [Beleidsregel toeslagen-matrix]) may be taken to infer that premium discounts and refunds must be justified by an up-to-date continuity analysis.
For more information contact: Roland van Gaalen.
It was already pointed out in the March Update that it is advisable for a pension fund to form a “granary buffer” in good times, when it is doing well on the financial markets, so that it can use this extra buffer when conditions are difficult. Pension funds that adopt a granary policy with a view to the long term must accept that pleasant surprises that result from an increase in share prices and interest rates are necessary for the time being for an extra buffer to be formed.
The increases in market rates and share prices pushed the desired granary buffer up to 20% as at 30 June 2007. This figure is for the example fund with an average liability structure and an investment mix of 50% shares and 50% bonds with a duration of 5 years.
The desired granary buffer is calculated in such a way that it moves within certain limits in line with general trends in the financial markets as expressed in the de-grees of coverage.
Desired granary buffer 1990 – mid-2007 (as % of provision) for an example fund according to the Branstoets system
For more information contact: Roland van Gaalen.
If you have any questions or remarks concerning this issue of the Watson Wyatt Update, please let us know.
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