Organisation for Economic Co-operation and DevelopmentPublication sponsored by

the Japanese Government

INSURANCE AND PRIVATE PENSIONSINSURANCE AND PRIVATE PENSIONSCOMPENDIUMCOMPENDIUM

FOR EMERGING ECONOMIESFOR EMERGING ECONOMIES

Book 2Book 2Part 2:1)dPart 2:1)d

PRIVATE PENSIONS: REGULATORY ISSUES

Jean-Jacques Gollier

2000

Insurance and Private Pensions UnitFinancial Affairs Division

This report is part of the OECD Insurance and Private Pensions Compendium, available on the OECD Web site at www.oecd.org/daf/insurance-pensions/ The Compendium brings together a wide range of policy issues, comparative surveys and reports on insurance and private pensions activities. Book 1 deals with insurance issues and Book 2 is devoted to Private Pensions. The Compendium seeks to facilitate an exchange of experience on market developments and promote "best practices" in the regulation and supervision of insurance and private pensions activities in emerging economies.The views expressed in these documents do not necessarily reflect those of the OECD, or the governments of its Members or non-Member economies.

Directorate for Financial, Fiscal and Enterprise Affairs

TABLE OF CONTENTS

Introduction 3Chapter I - General features of a private pension system 3

Section 1. Definition of private pension systems 3Section 2. Why private pension schemes? 4Section 3. Typology of private pension systems. Design of plans 6Section 4. Financing mechanisms of private pension systems 8Section 5. Regulations applicable to private pension funds 13Section 6. The role of financial institutions 14

Chapter II – Private pension funds in the countries studied 15Section 1. Structural options for the first pillar 15Section 2. Interaction between the three pillars 22

Chapter III – Second-pillar schemes and control rules in the countries studied 27Section 1. Statistics on funding provisions 27Section 2. The relative proportion of insurers in private pension schemes 30Section 3. Applicable supervisory standards 38Section 4. Technical standards 41Section 5. Tax standards 43Section 6. Accounting standards 46Section 7. Selected information about the third pillar 47

Chapter IV - Some specific points 54Section 1. The switch from defined benefit to defined contribution schemes 54Section 2. Commutation of benefits. Property aspects 58Section 3. Methods of adjustment 63

Chapter V – A dynamic approach to private pension management 64Section 1. General Considerations 64Section 2. Prudential standards and asset liability management 68

Chapter VI -- Current issues -- Conclusions 81Section 1. Review of current issues 81Section 2. Synthesis of main trends 85Section 3. By way of conclusion. 86

Note No. 1 : THE MEANING OF THE PARAMETER B1 88

Note No. 2 : USE OF REGRESSION LINES 89

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Introduction

1. There have been many studies of private pension fund systems, in particular by the OECD. A lot of information is available on this issue, as well as on social security systems. It is, however, extremely difficult to collate this information and comment because:

social security and private pension systems often differ significantly from one country to another;

it is difficult to communicate information within the same country and even more difficult for specialists from other countries to understand this information. As in many other areas, communication in this area is a big problem because what is considered quite normal in one country may be considered incomprehensible elsewhere.

when the study covers several countries there is always a risk that laws and regulations have changed between the date the general report was written and the date the documentation on the countries is compiled.

there are often shortcomings in the statistical material and it is sometimes difficult to know what the figures given actually correspond to. The difficulty is compounded when one tries to compile comparable tables of data that are valid at the same date.

This study covers the following countries. Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Korea, Luxembourg, Netherlands, New Zealand, Portugal, Spain, Sweden, Switzerland, United Kingdom, United States.

It aims to highlight a number of factors which are essential to the understanding of private pension systems and focuses in particular on the interactions between private pension funds and the financial services, insurance and banking sectors.

To facilitate understanding of the issues, the author thought it was preferable to begin by outlining the general features of a private pension system and then to describe actual systems in relation to the general model. This is done in Chapter I. Chapters II and III, after presenting the general typology of first-pillar pension systems which is essential for understanding the other two pillars, discuss the main features of the 22 countries studied in relation to the general model. A number of specific points are discussed in Chapter IV.

Chapter V offer some guidelines that may lead to a dynamic management of private pensions, within the context of the European Commission green book. Finally, Chapter VI reviews the main issues in the various countries and concludes.

Two notes are included in an annex, the first one concerning the precise meaning of parameter B 1 (a measure of the compensation bracket covered by first tier pensions), the second one deals with the use of regression analysis.

Chapter I - General features of a private pension system

Section 1. Definition of private pension systems

2. For the purpose of this study the term 'private pension system' shall refer to any financial arrangement implemented within a company or group of companies for the purpose of providing the

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employees thereof and their beneficiaries with complementary pension benefits in addition to those paid out by government pension schemes. That definition also encompasses systems set up

by companies on behalf of agents, or their beneficiaries, even though they are not payroll employees but rather independent contractors;

by trade and professional associations on behalf of individuals meeting the criteria for membership, or their beneficiaries.

The primary characteristic of such arrangements is that they are at once outside the realm of government pension plans such as social security and that they complement the benefits of the latter. Under normal circumstances, their purpose is not to substitute completely government pensions. A partial substitution exists in certain instances, such as in the United Kingdom, through the practice of 'contracting out', which is aimed at reducing the burden on government institutions and generating reserves applicable against future expenses.

The fact that these private pension systems are outside the government systems evidently does not mean that they escape monitoring by the authorities or even in some cases government oversight. The opposite in fact is true. We will see that multiple technical, legal, social, tax and accounting controls apply to them.

3. It should be noted that the above definition covers a very large number of schemes that differ in terms of the structure of the system as well as of the financing supports used. They have a common purpose, namely to supplement social security benefits, but they function in different ways and are hence subject to different government control structures.

The purpose of this report is to describe the common features of such schemes and to suggest some directions in which they might converge.

Hereafter the term “private pension fund” will denote any private system as defined above.

4. This study examines the pensions of civil servants only insofar as they have a first-pillar social security scheme which covers all workers in both the private and public sectors, together with supplementary schemes which can be usefully compared with private pensions.

Section 2. Why private pension schemes?

5. Before proceeding any further, it is worth describing briefly the three-pillar system which underpins our general model. In such a system, the theory of which comes from Switzerland, pensions should ideally comprise three pillars:

the first is the State-run public pension that is part of the social security system. In principle, it aims to provide a minimum income, is based on solidarity and is normally financed on a pay-as-you-go basis, without constitution of large reserves;

the second is the supplementary pensions provided collectively by firms or socio-professional groups. It aims to provide a deferred income in addition to the first which offers a sufficient rate of replacement of earned income. These pensions are usually funded;

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the third pillar consists of all the savings put aside by an individual for his old age. These are thus personal savings that need to be distinguished from precautionary saving for a nearer future.

6. A preliminary and fundamental question that needs to be asked is why second-pillar pensions, the supplementary pension plans, exist in the first place.

The social security system is the first constituent of old-age coverage and is based on the notion of solidarity, generally operating, therefore, on a pay-as-you basis, meaning that reserves do not need to be proportional to future commitments.

However, solidarity cannot be stretched without limit, even paying for pensions at the highest income brackets, since it normally implies a certain redistribution from the richest to the poorest.

Above a given ceiling, reliance on solidarity must hence be limited and an approach that is closer to capitalisation has to be used.

Under the circumstances, why would it not be sufficient to have social security on the one hand and individuals' personal savings on the other? In other words, why create a second pillar, that of supplementary pension plans set up by companies or trade associations? Why has this second pillar emerged between the first and the third?

Many answers can be given to these questions, the principal motives cited being

the risk that individuals will be improvident, even at a relatively high level of income;

the notion that employers have a certain responsibility towards their employees, even at this level of income;

the notion of deferred income, with compensation for workers consisting increasingly of elements other than cash wages;

the possibility of obtaining higher returns and of reducing financial risks when acting jointly.

These are some of the reasons why supplementary company pension plans, the so-called second pillar, have come into being.

7. In this three-pillar approach, where overlapping or substitution possibilities exist, pensions are ultimately divided into three constituent parts, which are

a common revenue, i.e. social security retirement benefits

deferred income, i.e. company supplementary pension plans

saved income, i.e. individual provident savings.

To sum up:

Social security can provide only limited pension benefits, restricted to what solidarity between generations allows short of taking excessive economic or political risks;

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the third pillar, made up of purely individual savings or provident plans, is financially risky from many points of view because of economic and social developments as well as the lack of foresight on the part of individuals.

All of this explains the existence and the continued growth of the second pillar, that of supplementary pension plans. Occupying a place between the first pillar - which is wholly collective, compulsory and interdependent - and the third, which is purely individual, it makes it possible to achieve objectives that supplement the former and the latter with a greater degree of security than either.

8. There is another important reason for the growth of supplementary pension plans, namely the ageing of the world population, especially in OECD Member Countries.

The drop in birth rates and the increase in life expectancy on the one hand (demographic factors) and the impact on employment of productivity increases in domestic economies as well as in the world as a whole (as a result of globalisation), on the other, are going to significantly increase the burden of pensions as measured in terms of the share of the total wage bill for which coverage exists, which, for all these reasons, will increase less rapidly than the benefits to be paid.

It cannot be postulated that solidarity between generations is limitless, with our children and grandchildren consenting, under an unfunded benefit system, to pay significantly higher contributions in return for the same or even lower pensions for themselves.

The current generations must therefore now accept to pay higher contributions in order to build up reserves that can be applied against future expenses. Those reserves will have a particularly positive impact since they will be invested directly into the economy, thereby promoting economic growth.

There are thus very good reasons to create such reserves as part of the second pillar, the supplementary private pension systems, as governments, in their role as managers of the first pillar -- the State pensions -- cannot usually perform that task.

Section 3. Typology of private pension systems. Design of plans

9. The idea of an objective to be attained

We shall first examine what form those systems can have, what is often referred to as the design of supplementary plans.

It is evident that, when creating this type of pension system, a given purpose is foremost in mind and certain objectives should be agreed upon jointly with representatives of the future beneficiaries of the pensions, following preliminary discussions concerning the general appropriateness and economic feasibility of the project.

At this stage of our examination, it would be useful to describe the financing mechanism used, which can be pictured by the following graph:

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During the worker's years of employment (A to R) contributions are paid which are, if possible, capitalised as reserves so as to enable the fund to pay out expected benefits from the time the worker ceases to be gainfully employed until the death of the worker, or of the worker's spouse if there is a beneficiary clause (R to D). The deferral of a portion of the worker income makes it possible gradually to generate the worker's replacement income.

10. Systems with defined benefits or defined contributions

Actuarial methods make it possible to compute the actual ratio of contributions to benefits. It would seem therefore that we are faced with an equation with two variables, where one is designated as the unknown, whose value must be determined. Consequently, two systems exist and operate in an opposite fashion, so to speak:

under a system of defined benefits, these benefits are determined primarily on the basis of pay rates, so that what needs to be computed are the contributions that make this possible; contributions are thus the unknown factor in the equation;

under a system of defined contributions (or costs), contributions are set initially and the benefits ultimately payable are the unknown element.

In the above graph, the movement can be said to be from the right to the left under a system of defined benefits, and from the left to the right under one of defined contributions, which shows that the systems operate in opposite ways.

It is evident that, in either instance, actuarial methods make it possible to compute the amounts required to be set aside in the case of defined benefits, or the benefits available at retirement time under a system of defined contributions. Increasingly, sophisticated actuarial and financial practices have considerably reduced the uncertainty margins in the contributions/benefits equation or, at least, have served to highlight those parameters whose variations are critical and the potential repercussions of such variations. In this connection, computing technology now makes it possible to achieve considerable progress in that area.

11. The existence of a degree of freedom

A further remark: contrary to frequently held views, a certain degree of freedom still remains as to the computation method, namely concerning the ways in which promised or expected benefits are calculated. Different actuarial methods can call for various manners of allocating contributions over the working life of employees, for instance by contributing little early on and far more in later years of employment. The assumptions made for the parameters can have a similar impact.

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If for instance, a high rate of interest is chosen for computation purposes, contributions required for funding will be lower when the employee is young, since pension benefits are still distant in time and accumulated reserves are expected to have a high yield. Had the assumption been made that interests rates would be lower, required contributions would be higher at first, but excess interest income over the assumption made would subsequently make it possible to reduce them.

Such a possibility of spreading in different ways over time the contributions required for funding a given benefit is not free of risks for future beneficiaries, including the possibility that the company may fail, or may experience difficulties in meeting fast-rising expenses; or even for the company's shareholders or creditors, who watch the financial position of the company deteriorate over time due to increasing pension contributions.

12. Obligation of “best effort” or of “result”

Attention must be given to the fundamental difference that separates defined benefit systems from those with defined contributions. From a legal point of view, the former carry an obligation to achieve a specific result (performance requirement), whereas the latter are only subject to a best efforts standard.

Systems with defined benefits guarantee the payment of a certain replacement income upon retirement or in the event of death either before or after retirement (obligation of result). Their operation therefore involves certain risks for contributors, plan members and employers. Since contributions vary according to developments of a demographic, economic and financial nature affecting the system, a clause may be included in the system's bylaws, pursuant to which, in the event that expenses incurred exceed a given level, the planned benefits may be adjusted accordingly. That is the type of problem that most government pension plans in OECD countries are currently faced with.

On the other hand, under defined contributions systems, the only obligation concerns funding, meaning that there is a commitment to make the contributions called for and to invest those set aside as prospective reserves in a responsible and prudent manner. Still, if the benefits obtained at the end are insufficient, contributions may have to be raised, for such purposes as to pay supplemental benefits out of reserves set aside or from additional contributions, required whenever inflation accelerates.

13. Commutation of benefits

Second-pillar schemes sometimes provide for the option of a partial payment in the form of a capital sum. In some cases, the pension may be paid entirely in the form of a lump sum.

The latter case, which corresponds in fact to a sort of severance pay, is usually found in countries with rapidly rising inflation, where private pension funds, and thus employers, find it difficult to finance life annuities.

When it is merely a case of partial or total commutation of benefits, it may be warranted by the attraction of a capital sum even if the price is a lower income.

Section 4. Financing mechanisms of private pension systems

14. Internal or external mechanisms

Once a decision has been made as to the 'design' of a private pension system, a financing mechanism has to be selected for it. As part of the financial package which the system requires, who is going to handle the

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process from point A where plan members contribute, to point R where they receive the benefits guaranteed by the system?

Hereafter we shall limit our discussion to those systems - the most common ones - set up by companies on behalf of their employees. A distinction must be made here between internal and external mechanisms.

In the case of internal mechanisms, the company makes no payment outside its accounts prior to the time when benefits are to be paid pursuant to the plan. It is often said, in such cases, that these supplementary pensions are not funded.

Then there are external mechanisms for which amounts required for funding are paid out by the company to an entity which subsequently pays the benefits called for under the plan.

We are going to examine first internal mechanisms, then external ones.

15. First internal mechanism: overhead expenses budget

The first internal mechanisms is the payment of pension benefits directly out of the company's budget for overhead expenses (the so-called "pay-as-you-go" practice). In this instance, a company pays benefits directly from the time of an employee's retirement or death, to that employee or to his or her beneficiaries. Payment can be made on the basis of internal company rules, either known to employees or not, or else on a case-by-case basis depending on merit or needs.

Operating in this manner is considered very hazardous

for the company which does not set aside any reserves for the future, even though the cost of the system is expected to increase with time and could pose a threat to the future financial soundness of the business;

for shareholders, as the profit and loss account does not reflect the accrued cost of supplementary pension benefits; dividends paid out today are therefore artificially high and biased in favour of current shareholders, at the expense of future ones;

for retired as well as current employees, who could lose everything if the company went bankrupt. Most countries have prohibitions against such pay-as-you-go systems.

16. Second internal mechanism: book reserves

The company and its shareholders can reduce the risks from pension costs being charged to overhead expenses by setting aside reserves in the books. The amount of such provision is computed by actuarial methods that are often the subject of detailed regulations.

The properties of such as system are as follows:

for the company, the setting aside of reserves against pension benefits payable in the future makes it possible to absorb coming increases in costs, while the corresponding funds are available to the company and can be invested in its operations;

Everything proceeds as if the long-term provisions were added to the company's equity, enabling it to fund its pension commitments. The interest paid on those provisions is equal only to the technical interest that serves as an underlying basis for the provisions and is generally below the long-term rate on money markets. In most cases, the provisions are in

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fact invested in the company, the return on them being that on the company, which usually makes it possible to cancel out the consequences of inflation, especially in countries where it is rising rapidly;

for the shareholders, fairness is restored between the generations;

for retired and current employees, on the other hand, the situation remains unchanged in terms of the risk that the company could go bankrupt; they have no special privileged claims on assets and are considered to rank equally with other creditors, after the tax authorities and social security administration, etc., meaning that they stand little chance of recovering a significant share of their pension benefits in the event of bankruptcy.

It is also possible to reinsure commitments entered into by a company under this kind of system. If an employer chooses to do so, it can secure a group policy from an insurer, providing coverage for the commitments made with respect to employees, either in whole or in part. The company, rather than its employees, is the beneficiary of such a policy.

Normally, the company thereby will book in its assets a claim against the insurer equal to the amount of the actuarial reserve set aside by the latter.

This approach enables the company to cut down on liquidity problems caused by the payment of benefits, although it does not seem, on the other hand, to provide employees with improved guarantees in the event of bankruptcy. Yet the safeguarding of vested pension rights, as that of the benefits themselves, has been the subject of a European directive (80/987 EEC).

In order to reconcile the interests of employers and employees and the requirements of the European provisions, some countries have introduced a reinsurance system covering companies' solvency in the event of bankruptcy, for those setting aside pension provisions in their balance sheet. Under that system, employers pay annual premiums to an insolvency reinsurance pool, based on reserves that are or should be set aside in order to pay future pension benefits to current and future retired employees, whenever no such provisions have been made outside the company.

17. Individual pension guarantees

A company may wish to provide special pension benefits to some of its employees or officers, on a purely individual basis.

This is sometimes handled through a personal pension guarantee in the form of an agreement between the company and the employee or officer in question.

Under that guarantee, the company promises to pay benefits upon retirement or in case of death prior to retirement and, in some instances, of disability. Normally, as in item 16, the company should set aside a reserve in its books.

It can avoid having to do so, however, by taking out an individual insurance policy on its own behalf, as in the case of the reinsurance of provisions, for the same benefits as those promised under the pension agreement.

18. First external mechanism: self-administered pension funds

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The first external mechanism is the self-administered pension fund. It is a legal entity distinct from the employer itself, generally a non-profit company or a similar legal entity, or trust on the Anglo-Saxon model.

The employer calculates - or has an actuary calculate - what reserves are required to provide for future benefits, and allocates to the pension fund, which is independent of the company, the corresponding amounts, taking into account interest income by the fund and benefits payable.

Because self-administered pension funds exist independently of the company, the employees of the latter are protected in the event the company goes bankrupt, with the effect being only that no more money is paid into the fund, while amounts already in the fund cannot be reclaimed by the company.

It is evident that this type of financing mechanism necessarily involves both fixed and variable administrative expenses. Among fixed expenses are those incurred for starting up the fund, preparing legal documents, accounting, etc. and they may account for a major share of total expenses. It is therefore obvious that such a structure can generally be used only if contributions to the private pension fund are substantial.

It must be recognised that savings can be realised only if the sums managed are substantial and if competition among insurance companies would not make it possible to obtain equally advantageous conditions, with the added advantage of limiting the investment risks.

The question may be asked whether the main advantage of self-administered pension funds is not precisely that they give employers the opportunity to choose on their own the financial risk to which they agree to be exposed.

All the available statistics show that properly managed higher-risk investments have a medium-to-long-term yield that is significantly higher than risk-free investments.

However, in that event, it is extremely important that the employer limits that risk as much possible, with due regard to the exposure of the company itself, for it would definitely run counter to the interest of the fund for it to incur investment losses at a time when the company is having problems, a factor that underscores the need to properly manage fund assets.

This situation is more likely to arise in the case of self-administered funds than in that of funds handled by outside insurers, unless more sophisticated methods of investment allocation are used.

Lastly, it should be noted that pension funds do not have performance obligations to their members. They collect contributions paid to them by employers so as to live up to the commitments resulting from the pension plan bylaws. Any financial shortfall would therefore be covered by the employer.

19. Second external support: group insurance

The second external mechanism consists of group insurance. Under that system, employers turn to an insurance company. The employer and the insurer jointly draft a group insurance contract specifying the respective rights and obligations of the parties, namely the insurer, the employer, policyholders and their beneficiaries.

Based on that contract, the insurer computes the premium that needs to be paid, in the form of contributions either by employees or by their employer.

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Individual contributions are always individually funded and therefore pay for individual insurance policies guaranteeing the payment of benefits upon retirement or in the event of death prior to retirement.

Under a system of defined contributions, contributions by employers are always individually funded and hence also pay for individual insurance policies.

On the other hand, under systems of defined benefits, two approaches are available. If the method used is that of individual funding, employer contributions are paid on individual policies, whereas if employer contributions are part of a group funding, no such individual policies exist.

The individual funding part determines the ratio of premiums to benefits, based on a life insurance rate schedule. That schedule in turn depends on interest rates, technical interest rates, mortality tables and administrative expenses incurred by the insurance company in connection with its operation as well as, in certain instances, commissions paid to intermediaries.

The fact that life insurance rates are used evidently implies that the insurer has performance obligations, since specific benefits are guaranteed in consideration for the payment of premiums.

It should be noted, in addition, that whenever employer contributions are - at least in part - allocated to collective funding, a certain interest rate can also be guaranteed, so that here again the insurer makes a commitment insofar as performance is concerned.

From the point of view of the insurer, the obligation to achieve a specific result is in fact always limited to the level of compensation established at the time of computing the premium. The performance obligation -- with benefits expressed as a percentage of the final income, in case of defined benefits -- implies that the necessary premiums are recomputed every year and thus always hinges on the employer being willing and able to pay the required premiums.

The case may also arise where the insurer funds all or part of the employer contributions on a group basis without making a commitment as to the rate of interest or the nominal value. This is the situation when assets are managed as mutual funds or as allocated investments.

20. The management of group pension funds

The notion of collective funding in group insurance is akin in fact to another concept, that of the management by insurance companies of group pension funds.

The technique was developed several decades ago, at the same time as group insurance. It is sometime referred to as 'deposit administration' or 'separate account'. As pointed out earlier, this is a special form of group insurance, where the insurance company manages a joint account into which an employer pays contributions, and from which the insurer pays out the benefits specified by the policies when they come due, hence the term 'deposit administration' reflecting the idea of an account that is set aside for a specific purpose, which constitutes a collective provision on the liability side of the insurer’s balance sheet.

One can go even further by covering this liability with an allocated investment, which is then called a “separate account”.

The insurer, or an actuary working for the employer, calculates -- using recognised actuarial methods -- the amount of contributions required by the group pension fund in order to enable it to pay out the benefits promised by the employer to the fund members, pursuant to the fund's bylaws.

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It can therefore be noted that, except where the insurer guarantees a minimum rate of return, it makes a commitment only to use its best efforts, just as in the case of self-administered pension funds.

This shows how close a group pension fund is to the notion of a pension fund. The major difference is that group pension funds are offered by insurance companies.

It should be noted, in addition, that insurance companies are in a position to offer a choice of two separate methods, one where the assets are considered by the insurance company to be part of its own technical provisions and are managed as such, the other where they are managed on behalf of a third party which actually owns a self-administered pension fund, the role of the insurance company being merely to perform financial management and actuarial duties on the fund's behalf.

In that instance, technical provisions are the property of the pension fund rather than of the insurance company, with all the legal, tax and other differences which that implies.

Section 5. Regulations applicable to private pension funds

21. Various kinds of regulations can apply to private pension funds. They vary in accordance with the type of fund and its financing support. Control can be exercised by various bodies accountable to the government.

22. Tax regulations

Private pension funds, the second pillar, constitute a system of deferred income accompanied by tax breaks, tax usually being deferred like income. Quite logically, the first control is tax legislation, which lays down the rules regarding their operation and the limitations to tax reliefs.

This legislation lays down the following:

tax deductibility and reduction;

limitation of benefits or contributions

mode of benefits taxation

tax status of financing supports

taxation of interest

inheritance taxation on benefits in case of death

23. Technical regulations

These consist primarily of financial and actuarial methods designed to ensure that pension funds actually deliver pensions. They concern actuarial methods, the choice of technical definitions, interest rates and mortality tables. They may set minimum reserves and solvency rules over and above them;

24. Business regulations

These rules, which are often coupled with tax or technical regulations, lay down minimum requirements regarding the soundness of supplementary pension schemes, i.e.

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whether or not plans are compulsory at national, sectoral and firm level;

possibility, or lack thereof, of discriminating between categories;

vesting and portability;

solvency margin and insurance against insolvency;

disclosure to members.

25. Accounting regulations

Technical and business regulations are designed to ensure that supplementary pension schemes pay out pensions to existing or future beneficiaries. For the benefit of shareholders of companies that had set up private pension funds, and more broadly of their creditors and the outside financial world, it was necessary to improve the clarity of financial statements of companies with regard to pension liabilities. Accounting standards, usually drawn up by national associations of statutory auditors, have therefore laid down (either privately or publicly) a set of fairly precise rules regarding:

disclosure in annual financial statements or notes thereto of financial shortfalls or surpluses (FAS 87 and more recently IAS 19);

other accounting standards (SSAP 24);

impact on the net worth of companies in the event of mergers or spin-offs.

With the growing globalisation of economies, these rules are beginning to be applied in an increasingly uniform fashion in large companies.

Section 6. The role of financial institutions

26. It is fairly safe to say that the second and third pillars would never have attained their present level of development without the wide range of services proposed by financial, insurance and banking institutions.

The services sector in the broadest sense of the term has likewise been involved in the growth of the first and second pillars. Actuaries, accountants, consultants, brokers, lawyers and auditors, to mention only some, have facilitated the application of the various regulations listed in section 5 of this chapter.

But obviously the biggest contribution of the services sector to the financing of pensions has been the financial management of the very large technical provisions accumulated in the second-pillar schemes, and to a lesser degree in the third pillar.

In the case of the second pillar, particularly private pension funds, it is important to examine more closely the structure of relationships between the funds and the financial managers. When a fund is run by a bank or financial institution, it usually remains the owner of the assets covering its liabilities.

In contrast, when a fund is run by an insurer, it usually constitutes a claim on the insurer, who becomes the owner of the assets covering the liabilities. In consequence, the management of such funds may be less transparent, and in particular it may be difficult to determine the allocation of profits and losses. However, in the most advanced countries the arrangements proposed by bankers and insurers are increasingly similar.

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This difference can also be expressed as follows: “...with few exceptions, institutions for retirement provision are essentially non-profit bodies, while banks and insurance companies charge for their financial services. In fact, the latter provide financial services, while pension funds buy financial services, a difference that is important to keep in mind”. [2]

In one form or another, the financial services sector plays an important role in the functioning of private pension funds, which in their turn contribute to the prosperity of firms of all kinds in the financial sector.

In this connection, mention may be made of the high administrative costs of defined-benefit schemes in the United States, which according to the US Department of Labor amounted in 1985 to 8.3 per cent of contributions to multi-employer schemes and to 4 per cent of the contributions to single employer schemes [19].

Chapter II – Private pension funds in the countries studied

Section 1. Structural options for the first pillar

27. It is not possible to grasp the various forms that private pension funds have taken in the countries studied without first looking at the structural particularities of the respective first pillars. Before studying private pension funds, it is therefore important to examine the options for basic schemes.

These schemes must first be defined. They include all Social Security systems, along with those mandatory supplementary schemes whose funding is almost exclusively on a pay-as-you-go basis. From this standpoint they encompass all systems that are based on national or socio-occupational solidarity, with funded plans excluded and subsumed under the second pillar.

It is necessary to distinguish between schemes that provide for flat-rate pensions and those in which benefits are wage-related, generally up to a certain earnings ceiling. Table 1 (“Typology of First-Pillar Schemes”) describes the actual situation in the 22 countries studied and shows that there are nine countries (40 per cent) with flat-rate pensions and 13 (60 per cent) in which first-pillar pensions are wage-related.

28. Flat-rate basic pension schemes

By all logic, flat-rate pension systems ought to be financed by taxes, but Table 1 shows that a majority of them (five cases out of nine) are funded by contributions that are proportional to wages. However, since taxes are themselves determined with respect to earnings, the two systems have more in common than might appear, except that contributions are generally tax deductible whereas taxes usually are not.

It must also be noted that, with the exception of Australia, no country applies means-testing to the attribution of flat-rate state pensions. Furthermore, as long as there has been a cessation of employment, the pension is generally provided to anyone who has resided in the country in question, irrespective of the type of work previously engaged in, whether dependent employment, self-employment or civil service.

29. Wage-related basic pension schemes

Wage-related first-pillar pension schemes are to be found in 13 of the 22 countries studied. Obviously, contributions in these countries are themselves related to wages.

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Wage ceilings generally apply in computing benefits and contributions alike, except in Portugal, where there are no ceilings. Ceilings on contributions (and especially those paid by employers) are in some cases higher than the ones used in computing pensions (reflecting the solidarity aspect).

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Table 1 – Typology of First-Pillar SchemesFlat-rate state pensions (9 out of 22 countries)

Australia Financed by the national budget and granted only after means-testing in respect of total income and personal wealth. As a result, managers are generally not eligible, especially if they receive supplementary pension benefits.

Canada Taxed-financed OAS + CPP/QPP benefits financed by personal and employer contributions on earnings. No means-testing.

Denmark Financed by the national budget. No means-testing.

Finland Same as above.

Ireland Personal and employer contributions up to a capped level of earnings. No means-testing.

Japan Flat-rate personal and employer contributions. No means-testing.

Netherlands Financed by worker contributions, proportional to income up to a certain ceiling. No means-testing.

New Zealand Financed by the national budget without means-testing.

United Kingdom Financed by worker and employer contributions up to a certain ceiling. No means-testing.

Wage-related basic pensions (13 out of 22 countries)All of the other countries, with a number of particularities, inter alia:

Switzerland Depending on income level, from 100 to 33 per cent at the highest wages.

United States Same as above, ranging from 72 to 24 per cent.

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In Belgium in particular, there is no longer any ceiling on contributions, whether personal or employer-paid, whereas the basic pensions of private-sector workers are capped at a certain level of earnings.

Wage-related first-pillar pensions are generally calculated on the basis of capped adjusted average career earnings, with a certain guaranteed minimum. In some countries, however, they are linked to average earnings near retirement age—for example, the last eight years in Spain and the best ten out of the past 15 years in Portugal.

In some countries, including the United States and to a lesser extent Switzerland, the percentage of past wages to be paid out in pensions decreases with the level of earnings—another type of measure that enhances solidarity and seeks to limit current and future liabilities.

Lastly, it should be noted that wage-related basic pensions can sometimes incorporate a flat-rate amount (as in Luxembourg).

Apart from limitations on receiving pensions and earned income at the same time, all of these wage-related pensions are awarded without any means-testing.

30. Mandatory supplementary schemes

Alongside many basic systems there are mandatory supplementary schemes which can also be considered part of the first pillar because they are, in fact, mandatory and therefore based on solidarity.

Of the nine countries with flat-rate state pensions, five also have mandatory supplementary schemes. Except in Denmark and Finland, it is possible to contract out of these schemes, providing that the business in question has a supplementary retirement plan that meets a number of minimum conditions. In Japan in particular, such corporate plans must provide benefits that are at least 30 per cent greater than those of the mandatory supplementary Employee Pension Insurance (EPI) scheme.

Of the 13 countries with wage-related basic pensions, four have mandatory complementary schemes, which in turn are related to wages. In only one country—Greece—is it possible to contract out.

Lastly, in France and Switzerland the mandatory complementary schemes involve defined contributions (money purchase) and not defined benefits.

In Section 2, and Table 2 in particular, we shall be coming back to supplementary schemes, including those that are mandatory.

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Table 2. Typology of Supplementary Schemes in the Countries Studied

SOCIAL SECURITY(basic scheme)

provides aCOMPLEMENTARY SCHEMES ARE

MANDATORY except for CONTRACTING-OUTif there is a scheme that is

VOLUNTARY

FLAT-RATE STATE PENSION

DENMARK (ATP): flat-rate

FINLAND: wage-related

AUSTRALIA (SGB): wage-related

JAPAN (EPI) : same as above

UK (SERPS) : same as above

CANADADENMARKIRELANDNEW ZEALANDNETHERLANDS

WAGE-RELATED BASIC PENSION

FRANCE (ARRCO + AGIRC)

KOREA

SWEDEN (ATP)

SWITZERLAND (BVG)

All wage-related

GREECE (TEAM) : wage-related GERMANYAUSTRIABELGIUMSPAINUNITED STATESFRANCE (rare)ITALY (rare)LUXEMBOURGPORTUGAL (rare)KOREASWEDENSWITZERLAND

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31. Table 2 (“Typology of Supplementary Schemes in the Countries Studied”) shows the position of mandatory supplementary schemes in nine of the 22 countries studied.

In the four cases in which contracting-out is possible, the mandatory complementary schemes in a sense play a minimum back-up role for employers who fail to voluntarily set up adequate supplementary pension plans. These countries are Australia (Superannuation Guarantee Bill, or SGB), Greece (TEAM), Japan (EPI) and the United Kingdom (SERPS). All of these systems are wage-related.

In the five countries in which mandatory complementary schemes do not permit contracting-out, supplementary pensions are wage-related, except in Denmark, where there are flat-rate benefits (ATP).

Table 2 summarises first- and second-pillar schemes in the 22 countries studied.

32. Wage brackets covered by basic schemes - Parameter B1

It is interesting to determine a number of parameters for assessing the importance of the other two pillars in relation to the basic schemes.

The first of these parameters is B1, the respective compensation bracket covered by each country’s basic system. We have identified five possible variants:

1. Countries in which the basic scheme is wage-related and applies a more or less standard percentage, up to a given ceiling. In this case, B1 is equal to this ceiling [non-managers (INPS) in the case of Italy].

2. Countries in which the basic scheme provides a flat-rate pension. In order to compare these schemes with those of countries in which the basic scheme is wage-related, we shall assume that this flat-rate pension covers 50 per cent of a basic wage. B1 will therefore be equal to double the flat-rate pension.

3. Countries (Switzerland and the United States) in which the basic pension is wage-related but the applicable percentage declines sharply as earnings rise. We have set B1 equal to the wage level for which the basic scheme covers 50 per cent.

4. Countries having a mandatory supplementary scheme:

If it is possible to contract out, we have disregarded the supplementary scheme, and B1 is equal to the basic scheme ceiling calculated as in (1) or (2).

Otherwise, B1 is equal to the ceiling of the supplementary scheme, also calculated as in (1) or (2), i.e. equal to the ceiling of the ARRCO scheme for non-managers.

5. Countries (Finland and Portugal) placing no ceiling on first-pillar pension benefits. Here we have set B1 equal to “infinity”.

The parameter B1 provides a measure of the compensation bracket covered by first-pillar pensions (see also Note 1 of the Annex).

33. Average earnings (AE)

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The second parameter is AE, which is the average gross earnings of manufacturing workers. Commonly used in international comparisons, and by the OECD in particular, it can serve to measure the wage level of each country.

GNP or per capita GDP, which are more readily available data, have the drawback of being affected by non-wage income, which we feel ought not to be taken into account in a study focusing essentially on private pension funds that are related to wage income alone.

34. A significant parameter: B1/AE

The third and final parameter is B1/AE, i.e. the ratio between the basic scheme “ceiling” (B1), as defined under Item 36, and average earnings, AE, as defined under Item 37. This parameter denotes the portion of average earnings that is covered by each country’s basic scheme.

Table 3 lists the values of B1, AE and B1/AE for each of the countries studied.

Later on, we shall see the major significance of B1/AE—a parameter that shows how important the second and third pillars can be to the funding of pensions in these countries.

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Table 3 Portion of Earnings Covered by the First Pillar

Country AE 95 B1 95 B1/AE

Local currency

(A) (B) (C) (D)

Germany 55.625 93.600 1.68

Australia 34.800 0 0

Austria 293.010 529.200 1.81

Belgium 890.138 1.335.317 1.51

Canada 33.500 26.400 0.79

Korea n.a. 7.438.584 n.a.

Denmark 231.333 158.760 0.69

Spain 2.061.586 4.346.280 2.11

United States 27.000 28.800 1.07

Finland 126.782 unlimited unlimited

France 119.191 467.820 3.93

Greece 2.584.617 4.542.000 1.76

Ireland 14.107 7.384 0.52

Italy 32.349.267 109,400,000 3.38

Japan 4.150.000 1.560.000 0.38

Luxembourg 1.037.441 2.372.900 2.29

New Zealand 33.300 18.467 0.55

Netherlands 57.546 36.312 0.63

Portugal 1.284.833 unlimited unlimited

United Kingdom 15.178 6.120 0.4

Sweden 190.596 270.000 1.42

Switzerland 60.500 34.920 0.58Notes: The figures in this table for the variables AE and B1 are based on the year 1995. The figures for 1997 have

been examined and found to show no significant variation relative to those of 1995. Hence, the level of the parameter B1 / AE shown in this table will be the one used in this study.

Source: (B): OECD, The tax/benefit position of production workers 1991-94, Paris, 1995.(C): Various sources listed in the bibliography.

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Section 2. Interaction between the three pillars

35. Various issues dealt with in the previous sections deserve a closer look in order to carry out a detailed examination of the second pillar.

In particular, we should examine in more detail the typology of pension arrangement, paying special attention to the multiple situations of “hybridisation” that exist. In these cases, a strict separation of concepts can sometimes be an arduous task.

The procedure we will follow is to start from a synthesis table of the typology of pension arrangements and of the different concepts relating to it.

Table 4 gives a broad outline of types of pension scheme together with the concepts that may be associated with them. The vertical dividers indicate the current theoretical situation and the lower case letters refer to particular schemes operating in the interstices between the zones thus defined (see text). The arrows indicate the dominant direction of change.

In the table:

6. DB = defined benefit, DC = defined contributions

7. The obligations are those of contributors or policyholders, not those of the organisations responsible for paying benefits. For the contributor, the obligation of results therefore implies paying the amounts necessary to obtain a given result. Best efforts implies merely paying the scheduled amount of the contribution or premium when the policy is taken out.

8. “Non-commercial” means the non-profit sector and “commercial” means the for-profit sector of the economy.

9. The decision-taker is the entity which chiefly decides how the pillar operates.

10. For information, the same individual can be a member of all categories.

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Table 4 Typology of pension schemes

PILLARS 1 <==

(a)

2 <==(b)

3

SCHEMES (1) DB <=== (c) DC

OBLIGATION (2) RESULT <=== (c) EFFORTS

SUPPORT (3) NON-COMMERCIAL <=== (d) COMMERCIAL

DECISION-TAKER (4) Authority <=== Employer <== Individual

WHO PAYS? (5) Taxpayer / shareholder / individual

As regards obligations (2), obligation of results means here that, unless laws, regulations or contracts are changed, the person responsible for paying the contributions or premiums must accept any adjustment to the contributions or premiums such as to enable the stipulated legal, regulatory or contractual result to be achieved. If that is not the case, we assume that the obligation is one of best efforts.

The line (3) SUPPORT intends to make a distinction between funding supports, i.e. from public sector and from insurance companies and financial institutions, established in commercial form. The Mutuals and Co-operatives which offer their products as insurance or financial markets are considered as being part of “commercial sector”. This distinction could also have been made between market/non market.

It can also be seen in the table that all the arrows indicate a move from right to left. As we will explain later, this shift represents an increase in individual choice, that is, a heightened responsibility of the individual and a shrinking role for the state.

In order to complete the picture, the last two lines of Table 4 are

Who decides?

and Who pays?

The preceding paragraphs have revealed a general trend towards deregulation and greater freedom of choice. It is interesting to see that the same movement is taking place at the decision-making level, with individuals replacing companies, which are themselves assuming obligations that used to lie with public authorities. Thus, Table 4 shows a broad movement from right to left, illustrating this trend.

In connection with the question Who pays?, we could raise the problem of the effect of these pension schemes on government budgets, referred to in broad terms as “tax expenditure”, but this goes beyond the

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remit of the present report. We have included the question for information only, in order for our treatment of the subject to be as comprehensive as possible.

36. Hybridisation of pillars: substitution effects

The separation marked (a) in Table 4 is the separation between the first pillar, namely social security pensions, and the second pillar, namely supplementary pensions constituted through company, occupational or assimilated schemes.

On this point, it should be noted that some countries, such as Chile, have replaced earlier pay-as-you-go (PAYG) schemes (which existed until 1981 in Chile’s case) with a system of funded schemes based on individual accounts. Contributions have been paid to pension funds or insurance companies in free competition with each other under the supervision of the appropriate authorities. Contributions are paid entirely by the worker (10% for retirement pension and 2.5 - 3.75% for invalidity, death and management costs). It is a defined contribution scheme (DC).

The switch from PAYG to a funded scheme was made by attributing vouchers representing previously acquired rights to all workers who had contributed to schemes before 1981. On retirement, these vouchers will be added to the accumulated proceeds of contributions. The private fund management organisations in the Chilean scheme invest about 40% of their reserves in government securities, thus facilitating the government’s funding of the vouchers.

In the Chilean system, therefore, the first pillar disappears for the future and is absorbed not into the second pillar but into the third pillar, since affiliations are individual and the employer plays no part. This does not in principle prevent the development of a second pillar at company or occupational level (a contribution to a funded scheme equal to 10% of wages guarantees at most a pension of around 40% of wages, thus leaving the door open for supplementary pensions).

However, competition has caused fund managers to incur high management and marketing costs, since contributors under pressure from a highly active sales network change funds too often. The Chilean authorities have had to step in to limit the frequency of such changes so as to avoid a reduction in returns relative to gross premiums.

Nonetheless, the Chilean experiment has aroused considerable interest in other countries, notably Mexico, which has recently introduced a similar system, and various other Latin American and east European countries. The main advantage of the system lies in the creation of substantial reserves which can be invested in the economic development of these countries, stimulating growth.

The situation would be very different in more developed countries, where the additional contributions needed to constitute such supplementary reserves would doubtless lead to a net reduction in household assets and a simple switch from individual to collective savings.

As long as the government covers the vouchers as they mature, the Chilean system therefore represents a shift from the first pillar to the third pillar, albeit in the form of compulsory collective saving.

37. The effects of contracting out

In the United Kingdom it is possible to partially substitute the second pillar for the first pillar, a less radical and older reform than the Chilean experiment. A relatively small flat-rate national old-age pension has existed in the UK since 1948, financed from tax revenue. A second pension was added in 1961, funded by contributions from workers and employers and linked to wages within a defined bracket.

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In order to take account of the importance of private pensions in the UK (in many cases dating back to the 19th century), employers were allowed to opt out of the scheme providing that they could prove that their pension scheme met certain minimum conditions. This method of partially replacing the first pillar with the second pillar is called “contracting out”.

The shift from the second pillar towards the first was consolidated by the Social Security Pensions Act of 1975, which maintained a relatively small flat-rate national basic pension (currently approx. £3,250 a year) alongside a pension linked (25%) to the portion of wages within a given bracket, a systems called SERPS (state earnings-related pension scheme). The possibility of contracting out was maintained and still exists. In this case, both worker and employer are exempted from a portion of their social security contributions, respectively 1.8% and 3% of wages in excess of £62 a week (i.e., approx. £3,250 a year).

It is interesting to note that the vast majority of large and even medium-sized firms have contracted out, for three main reasons:

11. some wonder whether the SERPS pension will be able to provide the promised 25%. The system was recently changed so that the pension would be calculated on the basis of a contributor’s entire working life and not just the last twenty years;

12. the 4.80% total saving on social security contributions can fund a pension equal to 25% of a worker’s average career wage;

13. private pension funds in the UK manage to extract extremely high returns, meaning that even the 4.80% contribution is unnecessary to fund contracting-out obligations.

In different forms, contracting out also exists in Australia, Japan and Greece, in all cases with the possibility of partially substituting the second pillar for the first.

In a nutshell, the rationale for contracting out runs as follows: some governments, perhaps rightly, wish to limit their excessively long-term commitments. As long as economic circumstances were favourable, the welfare state could promise ever bigger pensions without undesirable side effects. But as soon as these conditions (economic, demographic, etc.) start to deteriorate, the outlook becomes increasingly bleak. It is worth noting in passing that long-term projections in the UK have always been carried out by a government actuary, whereas during the “golden Sixties” in Belgium, for example, projections relating to state pensions were carried out with a horizon of only four to five years. For all these reasons, British governments have always been able to take a longer term view and hence rationally have encouraged contracting out.

The British reform system, therefore, favours the growth of second-pillar funded supplementary pensions while preserving the indispensable PAYG system and an element of solidarity in the basic pension.

A comparison of this method, based on a permanent combination of PAYG and funded schemes, with the Chilean method of gradually replacing PAYG with funded schemes would be of the greatest interest as regards

the long-term reliability of each method,

their macroeconomic results,

the resulting level of comprehensive coverage.

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As mentioned earlier, a distinction should doubtless be drawn between countries according to their level of capital intensity because the two methods lead to different levels of reserves for pensions: to what extent are additional savings desirable before they begin to crowd out other existing forms of saving?

38. Second-pillar/third-pillar hybridisation

The separation marked (b) in Table 4 is the separation that exists or ought to exist between the second and third pillars, i.e., between collective company, occupational or assimilated pension schemes and individual saving or provident schemes with or without tax incentives.

However, there are many cases of hybridisation between the second and third pillars.

In the UK, for example, since 1986 contracting out - a shift from the first pillar to the second - has gone hand in hand with a shift from the second pillar to the third. The 1986 Social Security Act allowed salaried workers to opt for an Appropriate Personal Pension scheme (APP) instead of SERPS or the company pension scheme. Available statistics indicate that some 5 million workers have chosen APPs, almost all with insurance companies.

This situation is comparable to the situation in Chile. When, as a result of excessively liberal policy, individuals are allowed to choose the type of scheme into which they pay their contributions, numerous excesses are possible because of the information asymmetry between insurer and policyholder in a particularly complex field. APP contracts are currently a hot issue in the UK and the subject of many legal claims, since under the terms of the Finance Security Act insurance brokers are required to give their clients best advice and tell them how much commission they (the brokers) will receive on life insurance business. The rows that have erupted over personal pensions suggest that the experiment was far from being a complete success.

There is also a trend in the United States towards partial substitution of the second pillar for thethird, though in this case the operation has been largely successful. Employees taking out so-called “401(k) plans” ask their employers to withhold a certain amount from their salaries in order to constitute a supplementary pension. The employer may also contribute to these individual schemes. Both employee and employer contributions to 401(k) plans are tax-deductible within certain income limits.

Their flexibility has made them highly popular, causing a shift from the second pillar to the third inasmuch as the plans, like APPs in the UK, are a matter of individual choice, although they are often partly funded by employers. The commercial excesses noted in the UK and Chile do not seem to have occurred in the US, doubtless because of the part played by employers in 401(k) plans.

In Belgium, and perhaps in other countries (though in order to be sure it would be necessary to carry out an in-depth study of the tax rules that apply), it is possible for a company to make individual pension commitments in favour of a limited number of executives or employees.

These commitments are generally covered by individual life insurance policies enabling the company to meet them at term. Premiums are paid by the company, though in return beneficiaries often accept a cut or smaller-than-otherwise rise in salary. This system is thus not without similarities to 401(k) plans in the US.

However, there is no direct link between the pension commitment and the insurance policy. This has a favourable tax effect, since the employer can deduct the amount of the premium and the beneficiary is taxed on the benefit only at term. As purely individual arrangements these schemes seem to fall into the third pillar, but in view of the employer’s role they in fact appear closer to the second.

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Chapter III – Second-pillar schemes and control rules in the countries studied

Section 1. Statistics on funding provisions

39. Having defined the characteristics and limitations of the first pillar in the countries studied, we are now going to examine the available statistics by comparing them with the parameter B 1/AE presented above. We will subsequently analyse the resultant findings in order to highlight the role played by the insurance sector in the development of the second and third pillars.

Financially, and as explained under Item 9, both of these pillars involve the accumulation of contributions in the form of reserves which will ultimately generate the projected benefits. Contributions constitute a flow and the reserves a stock.

To gauge the macroeconomic significance of these flows it is necessary to ascertain the amount of contributions allocated to private pension funds and to the third pillar in each country. However, the only information available is fragmentary—total premiums for group life insurance in a number of member countries of the European Insurance Committee (CEA), as a percentage of GDP in each of the countries concerned [14]. We shall come back to this later.

With regard to stocks, it should be reiterated, as explained in Chapter I - Section 4, that provisions can take the form of book reserves (Item 16), self-administered pension funds (Item 18), group insurance (Item 19) or management of group pension funds (Item 20). Statistics on insured funds are available from the CEA [14], and we were able to obtain figures on self-administered funds from the European Federation of Pension Funds (EFPF). The report of European Commission experts [2] provided useful information on book reserves in the countries that allow them.

40. Reference level for funding provisions

This enabled us to prepare Table 5, which lists the amounts, in local currency, set aside as of year-end 1994 for each funding method—insurance, self-administered pension funds, and book reserves. The interpretation of these data and the estimation of the market share of the insurance sector should however remain cautious, since it is not obvious that group pension funds managed by insurers (Item 20) have always been included in insurance data in national statistics. By comparing this total with the GDP of each of the countries studied, we can express aggregate second-pillar provisions as a percentage of GDP in each of the countries for which figures are available.

In order to proceed further, it is necessary to be able to compare this figure with the total provision that would exist if all first- and second-pillar pensions were funded. An initial indication is the OECD’s calculation [20] of the theoretical level of that provision in 1990 if all public pension schemes in the G7 countries had been operated on a funded basis. Without going into too much actuarial detail, it can be stated that, based on a discount rate, net of inflation, of 4 per cent for 20 years and 3 per cent thereafter, this provision averages roughly 200 per cent of GDP.

Based on our own estimates and a discount rate of 3 per cent net of inflation, which we feel is more realistic, we estimate [21] that a scheme that provides each pensioner with a pension of about 50 per cent of their previous earnings should entail a funding provision of approximately 250 per cent of GDP. This figure is obviously open to question, but we believe it makes little difference, the sole intention being to provide a reference for estimating the proportion of funding in overall pension financing and thus to be able to make comparisons across the various countries studied.

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41. Retirement allowance schemes

Some countries have allowance schemes which provide for (sometimes substantial) capital payouts when people stop working, e.g. when they retire. Such allowances can amount to as much as one month’s pay for each year of service with a given enterprise. These allowances are not generally considered part of the second pillar and, at most, are provided for as liabilities on corporate balance sheets and are not included in Table 5.

42. Respective proportions of funding and pay-as-you-go in the reference level

Table 5 therefore assumes that aggregate reserves of a funded reference system require a total provision equal to 250 per cent of GDP. Accordingly, the funded proportion in each country is equal to the ratio of the total provision actually constituted, as a percentage of GDP, and 250 per cent. The difference between this figure and 100 per cent is therefore the estimated proportion of pensions that are disbursed on a pay-as-you-go basis.

It can be seen that the pay-as-you-go proportion always exceeds 50 per cent, and that the countries listed can be divided into three categories with regard to funding:

14. In Switzerland, the Netherlands and the United Kingdom, the proportion of funding ranges from 35 to 41 per cent with respect to the reference level. It should be noted that this proportion is on the rise compared to a similar study carried out some ten years ago.

15. In the United States, Sweden and Japan, the proportion of funding varies between 12 and 18 per cent with respect to the reference level.

16. In the other countries for which figures are available in Table 5, the proportion of funding with respect to the reference level is less than 10, and in some cases 5, per cent.

Table 5 Second-pillar provisions and proportion of funding vs PAYG

Country GDP 94 Actual provisions in billions of local currency units

Prov. in %

% Funded

% PAYG

Billions

local curr.

Ins. Funds Book reserve

Total GDP Funded / 250 %

Balance

(A) (B) (C) (D) (E) (F) (G) (H) (I)

Germany (92) 3075,6 88 95 250 433 14,1 5,6 94,4

Australia 443,4

Austria 2262,9 16,2

Belgium 7625,9 601,8 219,6 0 821,4 10,8 4,3 95,7

Canada 750,1

Korea 185700

Denmark 933,2 167,8

Spain 64616,8 456,8 1497,4 n.a. 1954,2 3,1 1,2 98,8

United States 6931,4 900 2255 0 3155 45,5 18,2 71,8

Finland 507,8 6,7 46,4 n.a. 53,1 10,5 4,2 95,8

France 7376,1 270

30

Greece 23196,3 23,6

Ireland 34,7

Italy 1641105,1 36483,9

Japan 479100 n.a. n.a. n.a. 152027 31,7 12,7 87,3

Luxembourg 468,6 1

New Zealand 84,2

Netherlands 608,4 126,5 499 0 626,5 102,8 41,1 58,9

Portugal 13755 90,7 892 n.a. 982,7 7,1 2,9 97,1

United Kingdom 666,2 120(e) 451,8 0 578,8 86,9 34,8 65,2

Sweden 1516,9 224,4 374,6 n.a. 599 39,5 15,8 84,2

Switzerland 351,9 67,5 296 0 363,5 103,3 41,3 58,7n.a. data not availableSources : (B) : OECD 1996; (C) : GAP-FFSA, Les marchés de l’assurance vie en 1995

(D) : EFRP 1997; (G) : Total second-pillar provision; (H) : Proportion of funded pensions in relation to a reference system wherein pensions are equal to 50 per cent of wages, and for which the necessary provision would be approximately 250 per cent of GDP. H therefore equals G/250.

Group (1) includes (see Tables 1 and 2) two countries with flat-rate state pensions—the Netherlands and the United Kingdom—and one with a wage-related basic pension—Switzerland, although Swiss pensions are set at a very low level and the percentage declines sharply as eligible earnings rise. It is therefore logical that in these countries private pension funds account for a particularly large proportion of the total. It should be noted that Switzerland has instituted a funded mandatory second-pillar complementary scheme, which is included in our figures, and that the United Kingdom also has a mandatory complementary scheme (SERPS), but one from which businesses can contract out.

43. The impact of the B1/AE parameter on the proportion of funding

Looking also at the make-up of groups (2) and (3) shows that it is not the typology of the first pillar that determines the proportion of pension financing that is funded (% CAP). We shall now see that the determining parameter is B1/AE, i.e. the proportion of earnings to be covered by the basic scheme, as defined under Item 34. The higher the ratio of B1 to AE, the lower the proportion of pensions that are funded.

Table 6 and Figure 1 derived from it depict this situation in countries for which both CAP and B1/AE are known.

Table 6 Values of B1/AE and CAPin countries for which these figures can be estimated

Country B1/AE % CAPBelgium 1.51 4.3Germany 1.68 5.6Netherlands 0.63 41.1Spain 2.11 1.2Sweden 1.42 15.8United kingdom 0.41 34.8United states 1.07 18.2

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Table 6 draws upon data from Tables 3 and 5 and has been used to plot Figure 1, which does in fact show a strong negative correlation between CAP and B1/AE.

Regression analysis yields the following equation for the straight line passing closest to the points:CAP = 50.95 – 26.07 * B1/AE.

(standard error of estimate Y5.96, R2 0.890, standard error of coefficient – 3.73)

Figure 1 shows that the Netherlands is overfunded but that Belgium is underfunded, which explains the large standard deviations of the linear regression.

Other conclusions can be drawn: for example, Belgium, as compared to Germany, also has a lower B1/AE but also a lower CAP, which can be explained by the fact that in Belgium over 90 per cent of people opt for the capital sum on retirement, whereas in Germany they are obliged to take an annuity.

Section 2. The relative proportion of insurers in private pension schemes

44. As we said in item 40, it is often difficult to determine precisely the share of the insurance sector in the flows and stocks of the second and third pillars.

From the statistics available at the CEA [14], the GAP and in the review SIGMA [25][15], it is possible to ascertain total life insurance premiums, as a percentage of GDP, in each of the countries concerned, in some cases making a distinction between individual and group policies.

It is interesting to note that in France since 1995, the statistics have lumped group insurance together with voluntary subscriptions to individual life insurance.

In Table 7, we have listed 1995 data for total, group and individual life insurance premiums, along with the value of B1/AE in each of the countries studied when these data were available. Table 7 also gives a more general picture of the role of insurers in various countries. It also highlights the relationship between the various macroeconomic aggregates, as described below.

The impact of B1/AE on total life insurance premiums

Table 7 can be used to plot Figure 2, which depicts the negative correlation between B1/AE and total paid-in life insurance premiums in each of the countries studied, and to perform regression analysis, subject to the reservations below.

Figure 2 shows clearly that some countries do, in fact, lie outside a possible regression line. There are a number of reasons for this, including:

bancassurance in France (where total premiums are relatively higher);

international life insurance operations in the United Kingdom (higher);

the very under-developed state of the life insurance industry, due to a history of high inflation, in Greece and Italy (lower).

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Table 7 Life Insurance Premiums as a % of GDP vs. B1/AE

Country A1/AE Total Life Insurance 95/ %

Gdp

Group Life Insurance 95/ % Gdp

Individual Life Insurance

95 / % GdpGermany 1.68 2.6 0.23 2.37Australia 0 3.5Austria 1.81 2.1 0.04 2.06Belgium 1.51 2.3 0.96 1.34Canada 0.79 3.1Korea n.a. 9.1Denmark 0.69 2.7 0.35 2.35Spain 2.11 1.8 0.66 1.14United States 1.07 3.6Finland infini 5.4 2.86 2.54France 3.93 5.7 0.58 5.12Greec 1.76 0.8 0.09 0.71Ireland 0.52 4.5 1.47 3.03Italy 3.38 1.3 0.16 1.14Japan 0.38 10.1Luxembourg 2.29 n.s. n.s. n.s.New Zealand 0.55 3.1Netherlands 0.63 4.8 1.98 2.82Portugal infini 2.3 1.08 1.22United Kingdom 0.4 6.5 1.45 5.05Sweden 1.42 2.5 1.35 1.15Switzerland 0.58 5.9 3.39 2.51

Also excluded from the regression are:

Australia, in which the first pillar imposes means-testing above a certain level, making the value of B1/AE questionable if applied to the population as a whole;

Denmark and Sweden, which are special cases—also because of the particular structure of their first and second pillars.

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FIGURE 1 - PROPORTION OF PENSION FINANCING THAT IS FUNDEDVS. PROPORTION OF EARNINGS COVERED BY THE FIRST PILLAR

SWEDEN

UNITED KINGDOM

NETHERLANDS

USA

SPAIN

BELGIUMGERMANY

SWITZERLAND

0

5

10

15

20

25

30

35

40

45

0.25 0.45 0.65 0.85 1.05 1.25 1.45 1.65 1.85 2.05 2.25

B1/AE

% F

UN

DIN

G

FIGURE 2 - B1/AE AND TOTAL LIFE INSURANCE PREMIUMS

SWITZERLAND

SWEDEN

UNITED KINGDOM

NETHERLANDS

NEW ZEALAND

JAPAN

ITALY

IRELAND

GREECE

FRANCE

USA

SPAIN

DENMARK

CANADA

BELGIUM AUSTRIA

GERMANY

0

2

4

6

8

10

0 1 2 3 4 5

B1/AE

TOTA

L LI

FE P

RE

MIU

MS

AS A

% G

DP

Regression analysis on the seven remaining countries—Austria, Belgium, Germany, Ireland, the Netherlands, Spain and the United States—is then possible, and it yields the following result:

Y = 5.67 – 1.93 X

(standard error of estimate = 0.29, r2 = 0.95, standard error of coefficient = 0.20).

Other considerations aside, Table 7 and Figure 2 show that where the first pillar is most developed, with B1/AE high, life insurance has made the fewest inroads, except where it attracts a larger share of savings via bancassurance (in France) or is buoyed by a foreign clientele (in the United Kingdom).

The share of mathematical provisions constituted by insurers

Table 8 incorporates all of the available data on the insurance sector’s role in financing pensions in the second and third pillars alike. To make the table complete, we have also included the parameter B1/AE, which illustrates the extent of first-pillar financing.

Here, then, our comments will be limited to the second pillar, temporarily leaving aside the third, to which we shall return in Section 7. The relevant portion of Table 7 gives the available data:

(C) total second-pillar reserves, as a % of GDP;(D) proportion of those reserves placed with insurers, as a % of GDP;(E) insurance as a proportion of the total [(D)/(C)];(F) total life insurance premiums, as a % of GDP;(G) group life insurance premiums, as a % of GDP;(H) ratio of insurance reserves (E) to group premiums (G).

Concerning these columns, it should first be pointed out that the figures in (D) do not necessarily include reserves held by insurers in connection with group pension schemes similar to uninsured funds, as discussed in Item 20 above. However, the figures in (G) include premiums not only for pension plans, but also—and, in many cases, especially, as we shall see later—for a variety of death benefits and even credit cover and, in some countries, elective group policies having nothing to do with private pension funds.

It is precisely to shed light on this sort of situation that we have inserted column (H):

(H) = (D) 2nd-pillar insurance reserves / (G) group insurance premiums

Table 8 Summary of elements concerning the role of insurers

1st Pillar Second Pillar Third Pillar

CountryB1/AE

Reserves AS A %OF GDP Premiums AS A % OF GDP Net house-hold savings

% GDP

Tot. life ins.% GDP

Ind. life ins.% GDP

Ins. share of household

savings

Total Insurance Ins. % total

Total Group Res./Grp pre.

(A) (B) (C) (D) (E) (F) (G) (H) (I) (J) (K) (L)

Germany 1.68 14.1 2.86 20.3 2.6 0.23 12.44 11.7 2.6 2.37 20.3

Australia 0 3.5 1.5 3.5

Austria 1.81 2.1 0.04 13.6 2.1 2.06 15.1

Belgium 1.51 10.8 7.92 73.3 2.3 0.96 8.25 15.9 2.3 1.34 8.4

Canada 0.79 3.1 7.6 3.1

Korea 9.1 9.1

Denmark 0.69 2.7 0.35 - 4.4 2.7 2.35

Spain 2.11 3.1 0.72 23.3 1.8 0.66 1.09 6.2 1.8 1.14 18.4

United States 1.07 45.5 12.97 28.5 3.6 6.1 3.6

Finland inf. 10.5 1.32 12.6 5.4 2.86 0.46 3.3 5.4 2.54 77

France 3.93 5.7 0.58 9.5 5.7 5.12 53.9

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Table 8 Summary of elements concerning the role of insurers (continued)

1st Pillar Second Pillar

Third Pillar

CountryB1/AE

Reserves AS A %OF GDP

Premiums AS A % OF GDP

Net house-hold savings

% GDP

Tot. life ins.% GDP

Ind. life ins.% GDP

Ins. share of household

savings

Total Insurance Ins. % total

Total Group Res./Grp pre.

(A) (B) (C) (D) (E) (F) (G) (H) (I) (J) (K) (L)

Luxembourg 2.29 n.s. n.s.

New Zealand 0.55 3.1 - 0.3 3.1

Netherlands 0.63 102.8 20.77 20.2 4.8 1.98 10.49 11.4 4.8 2.82 24.7

Portugal inf. 7.1 0.65 9.2 2.3 1.08 0.6 12.4 2.3 1.22 9.8

United Kingdom 0.40 86.9 17.99 20.7 6.5 1.45 12.41 5.6 6.5 5.05 90.2

Sweden 1.42 39.5 14.77 37.4 2.5 1.35 10.94 8.6 2.5 1.15 13.3

Switzerland 0.58 103.3 19.21 18.6 5.9 3.39 5.67 17.4 5.9 2.51 14.4

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FIGURE 3 - B1/AE AND GROUP LIFE INSURANCE PREMIUMS

SWITZERLAND

SWEDEN

UNITED KINGDOM

NETHERLANDS

ITALY

IRELAND

GREECE

FRANCESPAIN

DENMARK

BELGIUM

AUSTRIA

GERMANY

0

0.5

1

1.5

2

2.5

3

3.5

4

0 1 2 3 4

B1/AE

GR

OU

P LI

FE P

RE

MIU

MS

AS A

% G

DP

39

Using the statistics established by the Office de Contrôle des Assurances in Belgium, we note that this ratio of reserves to group insurance premiums came to 7.85 in 1994, versus 8.31 in 1993. This relatively low (and declining) value can be explained by a substantial number of instances in which pension liabilities have been taken over from local authorities, with expenditures staggered over time, which tends to lower the ratio of reserves to premiums.

The same statistics produce a ratio of 12.41 for funds managed by institutions other than insurance undertakings.

This shows that in countries, such as Belgium, in which most group life insurance involves private pension funds, the ratio varies between 8 and 12.5, averaging about 10. The figures in Table  7, column (H) show that, of the countries for which data are available, Belgium, Germany, the Netherlands, Sweden, the United Kingdom and probably Switzerland have private pension funds that are administered by the insurance sector, since their values are of approximately that amount. It can therefore be assumed that, in these countries, group insurance plays a substantial role in the financing of private pension funds. More comprehensive statistics would probably lead to the same conclusion for other countries. In countries for which the ratio is significantly lower, group life insurance premiums must go towards other types of cover, as explained above.

Table 7, column (E)—reserves held by insurers over total second-pillar reserves—shows that insurers have roughly 20 to 30 per cent of the market (Belgium being an exception, with 73.3 per cent), although these figures are probably underestimated because of the large number of hybrid financing plans that are a cross between insurance and independent financing (Finland would seem to be typical of such a situation with its compulsory supplementary schemes administered by independent bodies constituted as insurance undertakings—see Table 2) and that are not included in insurance statistics.

Lastly, in Figure 3 we can observe the negative correlation between B1/AE and group life insurance premiums. It shows that the greater the value of B1/AE, the lower the premiums. By eliminating France and Italy for the same reasons as for Figures 1 and 2, the following regression line could be plotted for the other points:

Y = 1.75 – 0.72 X

(standard error of estimate = 0.54, r2 = 0.44, standard error of coefficient = 0.29).

It also shows a correlation between group life insurance premiums and B1/AE, but one that is far less significant than for total life insurance premiums in Graph 2.

Section 3. Applicable supervisory standards

47. In accordance with the objective of this study, we shall limit ourselves to outlining the general principles of supervisory standards applicable in the countries studied, and to highlighting the similarities and (especially) the differences that can exist between private pension funds, depending on the type of administrative financing arrangements, as defined under Items 15 to 20.

48. The origin of private pension funds

Private pension funds were initially conceived by employers. The first such plans were set up in the nineteenth century by the largest industrial firms in order to provide a portion of their staff—generally managers and other office workers—with pension arrangements comparable to the schemes that

40

governments had gradually been putting in place for civil servants. The essential goal was to enable the oldest employees to cease all work and still enjoy an adequate level of replacement income. The main result was that these pension plans were non-contributory, i.e. they were financed solely by employers and made no provisions for workers who might leave the company before reaching pensionable age; moreover, early retirement was possible only with the employer’s consent. This absence of vested rights in the event of early retirement has been, and still is, the rule for civil service pension schemes in a large number of countries.

49. In addition, this condition was conducive to “loyalty” among the staff of private firms, who had a great deal to lose by switching employers. In many cases, even when private pension funds involved contributory financing, i.e. contributions from workers (as later became commonplace), all rights to the proceeds of employer-paid contributions were forfeited if an employee left before retirement age or, in any event, before accumulating a certain number of years of service.

In that context, it went without saying that workers were never consulted, that whether a pension scheme was provided or not was entirely a matter of management discretion, and that the information given to staff was generally limited to a copy of the pension plan rules—if such a document existed, which was not always the case.

50. Later developments

Initially, these private pension funds were financed exclusively via overhead budgets (Item 15), book reserves (Item 16) or self-administered pension funds (Item 18), and they could even take the form of individual pension guarantees (Item 17)—generally when the sole focus of concern was a particular director or senior executive. In this context, the insurance sector could hardly play much of a role.

Overall societal trends in the latter half of the twentieth century had a decisive impact on these former arrangements, and today, in all of the countries studied, highly detailed legislation and regulations set forth the principles governing consultation, disclosure and vested rights in private pension schemes, irrespective of how they are financed and whether an insurance undertaking is involved or not.

At the same time, private pension funds gradually spread to workers in ever-smaller businesses. Paradoxically, the creation and extension of first-pillar retirement pensions, with their ceilings on pensionable wages, made supplementary schemes increasingly necessary (see Items 5 to 8). All this had two consequences:

Insurers were able to offer their services, particularly in the form of group policies—a financing mechanism that was better suited to small, and even medium-sized, businesses.

A system of defined contributions, rather than one of defined benefits, was frequently adopted in such cases, further strengthening the role of insurers in private pension funds, since the insurance sector’s implicit performance requirement was particularly well suited to systems of that type.

51. With regard to financing, there was a decline in the charging of pension outlays to overheads or book reserves, which do not offer sufficient guarantees when businesses fail—regardless of any applicable accounting standards, as is discussed below.

Insolvency (credit) insurance became compulsory in a number of countries for companies that were unable to constitute adequate external reserves: examples include Germany, Sweden, Finland (for employers who borrow from such reserves), Switzerland and the Pension Benefit Guaranty Corporation in the United States.

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52. Mandatory consultation and disclosure

The laws of most countries now require that the employees concerned be consulted and provided with adequate information. With regard to consultation, it is commonplace for the boards of directors of self-administered pension funds set up as separate legal entities, apart from insurers, to include staff representatives, who can be attributed up to half the seats if a fund is financed in part through worker contributions. Such is the case, for example, in Belgium, the Netherlands, Switzerland, Australia (as regards trustees) and, in some cases, the United Kingdom.

With regard to disclosure, the law often stipulates that each person enrolled in a scheme be provided with a sufficiently clear picture of his supplementary pension benefits, i.e. the amount of pension or capital, if an annuity/lump sum option is available, to which he would be entitled at the normal retirement age, as well as his vested benefits if he were to leave the company immediately.

53. The definition of vested benefits

It is, in fact, in the realm of vested benefits that the most recent wave of legislation (e.g. 1995 in Belgium) has been the most substantial. When a private supplementary pension scheme confers no entitlement to the proceeds of employer-paid contributions prior to retirement, or prior to reaching a certain advanced age or number of years of service, it loses much of its economic or financial value for the person in question. Under the circumstances, a worker who loses both his job and his future supplementary pension cannot include the latter in his projected future income and desirable level of savings.

It was therefore imperative for society to legislate vested rights into private pension schemes, although agreement is needed on the actual contents of those rights. We believe it is necessary to distinguish among five possible levels:

1) recognition of a vested right corresponding to employer-paid contributions up to the date of severance;

2) recognition of a vested right corresponding to defined benefits based on the worker’s wage level and length of service as of the date of severance;

3) as in 1) or 2), with compulsory adjustments to compensate for inflation;

4) as in 1) or 2), but with the worker given an option to have the vested reserve transferred to the private pension fund of his new employer (“transferability”);

5) as in 4), but with an obligation for the new employer, when incorporating the transferred reserve, to credit the worker for a certain amount of past service prior to his arrival (“portability”).

Legislation in most of the countries studied is at stages 1) or 2) (“vesting”), with rights accruing immediately or after no more than one year, except in the United Kingdom (two years), Austria and Italy (five years), and Germany (ten years, with a fairly complicated formula which takes age and length of service into account). The same holds true in the United States. Type 3) conditions are sometimes found, as in the United Kingdom if a firm has contracted out.

Belgium has been at stage 4) since the 1995 legislation was adopted, and the Netherlands would appear to be at stage 5). Full portability is feasible only if a country’s private pension schemes are sufficiently uniform, as is the case in the Netherlands (70 per cent of final pay). The same holds true for Finland,

42

Sweden and Switzerland, for example (Switzerland having the interesting concept of prestations de libre passage, or benefits that can be transferred freely).

54. Convergence between financing mechanisms

In conclusion, it should be pointed out that these social protection regulations apply to all financing mechanisms, insured or not, with the possible exception of worker co-management of a separate legal entity in the case of insured contracts. The latter is not possible with group insurance, although other arrangements are feasible, as in Belgium, via creation of a pension committee, in association with the works council, also for the purpose of consultation and co-operation.

Section 4. Technical standards

55. Content of technical standards

Technical standards seek to ensure that private pension funds function properly, and that they are in a position to deliver the benefits stipulated in their by-laws.

Rules focus first on the level of contributions and the mathematical reserves that need to be constituted. This involves a choice of actuarial calculation methods, along with assumptions as to interest rates and mortality tables.

These rules share the same prudential aims as those governing investment of the assets of private pension funds, at least as regards general investment principles.

56. Differences and areas of convergence

The main question is to ascertain the extent to which similar, if not identical, rules could be applied to all types of pension scheme financing, whether insured or not.

Most of the countries studied have made group policies subject to the same regulations as life insurance, which in many cases are quite long-standing.

Such rules were based on individual life insurance policies (providing lump sums or deferred annuities) under which each participant in a supplementary pension scheme was assured of receiving the benefits stipulated in the by-laws. More recently, however, supervisory authorities have afforded insurers greater latitude in the realm of collectively funded group pension funds (see Item 20), thus expanding the possibilities for market competition.

In contrast, prudential rules were applied to uninsured pension funds only subsequently, except for tax legislation, which in many cases was extremely specific.

In Australia, for example, the only rules initially applicable were tax-related, denying tax concessions to plans that failed to meet certain technical specifications. A new law—the Superannuation Industry Supervision (SIS) Act—has been in force since 1 July 1994 and theoretically applies to insured funds as well.

This reflects a desire for harmonisation between insured funds and other schemes, and the same trend is also to be found in Belgium and the Netherlands, where all funds are subject to a single supervisory authority—the Office de Contrôle des Assurances in Belgium and the Verzekering Kamer in the Netherlands.

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57. A trend toward more stringent supervision

Another discernible trend is the reinforcement of supervisory rules, with regard to uninsured funds in particular. For example, the AIDA report [3] notes (on page 444), in respect of the United Kingdom, that the volume of laws and regulations (in the broad sense of the term, i.e. both technical and social), which in 1973 amounted to only 40 pages, totalled some 2 900 pages in 1993, constituting “one of the great growth industries of the United Kingdom”. In the UK in particular, the Maxwell scandal triggered a major legislative reform based on the Goode Committee report.

Moreover, the increasing regulatory complexity, applicable to defined-benefit schemes in particular, may hasten a shift to defined-contribution systems, as is already manifest in a number of countries including the United States (see Chapter III, Section 1).

58. Investment rules applicable to representative assets

Most countries also impose prudential restrictions on the investment of reserves. The problem obviously does not arise in (the very few) countries that allow the book reserves method, such as Germany and Sweden, inasmuch as insolvency insurance is compulsory.

In other countries, regulations may be based on an open list of possible investments, as they are in Belgium and Switzerland, or on a mere statement of general principles of prudent management, with concurrent aims of security, yield and liquidity—requirements that are extremely difficult to reconcile.

An important point is that there are limits on the proportion of a private pension fund’s representative assets that can be invested in the firm that creates the fund for its employees, or in other firms belonging to the same group. If private pension funds are self-administered and uninsured, the regulations generally set fairly high limits—10 per cent in Switzerland, 5 per cent in the United Kingdom and 15 per cent in Belgium—although new regulatory provisions will probably lower those percentages. In contrast, there is nothing to prevent insurers of insured funds, in transactions totally independent of the group insurance, from investing in the employer’s equity or medium- or long-term debt. As a rule, however, such investments are limited, in respect of any one firm, to 5 per cent of the insurer’s aggregate technical provisions. It should be noted that, in this sort of arrangement, risks related to employer failure are borne by the insurer and not by group policyholders. This sort of borrowing is allowed in Finland, for example, on the condition that the employer has taken out credit insurance.

There has been a widespread trend toward liberalisation of investment restrictions—allowing, and even encouraging, greater investment of private pension fund reserves in equity rather than debt. Moreover, there is very broad consensus that over a long period of time such investments, if undertaken with all the requisite expertise, can provide higher returns than investments in bonds.

59. Asset/liability management

An essential characteristic of private pension funds is that they invest in very long-term bonds. Using actuarial projection models, financial inflows and outflows can be estimated over fairly long periods—an ideal context for using asset/liability management (ALM). This management method, which is cited favourably in the EU’s Third Life Directive, is probably particularly well suited to private pension funds insofar as the long-term nature of their liabilities should enable them to earmark a substantial portion of their investments for higher-yielding equity.

However, this probably requires a change in the methods by which representative securities are valued, adopting a going-concern assumption—either using the Anglo-Saxon actuarial method, i.e. calculating the present value of the future financial flows generated by investments, in order to calculate financial

44

equilibrium, or using a cost basis (possibly adjusted for other factors) rather than market value, for equities as well as bonds.

This would apply to all funds with group capitalisation, whether they are self-administered or insured.

60. Convergence between the types of financing mechanisms

Lastly, with regard to technical supervisory standards (including investment rules), it can be seen that there remain substantial differences between private pension funds, depending on whether or not they are insured. Because the basic activity is the same, however, as the most recent Australian legislation (the Superannuation Industry Supervision Act) recognises explicitly, a certain convergence would seem to be taking shape. This trend is likely to be confirmed and accelerated by supervisory rules more closely tied in with ALM.

Section 5. Tax standards

61. The three stages of taxation

Taxwise, the financial processes involved in the operation of a private pension fund can essentially be divided into three stages:

1) what happens when contributions or employer- or employee-paid premiums are paid in;

2) what happens while reserves are being constituted;

3) what happens when benefits are paid out—either as annuities or as lump sums.

A review of the abundant documentation on tax issues, a selection of which is reproduced in the annex, shows that at each stage there are enormous differences from one country in the study to another. To an even greater extent than for social or technical standards (where the diversity was less extensive) we shall limit ourselves here to general principles, highlighting the various types of solutions that exist in the countries studied.

With regard to the differences that can arise between the various financing mechanisms, it is clear from the outset that the most significant differences are to be found at stage 2), rather than stage 1) or (even less so) stage 3), where as a rule uniform principles apply.

62. Taxes or duties on premiums or contributions

At stage 1), i.e. when contributions or premiums are paid in, we can focus on the applicable taxes or duties, and the particular tax treatment thereof.

In some countries, premiums on insurance contracts—even group policies—are subject to tax: e.g. the United States (from 2 to 5 per cent, depending on the state, averaging 2.35 per cent), Canada (2 per cent), Greece (2.4 per cent), Italy (2.5 per cent), Austria (4 per cent) and Belgium (4.4 per cent). Most other countries have abolished this tax on life insurance premiums—first on group policies, then on individual ones. In Belgium, however, the tax has been maintained and extended to contributions to self-administered pension funds.

Apart from this exception and that of Austria, where a 2.5 per cent tax is levied on self-administered funds, such taxes apply only to insurance policies.

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63. Tax treatment of employer contributions

As a rule, employer-paid contributions or premiums are deductible from taxable corporate profit without being considered indirect taxable income for participants—within certain limits, and on the condition that supplementary pension systems fully comply with social, technical and tax-related regulatory standards. There are major exceptions to this general principle, however: in Germany, while employer appropriations to irrevocable book reserves are tax deductible for employers, employer-paid insurance premiums are deductible for the company but constitute taxable income for employees. Within certain limits, employers can assume this tax liability on a flat-rate basis, which is currently set at 22.9 per cent. Comparable provisions are in effect in Luxembourg.

In Portugal as well, employer contributions constitute taxable income for scheme participants, except if they have no vested rights in the event they leave their employer early, e.g. if there is no individual attribution within group capitalisation. This system is sometimes used when there is a risk that employees will be liable for tax on employer appropriations.

Elsewhere, employer appropriations are deductible for employers and non-taxable for employees, subject to the reservations described under Item 64. Attention should be drawn, however, to the special case of New Zealand, where these appropriations, although deductible, are subject to a 33 per cent withholding tax, which is paid by the employer.

64. Tax treatment of personal contributions

Personal contributions are tax-deductible for participants in many countries, subject to the limitations described under Item 64. They are deductible only within certain limits in Australia, Austria, Germany and Luxembourg. In the United States, they are deductible for defined-contribution schemes such as IRAs and, especially, 401(k) plans. They are not deductible in Portugal or New Zealand.

In some countries, including Belgium and Italy, reduction of the tax base is replaced by a reduction of the tax liability.

65. Limits on contributions and benefits

Many countries impose absolute or relative limits on private pension funds, in respect of allowable contributions or benefits.

Contributions are limited to 15 per cent of salaries in Australia and Spain, and to 19 per cent of eight times the social security ceiling in France.

In Australia, payouts are subject to a “reasonable benefit limit” (RBL), which caps accumulated retirement capital at A$418 000 (in 1996), or A$836 000 if more than half of the benefits are paid out in annuities.

Eligible salaries were capped in 1996 at $150 000 in the United States and £82 200 in the United Kingdom.

Limits on pensions as a percentage of salaries are imposed, inter alia, by Ireland and the United Kingdom (two-thirds), the Netherlands (70 per cent) and Belgium (80 per cent).

All of these restrictions aim to keep private pension scheme benefits within the normal limits of replacement income.

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66. Tax treatment of pension fund income

Stage 2) involves the tax treatment of the interest income and capital gains generated by the investment of private pension funds. The general rule is that such income is not taxable for the institution managing the supplementary pension system if that institution complies with the other standards.

Among the exceptions to this general rule:

Denmark imposes a 100 per cent tax on bond interest in excess of 3.5 points over inflation.

Sweden taxes interest income at a rate of 15 per cent.

Austria levies a 15 per cent tax on interest income and capital gains.

New Zealand taxes income at a rate of 33 per cent.

In Belgium, self-administered funds pay an annual tax of 0.17 per cent on their assets and a withholding tax of 15 or 25 per cent on realised income; insured funds are subject to a 9.25 per cent tax on allocated profits, which is not tax-deductible for insurers.

These measures are clearly complex, and in some cases they involve discrimination between self-administered and insured funds.

67. Tax treatment of benefits

Stage 3) involves the taxation of benefits. The almost universal rule is that benefits paid out in annuities are taxable as ordinary income.

In New Zealand, however, benefits are entirely tax-exempt, since contributions and the income generated by the investment of reserves are subject to a 33 per cent withholding tax.

If, as is frequently the case, a supplementary pension system allows for at least partial lump-sum payment of benefits, special rules (described in Section 2 of Chapter IV) apply.

It should be noted that the tax treatment of benefit payouts, whether in a lump sum or annuities, is the same, regardless of how a scheme is financed, except in Belgium, where the portion of insurance benefits obtaining from profit-sharing is not taxable.

68. Applicable social contributions

Close attention should be paid to a phenomenon about which very little information is available: the growing trend toward imposing social security levies on private pension fund contributions and benefits.

The situation seems vaguer with regard to employer contributions to pension funds. In the past, a lack of social contributions by either employees or employers seems to have been a fairly widespread rule, but the growing financial difficulties of first-pillar schemes could alter the authorities’ attitudes in this respect. This has already happened in Belgium, where a social contribution of 8.86 per cent (equal to the rate of employer contributions for State pensions) is levied on employer contributions to group insurance and pension funds, as well as in Italy, where the contribution is apparently 10 per cent for the pension funds introduced by the 1993 legislation.

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Section 6. Accounting standards

69. Comments on FASB 87

We shall make very few comments about accounting standards.

The theoretical aim of these standards is to afford all parties to a supplementary pension scheme with a clear and transparent picture of the commitments in force, and of the degree to which they are covered by assets outside the participating business and/or by internal book reserves.

The standards generally do not stem from accounting legislation [16], which as a rule makes only scant reference to the subject—at best, the obligation to furnish (fairly vague) information about supplementary company pension plans in the notes to corporate financial statements.

There are, however, codes of good practice among international auditing firms in particular.

The most comprehensive rules come from the United States, in the form of the Financial Accounting Standards Board Statement No. 87 (FASB 87). The underlying principle is simple, even if its application is extremely complex.

The basic idea is to compare the funding of a supplementary corporate pension plan with what it would be under a standard method that eliminated the “degree of freedom” referred to in Item 11 above, in respect of either the existing reserve or the annual employer contribution. Any differential with respect to the standard system must be recognised:

on the balance sheet, in respect of reserves—underfunding as a liability, overfunding as an asset;

in the profit and loss account, in respect of annual contributions—underfunding as an expense, overfunding as income.

It goes without saying that a large number of highly complex rules govern the implementation of these principles [21].

All of this has recently been extended to health care schemes to the extent that access to such schemes are maintained by employers after retirement age.

FASB 87 and, to a lesser extent, the British standard SSAP 24 are frequently applied to businesses that operate in international markets, including some non-US companies. In particular, the standards are used when firms are acquired or merge, and in such cases the selling price is often reduced by a substantial amount representing the underfunding of supplementary pension liabilities. The extent of the problem can be gauged by consulting [24], which shows that in 1990 the average book reserves of the supplementary schemes of seven large German firms equalled 28.5 per cent of shareholders’ equity and 21.4 per cent of total assets; a difference in the method of valuing, and especially of projecting, commitments can therefore have a substantial impact on the assessment of a company’s net assets.

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Section 7. Selected information about the third pillar

70. Forms studied in this report

The third pillar consists of individual cover i.e. in principle any form of personal saving.

However, this study of private pension funds deals only with those third-pillar schemes that can be bracketed to a certain extent with second-pillar schemes. Our goal is to highlight the role that life insurance can play in the creation of household savings.

71. Interpretation of the few statistics available

The last part of Table 8 deals with the third pillar and contains the following columns:

(I) net household savings as a % of GDP;(J) total life insurance premiums as a % of GDP;(K) total individual life insurance premiums as a % of GDP;(L) =(K)/(I), i.e. the share of individual life insurance in net household savings.

Column (L) shows that individual life insurance generally represents only 10 to 20 per cent of net household savings, except for the two major exceptions already cited under item 46—France, because of the bancassurance phenomenon, and the United Kingdom, because of the major role of British life insurance internationally.

It might be tempting, as was done for the second pillar, to attempt regression analysis, but the success of such an approach would be very limited, as we shall see in the items immediately below. This suggests that other factors have a more direct impact on the figures observed than those that we have listed.

72. Net household savings and the first pillar

Columns (B) and (I) of Table 8 can be used to ascertain whether the relative size of the first pillar (B1/AE) influences net household savings. Figure 4 has been plotted for countries for which these two figures were available. The points are highly scattered, and regression is possible on only nine of them, i.e.  eliminating France, Italy and Spain (it would be interesting to study the reasons for the particularities of these countries). The result is:

Y = 3.81 + 6.28 X

(standard error of estimate = 3.16, r2 = 0.69, standard error of coefficient = 1.61).

This would suggest that the extent of social security cover has in fact little impact on net household savings, except perhaps for a slight positive correlation—meaning, paradoxically, that the higher the social security cover, the higher the net household savings rate. Could it be concluded from this that the current widespread concern over the State’s ability to keep its pension promises is all the keener in countries where those benefits (B1/AE) are high, triggering greater third-pillar savings in those countries? Nevertheless, it is rather likely that other economic, social and even political factors play a more decisive role than B1/AE, as does a second-pillar crowding-out effect, discussed below.

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FIGURE 4: NET HOUSEHOLD SAVINGS AND B1/AE

SWITZERLAND

SWEDEN

UNITED KINGDOM

NETHERLANDS

NEW ZEALAND

JAPANITALY

GREECE

FRANCE

USA SPAIN

DENMARK

CANADA

BELGIUM

AUSTRIA

GERMANY

-10

-5

0

5

10

15

20

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5

B1/AE

NE

T S

AVIN

GS

% G

DP

50

FIGURE 5 : NET HOUSEHOLD SAVINGS AND SECOND PILLAR RESERVES

SWITZERLAND

SWEDEN

UNITED KINGDOM

PORTUGALNETHERLANDS

JAPAN

FINLAND

USASPAIN

BELGIUM

GERMANY

-10

-5

0

5

10

15

20

0 20 40 60 80 100 120

SECOND PILLAR RESERVES AS A % GDP

NE

T H

OU

SEH

OLD

SAV

ING

S %

GD

P

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FIGURE 6 : INDIVIDUAL LIFE INSURANCE PREMIUMSAND NET HOUSEHOLD SAVINGS

SWITZERLAND

SWEDEN

UNITED KINGDOM

PORTUGAL

NETHERLANDS

ITALY

GREECE

FRANCE

FINLAND

SPAIN

DENMARK

BELGIUM

AUSTRIAGERMANY

0

1

2

3

4

5

6

-10 -5 0 5 10 15 20

NET HOUSEHOLD SAVINGS AS A % GDP

IND

IVID

UAL

LIF

E IN

SU

RAN

CE

PRE

MIU

MS

AS

A %

GD

P

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73. Net household savings and the second pillar

Columns (C) (“second-pillar reserves”) and (I) (“net household savings”), both expressed as a percentage of GDP, can be used to measure any influence of the second pillar on the third by plotting Figure  5 (“Net household savings and second-pillar reserves”), also in relation to GDP. The fact that the points are highly scattered throughout the graph would suggest that other factors play a major role.

By limiting the data to six countries—Belgium, Germany, Japan, Portugal, Sweden and the United States—it is possible to establish a certain regression line, although it is necessary to explain why the five other countries had to be eliminated.

Y = 15.49 – 0.17 X

(standard error of estimate = 2.26, r2 = 0.65, standard error of coefficient = 0.06).

The result is not devoid of interest, however, because it indicates a certain recessive influence of the second pillar on the third. When the second pillar is extensive, net household savings is less, inasmuch as it is drawn down to the level of a short- or medium-term precaution, rather than constituting a source of replacement income. It is probable that the second pillar is clearer, more transparent and more reassuring than the first, which does not exert this downward pressure on the third pillar—on the contrary, as stated above.

This phenomenon probably explains the relationship in Figure 4 between net household savings and the extent of social security schemes (Item 72), which suggests that, in some cases, high social security cover paradoxically causes net household savings to rise proportionally. Perhaps this stems from social security’s crowding-out effect vis-à-vis the second pillar: when social security benefits are high, private pension fund benefits are lower and therefore net household savings is greater because of the current lack of confidence in the first pillar.

74. The role of insurers in net household savings

The last column (L) of Table 8 shows that, in most cases, individual life insurance accounts for a relatively limited proportion of net household savings—generally between 10 and 20 per cent, as indicated in Item 71.

Figure 6 plots net household savings against total individual life insurance premiums, again as a percentage of GDP. It is immediately obvious that in this case no regression, however limited, is possible. At the very most, it is possible to distinguish three groups of countries among those for which statistics (in most cases for 1995) are available:

France and the United Kingdom, where individual life insurance represents about 5 per cent of GDP, for the reasons cited above;

Austria, Denmark, Finland, Germany, the Netherlands and Switzerland, where the proportion is between 2 and 3 per cent of GDP;

Belgium, Italy, Portugal, Spain and Sweden, where the proportion is between 1 and 1.5 per cent of GDP, and Greece, where it is even lower.

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The differential between the last two groups probably stems from the sometimes substantial differences in the levels of tax concessions and possibly, in some cases, from a more modern range of life insurance products on offer.

75. Crowding-out or substitutions between pillars

We have just seen that the available statistics would suggest instances of crowding out between pillars. When the first pillar is strong, the second is more reduced and the third, in respect of net household savings, is more extensive.

As it was mentioned above, a number of countries have made provisions allowing for substitution between pillars. In the United Kingdom and Japan, for example, the first pillar provides flat-rate State pensions supplemented by schemes under which pensions are earnings-related. Employers who create second-pillar schemes meeting certain minimum criteria are exempted from participating in the second part of the first pillar—they “contract out”, i.e. a well adapted second pillar is partially substituted for the first. This substitution option is probably linked to the desire of certain States to shift some of their first-pillar financial obligations to employers.

Alongside this second-for-first pillar substitution, note must also be taken of recent possibilities for third-for-second pillar substitution in some countries, such as the United Kingdom. In that country, employers can no longer compel workers to participate in the private pension funds they set up; if workers prefer, they can substitute private pension contracts. These substitution options undoubtedly arise from notions of deregulation and individual freedom in the context of new career profiles involving greater mobility; giving workers the option to have individual pension plans can solve the mobility problem just as well, if not better, than requiring portability in the second pillar (see Item 53), which poses serious problems for employers.

To a certain extent, this same idea is taking hold in the United States with IRAs and 401(k) plans.

76. The role of government

The third pillar theoretically covers net long-term household savings, i.e., excluding shorter-term precautionary savings. As far as private pensions are concerned, the third pillar is often defined even more strictly to include only pension savings schemes with government tax incentives.

Governments have five main reasons for intervening:

(1) to encourage saving,

(2) to keep savings inside the country,

(3) to offer self-employed workers an individual structure comparable to the second pillar available to salaried employees,

(4) to encourage the acquisition of risk capital in order to boost the economy,

(5) to encourage individual initiatives in place of collective measures (shift from the first and second pillars towards the third pillar).

Recent government initiatives in various countries highlight these different reasons, though with some hesitance as to final choices.

Let us now take a closer look at each of these five motives.

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Many countries encourage saving, generally in the form of tax incentives for life insurance or long-term investments. Incentives may take several forms, such as the deduction of premiums from income or tax, non-taxation of interest during the lifetime of the policy or preferential rates of tax on payment of benefits, which in some countries may be paid only in the form of an annuity. There is a broad trend in many countries towards a reduction in such tax breaks; in the European Union, for example, this is partly attributable to the need to meet the Maastricht criteria.

The notion that tax incentives help to keep savings at home has posed problems within the European Union. The Commission has argued that making the benefit of tax incentives conditional on the payment of premiums to a government-approved insurer constituted an obstacle to the free movement of capital and took a test case against the Belgian government, the Bachmann case, to the European Court of Justice. Contrary to all expectations the Court rejected the Commission’s argument, finding that Member States could maintain this sort of discrimination on the grounds of “tax consistency”. The Court’s reasoning is that a government which grants a tax incentive on payment of a premium should be able to tax the benefit at term. This is difficult to ensure if the premium is paid in another Member State. However, some observers believe that for many reasons the Court’s case law could be overturned in other cases, thus undermining the force of this second motive within the EU at least.

The third motive concerns the supplementary pensions of self-employed workers. Self-employed workers may be able to constitute supplementary pensions within the second pillar through occupational schemes, though such schemes have been popular only in some countries. In others, the attitudes of certain types of self-employed worker, such as retailers and those in the professions, have meant that only individual measures are possible. In such cases, substantial tax incentives have often been granted so as to enable self-employed workers to bring their pension entitlements into line with those of salaried employees.

Encouraging investment in risk capital in order to stimulate the economy is a motive found in some countries, notably France, where plans for the systematic acquisition of equities (Plan Monory) have been followed, somewhat erratically on occasion, by the PER (plan d’épargne retraite - retirement savings plan), PEP (plan d’épargne populaire - popular savings plan) and, most recently, PEA (plan d’épargne actions - equity savings plan). Similar initiatives have been launched in Belgium, where it proved necessary in the early 1980s to support equity markets, as illustrated in Table 9 by the weaker performance of equities over the period 1942-1981.

The fundamental reasons behind this fourth motive are that depressed share prices are generally linked to high interest rates, which make it expensive for governments to finance public borrowing. In addition, low share prices prevent companies from strengthening their capital base by issuing new shares; consequently they issue bonds, pushing interest rates on capital markets even higher. Unsurprisingly, factors such as these have led governments in some countries to encourage investment in equities.

The fifth motive has a more philosophical basis, since its purpose is to encourage individuals to assume responsibilities rather than look to the welfare state. It lies behind much of the legislation that has led to pillar 1/2/3 hybridisation.

A certain degree of caution is needed here, underlined by the problems encountered in Chile and the UK in connection with over-zealous campaigns to sell pension schemes. Nonetheless, this line of reasoning is in tune with the prevalent philosophy of the market economy, which in theory permits the best allocation of available resources.

Viewing these third pillar motives as a whole, it is possible to identify a number of shortcomings and perhaps perceive the lack of a stable long-term vision, which is doubtless not the most rational behaviour in an area where the long term should predominate. The jumble of savings plans in France, the incessant

55

tinkering with tax incentives in Belgium over the last twenty years, the changes that have taken place in Australia, the US, Japan, etc. are all evidence of a fundamental need for greater coherence.

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77. Market structure

As mentioned earlier, the third pillar includes life insurance policies and long-term financial products. In fact, on most markets insurance products and financial products are increasingly tending to resemble each other.

However, life insurance products have a certain formal legal structure: they are taken out for a certain term and provide for a beneficiary if the policyholder dies and a beneficiary if the policyholder lives. Although there may be tax incentives for premiums, policies cannot normally be bought out before maturity without tax penalties. If financial products are also to benefit from the same tax incentives, they must adopt a similar legal form to life insurance policies, contributing to the growing similarity between the two types of product.

The structure of the investments underlying the products is also tending to converge. One obvious proof is that it is possible in most OECD countries to take out unit-linked life insurance policies, which have most of the features of purely financial products. In many countries where performances of UCITS, investment funds and unit-linked insurance policies are published regularly, returns on insurance products are at least equal to the returns on pure financial products.

One relatively important difference remains, relating to distribution channels. Life insurance is a “push” product; in other words, it has to be sold through a sales force, the cost of which cuts into performance.

Financial products, on the other hand, are “pull” products; in other words, customers go to the bank, where in all events they will invest the excess of their income in relation to their consumption, i.e., their savings. As a result, the distribution costs of financial products are significantly lower than those of life insurance products.

This situation has changed considerably in recent years, however, especially as a result of the development of closer ties between banking and insurance (bancassurance), enabling customers to take out life insurance policies at bank branches and hence at more or less the same distribution cost as financial products. Statistics from the CEA (Comité Européen des Assurances) show substantial growth in life insurance business in many countries.

Chapter IV - Some specific points

Section 1. The switch from defined benefit to defined contribution schemes

78. DB/DC schemes in the different pillars

In principle first-pillar benefits, mainly social security pensions, are calculated according to formulae defined by statute, whether they be flat-rate or earnings-related. Compulsory supplementary pension schemes, such as ARRCO-AGIRC in France, generally operate on a defined contribution basis with no guarantee of results.

As regards the second pillar, it is important to distinguish between company schemes and occupational schemes (i.e., schemes intended for a particular socio-professional group). In the case of company supplementary pension schemes, the DB system was for many years the most widely used, either as a result of being modelled on the first pillar or because private pension schemes had started before the first pillar came into existence. In 1985, DC schemes accounted for less than 5% of workers with supplementary pensions in Germany, the UK, Ireland and Japan. In the United States, by contrast, the

57

proportion was already 45%, mainly due to the proliferation of company savings or stock option schemes, which are always in DC form. In the case of occupational schemes, the DC system is the most widespread.

However, these distinctions between DB and DC are becoming increasingly theoretical even for the first pillar. In Latin America and various transition economies public first pillars are being transformed into defined contributions capitalised for each member of the scheme. In OECD countries, at least two countries, Sweden and Italy are setting notional defined contributions first pillars. These systems, unlike those of Latin America and transition economies, do not require the constitution of reserves.

Some countries thus operate DC schemes even within the first pillar.

As regards the second pillar, there is growing pressure in most OECD countries for a move towards DC company schemes for supplementary pensions.

79. DB/DC hybrids within pillar 2

DB/DC hybrids also exist. The first example, fairly widespread in Belgium, is that of defined benefit supplementary pension schemes whose rules provide for an individual or collective limit on contributions, generally paid by employers, as a percentage of the salaries covered.

If this limit is applicable to individuals (in which case policies are generally individual capitalisation policies), the employer’s payment in respect of the beneficiary in question remains frozen at the limit once it is reached, meaning that from the beneficiary’s standpoint the scheme changes from DB to DC.

If the limit is collective, the fact of reaching the limit causes an overall change of system for all beneficiaries, either by a reduction of the benefits to be acquired for the future or by a shift from DB to DC, acquired rights in each case being respected according to the legislation of the day.

Such clauses limiting the employer’s contribution to a certain percentage of salaries (safeguard clauses) are not widespread in other countries and would actually be illegal in Germany or Luxembourg, for example.

The comments above refer to hybridisation from DC towards DB but the opposite may also occur, since a DC scheme can limit the benefit to a certain percentage of salaries. This is the case in particular when tax law imposes a limit on the benefit that may be obtained under a favourable tax system. In Belgium, for example, the total pension may not exceed 80% of salary, while Luxembourg is considering legislation to limit supplementary pensions to 60,000 LUF a month (approx. 17,750 ecus a year).

80. The growing burden of regulation

Sections 3 to 6 of Chapter III described the current level of regulation of private pension funds. The regulations are much less constraining for employers and the institutions that administer the funds when the system is one of defined contributions rather than one of defined benefits (see item 10). In a defined-contribution system, the employer is required only to pay the contributions (see item 12), any performance obligation being incumbent solely on the body administering the fund.

As regard business regulations, the only obligation for the employer is thus to pay the contributions, the acquired benefits being determined solely by the amount of contributions paid plus the interest earned at a rate that may be guaranteed by the institution administering the fund. There is therefore no risk of the employer underestimating his liabilities and thus also no problem from the standpoint of compliance with technical regulations.

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In consequence, accounting regulations do not pose a problem either, and there will be no need to make balance sheet or income statement adjustments of the kind provided for by FAS87 (item 68). Similarly, in the event of a projected merger, disposal or acquisition, there will be no need to fear a bad surprise or a reduction in the selling price.

It is probably on account of the growing complexity of the regulations associated with defined-benefit schemes that the present trend is towards defined-contribution schemes.

81. Recognise and promote mobility

The growing burden of regulation is probably the reason why employers are currently in favour of switching to defined-contribution schemes, which have the added advantage of reducing considerably their future liabilities.

Sometimes, employees may also be in favour of switching to defined-contribution schemes. This is rather paradoxical given that a defined-benefits system gives them substantial financial guarantees, the cost of which is borne by the employer (see item 12), such as an inflation-proof guarantee up to retirement age.

The reason for this change of attitude among employees has to do with the fact that career profiles have themselves changed, with workers now having to be much more mobile.

Indeed, it may be asked whether the defined-benefits system is not part and parcel of the idea of spending one’s entire career in the same enterprise, joining it at 25 and retiring at 65. While this was possible in the past (although it had already become rare in the second half of the century), it now seems gone forever. Whether at the level of the individual or the firm, are not mobility and flexibility now going to outweigh all other considerations?

Also, is not the retirement age itself, after having fallen with early retirement arrangements, now going to rise again? Are we not moving towards fully-flexible retirement, with retirees working part-time, tapering off towards the end of their career? Are not these ideas, which have been regularly canvassed in recent years, going to win acceptance in the near future?

Is not the crucial question, given this trend, whether the notion of “defined benefits” (the so-called objective to be attained) is still meaningful if the portability of pensions is to be guaranteed (see item 53)?

As said earlier (item 75), growing career mobility has no doubt been the reason for the shift from second to third-pillar schemes that has already taken place in the United Kingdom and the United States. The same factor is also liable, within the second-pillar itself, to trigger a shift from defined-benefit systems to defined-contribution systems, in which the fact of changing employer does not pose a problem.

82. Changes in career profiles

It is not only mobility that has increased. For managers in the private sector in particular, it is no longer the case that their salary will be highest at the end of their career. This can be due to mobility: a worker who has been made redundant may sometimes have to accept a lower salary in order to find another job. It may also be due to the fact that the worker changes jobs within the same firm, for example switches from a production job to an advisory or training job. According to the law of the market, should not remuneration be related to the value added generated by the worker, so that it would peak before the end of the worker’s career and fall thereafter, since productivity and the resulting value added usually decline with age?

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This would be a valid alternative -- reduce end-of-career- salaries rather than lay off workers -- to current early retirement schemes, which it will not be possible to continue for much longer for demographic reasons in particular, since they would make it necessary to raise the retirement age in the medium-term.

But even with such a career profile, the same question has to be asked again: is the notion of “defined benefits” still meaningful? If a worker changes employer with a reduction in pay, is the portability of his vested rights sufficient to safeguard them?

At the present time, it would seem that the answer to both of these questions is no, making defined-contribution systems more attractive than in the past, all the more in that there seems to be less need than in the past for the inflation-proof guarantee which defined-benefit systems offered -- inflation having been curbed to a large extent -- and also because there is a better understanding of the investment techniques that make it possible to hedge against inflation.

The system of defined contributions has therefore become attractive again, in contrast with the periods of high inflation and stable employment, i.e. the 1950s and 60s.

Employers and employees increasingly think that the best system is one in which both employer and employee contributions are a fixed percentage of wages and are capitalised over time, and can be transferred easily from one employer to another throughout the individual’s career.

The only obligation involved is to pay the premiums provided for by the plan’s rules, changes in pay or employer creating no new liability and the final outcome being the situation at the end of the worker’s career.

It is therefore likely that firms setting up new plans will henceforth give serious consideration to the possibility of adopting a defined-contribution scheme. This is, moreover, confirmed by numerous studies and surveys, for example benefits surveys [4], [5], [6] and [7], which sometimes describe “community practice” in certain countries. Figure 9, which illustrates this trend in the United States from 1975 to 1990, is taken from [22]. It shows that:

the number of members of defined-benefit schemes has remained extremely constant;

whereas the number of members of defined-contribution schemes has risen considerably.

This would indicate that the new schemes that have been set up are defined-contribution schemes.

83. A difficult transition

However, usually the transition from a defined-benefits scheme to a defined-contributions scheme is not easy. Figure 8 shows the level of contributions required to finance comparable benefits:

in a defined-benefits scheme, with a fraction of the final guaranteed benefits vested each year;

in a defined-contributions scheme, with the percentage of salary calculated at the outset and remaining constant subsequently but without any guaranteed defined benefit; it may be noted that that the percentage is not uniform since a lower rate of contribution is levied on bracket B1 (see item 32).

The calculations are based on a career stretching from the age of 25 to 64 with the same employer, with the salary increasing three-fold over that time plus an annual indexation of 3 per cent.

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Figure 8 shows that the contributions are lower, sometimes very substantially so, in a defined-contributions scheme, up to the age of 52. This has two consequences:

1. in the event that the employee leaves the company before that age, the portable reserve is much smaller in a defined-benefits (DB) scheme than in a defined-contributions (DC) scheme. This fact makes defined-contributions schemes more attractive to mobile employees;

2. in the event that a company switches from a DB plan to a DC plan, there will be:

with respect to the past, a deficit of reserves for young employees;

with respect to the future, a deficit of contributions for the oldest employees

The transitional generation (or rather its employer) will thus have to contribute twice-over, i.e. to the new plan and to make good the shortfall of reserves for the youngest employees and of contributions for the oldest -- a problem comparable to some extent with that of the transition from a pay-as-you-go system to a funded system. Of course, the transition will be all the easier in that the defined-benefits system has been over-funded, i.e. that the reserves exceed the strict amount required to finance vested rights.

Section 2. Commutation of benefits. Property aspects

84. The main reason for this option

Supplementary pensions are usually funded, i.e., employees and employers contribute to institutions outside the firm in order gradually to build up a reserve which will finance the promised pension at retirement age. Assuming these conditions are met, it may be reasonably asked whether the beneficiary should not be given the option of taking a single lump payment rather than a pension paid over the period of retirement.

Some people question this reasoning, however, arguing that the purpose of the second pillar is normally to provide a pension to a surviving retiree and not a capital sum, which may be badly invested, and thereby deprive the retiree of this income until death occurs, perhaps at an advanced age.

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FIGURE 7 - MEMBERSHIP OF THE US EMPLOYER PENSION SYSTEM, 1975 - 1990

0

5

10

15

20

25

30

35

40

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

Mill

ions

DEFINED CONTRIBUTION DEFINED BENEFIT

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FIGURE 8 - EVOLUTION OF CONTRIBUTIONS AS A % OF SALARIES

0.0000

0.0500

0.1000

0.1500

0.2000

0.2500

0.3000

25 30 35 40 45 50 55 60

DEFINED BENEFIT DEFINED CONTRIBUTION

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In some countries -- the United States (401 k) and Australia until recently -- it was in principle possible to use the savings accumulated before retirement in order to borrow. While this seems logical within certain limits if the savings are used to purchase property, as is still possible in Belgium, it is not in keeping with the primary objective of the system -- to provide a supplementary pension.

Subject to this reservation, and provided that there are certain limitations and restrictions, it may asked however whether such an option is not in tune with the current general trend, especially as it in keeping with the principle of defined-benefit (money purchase) systems.

We shall now review the situation in the countries surveyed, plus Iceland, Norway and Turkey (25 in all), together with the tax treatment of the capital payment.

85. Those countries in which the option does not exist

France is one of the countries in which it is not possible to commute benefits. As supplementary pensions are usually financed on a pay-as-you-go basis, in contrast with the norm, it is obviously not possible to commute the benefits in the form of a capital sum since there is no reserve.

Furthermore, doubts have been raised in France about the medium and long-term viability of a supplementary pension scheme financed solely on a pay-as-you-go basis. A recent law -- the “Loi Thomas” -- made it possible for firms to set up supplementary pension funds. It is worth noting that these pensions can be paid only in the form of an annuity. One of the reasons for rejecting the capital sum option was not to compete with the third pillar, in which personal life insurance plays a very important role (see Table 7 and Figure 6) and which offers the choice between a capital sum and an annuity.

The capital option does not exist in Germany or Austria either, though it should be noted that in Germany in particular the most commonly used method of financing supplementary pensions --accounting for nearly 60 per cent of all such arrangements -- is a book reserve on the liabilities side of the firm’s balance sheet. This means that contributions are not capitalised outside the firm, that the assets covering pension liabilities are lumped together with the investments in the firm, and that in consequence the firm prefers to pay out pensions gradually rather than in the form of a capital sum.

Five other countries do not allow benefits to be commuted: the Netherlands and the Scandinavian and similar countries, Norway, Sweden, Finland and Iceland; in Denmark, however, supplementary pensions are normally paid in the form of a capital sum.

Thus, in eight of the 25 countries examined, the capital option is totally impossible, either for reasons of financing or for social or political reasons which emphasise collective rather than individual choice.

86. Countries in which the option does exist

In the other 17 countries, i.e. a very large majority, the option does exist, though in some cases subject to restrictions.

In the United Kingdom and Ireland the beneficiary can ask to have a quarter of his accumulated rights paid in the form of a capital sum, up to a maximum of 1.5 times his annual salary. The capital sum is tax free. Total annuities, or residual annuities if the beneficiary has opted for a part payment in capital, are taxable like ordinary income. There seems to be an obvious incentive to take part of the pension in the form of a capital sum since one can always reinvest it in an annuity which is taxed at a lower rate than pensions.

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In Portugal too it seems possible to take a third of the pension in the form of a capital sum but this remains to be verified.

In the other countries, it is usually possible to take the entire pension in the form of a capital payment provided the plan meets certain conditions.

The situation in Australia is very similar to that in Belgium in the sense that most plans provide insurance for the capital but not for the annuities, and that virtually all the beneficiaries take the capital sum and not the annuity, since they can always invest it with an insurance company to obtain an annuity. The capital is taxable at the rate of 5 per cent for the premiums paid before 1 July 1983, but at about 16 per cent for the premiums paid after that date. Pensions are taxed like ordinary income (except for the portion accumulated before 1 July 1993). There is thus an incentive to take the capital sum and not the annuity. However, it should be noted that the Australian authorities have been recently trying to introduce various restrictions, a “reasonable benefit limit” (RBL) which varies according to the case. The maximum tax-free capital is A$ 836 000 if only part of the pension is taken as a capital sum, it is smaller if the entire pension is taken as a capital sum.

In Belgium as we saw, the entire pension can be taken in the form of a capital sum taxable at the rate of 16.5 per cent, whereas annuities are taxed at the normal rate.

In Denmark, most plans provide for capital payments according to a system of defined contributions. Capital sums are taxed at 40 per cent, while annuities are taxed at the normal rate, which is highly progressive.

It is difficult to comment on the situation in Italy because the statutory pension system has just been reformed twice in the space of two years. The most important supplementary system, which is moreover mandatory for all firms, provides for the payment of a capital sum when the worker leaves, in particular when he retires. This sum can amount to as much as three times the annual salary for a long career. It is taxed separately at a lower rate than the standard rate, especially for long careers. A recent law authorised the creation of pension funds, the tax status of which would not be extremely favourable but would allow 50 per cent of the pension to be taken in the form of a capital payment.

Mention may also be made of Luxembourg, which allows the entire pension to be taken as a capital sum taxed separately at a maximum rate of 35 per cent, New Zealand, where one is free to choose, and Spain, Turkey, Korea and Greece where various capital/annuity options are possible.

In Switzerland, the beneficiary is free to choose between a capital sum and an annuity. Annuities are taxed liked ordinary income and capital sums are taxed separately, either at a special rate that varies according to the canton or at a maximum rate equal to that at which the annuity would have been taxed, applicable to only part of the capital. Capital sums are thus taxed moderately.

In Japan, the system of supplementary pensions allows the beneficiary to choose between a capital sum and an annuity. At the present time, a first tranche of ¥15 million is tax-free plus half of the remaining capital (at least thirty years’ service required). The other half is taxed at the normal rate but separately.

In the United States, defined-contribution plans, often constituted in the 401 (k) form, allow the pension to be taken as a capital sum, the taxation of which is spread out over time and limited. In Canada, defined-contribution plans also allow the pension to be paid in the form of a capital sum but it is tax-free only if is transferred to certain types of other plans.

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87. Brief comments and property aspects

Most countries examined -- 16 of the 25 surveyed -- allow the beneficiary of a supplementary pension to choose between a capital sum and an annuity, and in most of them the pension is taxed like ordinary income while the capital sum is generally taxed at a more favourable rate.

Sometimes the capital sum is tax-free, sometimes it is taxed on a one-off basis at the rate of 15 to 20 per cent, the reason for this special rate being simply that the income which the capital sum will generate will itself be taxed. Also, the beneficiary will have to bear the investment risk, which is another reason why the capital is often taxed at a lower rate.

It is worth examining the reasons put forward for allowing a retiree to choose between a capital sum and an annuity:

the statutory pension systems in most of the countries surveyed provide a socially acceptable income and sometimes even relatively high statutory pensions.

if a supplementary pension is not an individual’s sole source of income, why deprive him of the possibility of choosing between a capital sum and an annuity?

a final, major, reason -- and one that seems to have been particularly important in Japan -- is that part of the capital can be used to buy a home for retirement. No longer having any rent to pay, the retiree has smaller outgoings, thereby increasing the value of his disposable income, and the statutory pension in particular.

The use of the capital sum to purchase a dwelling is particularly common in Belgium and perhaps in other countries too, since in the past group insurance was widely used to obtain mortgages and advances in order to buy a home.

Section 3. Methods of adjustment

88. The first pillar

First-pillar pensions - social security and similar pensions -- are financed on a pay-as-you go basis. This means that employee and employer contributions are used immediately to pay for pensions. In consequence, as pensions are equal, overall, to the contributions paid, they are directly proportionate to the wage bill; consequently, as long as the other parameters remain constant, pensions can be linked directly to the salaries of workers. This means that in a stable demographic and economic environment, first-pillar pensions can be linked to wages and thus that an adjustment based on the trend of real wages can be added to the price-indexed adjustment. This is what they call in Belgium a “prosperity” adjustment, or in Germany a “dynamic” adjustment.

For a long time, this was the method used to adjust first-pillar pensions in most countries. But when the economic environment worsened, most countries abandoned it and linked pensions to prices instead of wages, except, sometimes, for the lowest pensions.

There has been an interesting development in Germany: the dynamization of pensions has been abandoned and instead they have been linked to net wages. If the financing of the first pillar pushes up parafiscal or even fiscal charges, net wages, assuming constant purchasing power, will fall. Linking pensions to net wages introduces an idea of solidarity between the retired and workers. The same idea seems to have been adopted in Japan.

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89. The second pillar

Second-pillar pensions are adjusted in line with the mode of financing adopted. It should be noted that when the beneficiary has a choice between a capital sum and an annuity, the employer or the institution administering the supplementary pension scheme is under no obligation to adjust it for those who took the capital sum (which perhaps explains why employers tend to be in favour of at least a partial capital/annuity option).

In mandatory supplementary schemes such as the ARRCO and AGIRC in France, pensions are adjusted as in first-pillar schemes insofar as they are financed on a pay-as-you go, or similar, basis. In the United Kingdom, in the SERPS or when the private pension fund is contracted out, benefits are index-linked to those provided for by the SERPS. In addition, the Occupational Pension Board can impose an increase on the trustees of a pension fund when the fund is overfunded.

When the method of financing is a provision on the liabilities side of the balance sheet, the employer has funds at his disposal at relatively low cost (5.5 per cent in Germany, 6 per cent in Austria). Successive court rulings in Germany have held that employers must raise benefits periodically.

In other countries, it is usually the employer who decides to adjust pensions in self-administered funds or collective pension funds, for example in accordance with the yield on investments. In the case of insured contracts, the adjustment is usually replaced by a share of the profits (dividends) paid by the insurer.

Chapter V – A dynamic approach to private pension management

Section 1. General Considerations

90. Past developments and current practice

It is interesting to note that private pension funds were initially introduced by employers and in many cases preceded the creation of social insurance (the Bismarck doctrine) or, subsequently, social security (the Beveridge doctrine). In the English-speaking countries, the major railways, distributors, gas utilities, banks and insurance companies, along with municipal governments, had instituted such plans by the end of the nineteenth century—to such an extent that before the First World War two-thirds of British wage-earners were covered by a pension scheme [24].

In Germany, private pension funds were set up in 1858 by Krupp, in 1872 by Siemens, in 1879 by BASF, and so on.

Very quickly, it became clear that reserves needed to be constituted in order to finance future pensions, primarily to satisfy the aims of prudent accounting. These reserves generally took the form of trusteed funds—separate legal entities in the English-speaking world—whereas in a number of other countries, such as Germany, a system of book reserves was employed.

The first actuarial methods (such as King’s) were described in the Text Book of London’s Institute of Actuaries (1895) and involved collective capitalisation to determine a single contribution rate applicable to all employees in order to meet pension commitments. This method is still used today and is known as the aggregate cost method (AGCM), with no individualisation of rights.

In France, 1895 legislation called simply for separation “of funds collected for the purpose of meeting pension expenditure from the employer’s assets in order to shield those funds, in the event the employer should fail, from the claims of creditors”. The Decree-Act of 28 October 1935 stipulated, in Article 35,

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Section 1, that pension funds were required to establish “a technical inventory proving that their financial situation was adequate to guarantee their prior commitments”. This very vague wording was made no more explicit in the Rules of Public Administration of 18 March 1936.

What should be remembered from this brief historical overview is that private pension funds originated with employer initiatives that involved neither precise rules as to how commitments would be met nor even a legal obligation, except in France, to separate a fund’s assets from those of the employer who created it. Prudential objectives, and probably tax obligations, nonetheless led to such a separation in most countries where the Anglo-Saxon influence was substantial, and as a rule it took the form of self-administered funds.

Only much later did insurance companies take an interest in this market, which had become that of group retirement benefits, and initially they tended to enter it with existing products, i.e. by combining individual life insurance policies, with each amount of worker- and employer-paid premiums corresponding to a specific amount of tariff-based defined benefits—i.e. a system of individual capitalisation. The regulations applicable in many countries to insurance transactions, and to these life insurance policies in particular, allowed no other option.

Frequently, however, self-administered pension funds used to be voluntarily excluded from the scope of application of supervisory standards applicable to life insurance companies. This was the case in Belgium, for example, where a 1930 law formally excluded such funds from life insurance supervision; in 1975, subsequent legislation called for the supervision of “private provident institutions” (i.e. self-administered funds), but the applicable rules and conditions were not specified until 1985.

To be sure, the technical structure of transactions was significantly different, precluding application of a single set of supervisory rules to both insured and self-administered schemes and making it difficult for the same supervisory body to oversee both.

A natural consequence of this historical development was that, until recently, the group pension benefit sector in which insurance companies operated was subject to significantly different rules than the ones applicable to uninsured funds.

91. Fundamental technical differences for defined-benefit systems

The Anglo-Saxon concept of the actuarial stability of pension funds was based essentially on aggregate equality between the present value of total employer pension commitments and the fund’s current assets plus the present value of future contributions by both workers and employers.

In contrast, insured contracts were based on individual equality between the present value of benefits and the present value of personal and employer contributions. One involved collective capitalisation, the other individual capitalisation.

To calculate aggregate equilibrium in a collective capitalisation scheme theoretically entails the use of wage projection models, since benefits are generally tied to earnings at the time of retirement, or to an average close to that level. We should reiterate that the purpose of calculating in the aggregate is to determine a stable rate of financing which therefore incorporates assumptions as to future changes in parameters.

In contrast, individual calculations are based exclusively on current data and make no projections. This explains why the financing burden tends to increase gradually as a worker nears retirement age, since there remains less and less time to fund the higher benefits arising from increases in earnings.

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As a result of all these factors, it was necessary, until recently, to draw a fundamental distinction between:

the Anglo-Saxon tradition based on the idea of trusteed funds aiming for aggregate actuarial equilibrium between current assets plus the present value of future contributions, and the present value of benefits; and,

a more Continental tradition tied rather to the idea of individual capitalisation. [Note: A shift to defined-contribution schemes (Chapter III, Section 1) might revive interest in this type of individual technique, which in this case is the only option.]

It is also interesting to cite a fundamental difference between the two traditions on a legal level. With individual capitalisation, there is generally a “performance obligation”, i.e. the entity that administers the system guarantees a specific level of benefits for a given amount of contributions, assuming liability for the financial consequences of any differential between reality and actuarial, interest rate and mortality assumptions.

In contrast, if aggregate equilibrium is the objective, the administrative entity generally assumes only a “best-effort” obligation, i.e. a commitment to manage the funds entrusted to it by the employer as well as possible, the final commitment continuing to rest with the employer. This is the case with self-administered funds, but also for the new products of insurers, although some of the latter do offer guaranteed minimum returns.

92. A shift toward the notion of deferred compensation. Vested rights.

The high inflation that prevailed during the Second World War and, generally, in the years immediately thereafter made defined-benefit plans more attractive than defined-contribution schemes: most of the schemes created in almost all countries during the 20 years following the war were set up to provide defined benefits (for example, see Figure 7 in respect of the United States).

Over that same period, these plans came increasingly to be considered a form of deferred compensation, guaranteeing a certain rate of replacement for the income to be lost upon retirement. The cost of these supplementary schemes was therefore part of the total wage bill, which as a result tended increasingly to cover both current earnings and deferred compensation. This naturally generated obligations in the form of vested rights: when a worker left his employer after a certain number of years of service, he had to be credited with a vested pension that corresponded exactly to those years and that could, in some cases, be transferred to his new employer (see Item 53).

Here, the Anglo-Saxons’ prized concept of aggregate long-term equilibrium became insufficient. To use a simple image, the aggregate cost method, which, as its name implies, makes no distinction between past service and future service, constitutes a sort of motion picture in the sense that the camera, turned always toward the future, checks that future contributions, along with current reserves, will be sufficient to cover all projected future benefits. In point of fact, this entails a going-concern assumption whereby vested rights accrued in the past may be covered not by currently existing reserves but by future contributions.

Such actuarial equilibrium may therefore be inadequate to guarantee vested rights as calculated individually for each worker on the basis of current length of service: Here the motion picture gives way to a snapshot of current reality, in which the assets managed by the pension fund administrator must be able to cover all vested rights if everyone were to leave the company immediately, or if the pension scheme were to be discontinued. It should be noted that such a termination assumption is generally not very realistic.

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Even so, most regulations require private pension funds to possess reserves calculated one way or another to meet this last assumption.

Moreover, the two actuarial techniques are not incompatible, and it is possible to strive for long-term equilibrium while at the same time requiring a minimum provision at all times.

93. The activity of insurers

For quite some time in the English-speaking countries, and more recently elsewhere, insurers have not merely offered individual capitalisation contracts in the second pillar; they have also proposed group solutions similar to those of pension funds, engaging in group retirement fund management, or deposit administration (DA—see Item 20). In some countries, such as Belgium, collective capitalisation of employer contributions is also an option in group insurance, in which individual capitalisation of personal contributions may now be combined with collective capitalisation of employer contributions. When such a system is available, minimum financing rules stipulate, however, that vested rights are retained if a participant leaves the company.

Apart from a line of business—individual capitalisation—which is still an exclusive for them, insurance companies in most countries offer plans (rather successfully, it would seem) that are comparable, if not identical, to those of self-administered pension funds.

94. Brief description of the general principles of supervision in selected countries

In a large number of countries there is a single supervisory body with jurisdiction over private pension funds, whether they be self-administered or administered by insurers:

Australia: Superannuation Industry Supervision (SIS)Belgium: Office de Contrôle des Assurances / Controledienst voor VerzekeringenItaly: Ministero del Lavoro e della Previdenza SocialeNetherlands: Verzekering KamerUnited Kingdom: Occupational Pension Regulatory Authority (OPRA)United States: Internal Revenue Service, in respect of the Employee Retirement Income Security Act

(ERISA)

Similar authorities exist in Denmark, Finland, Sweden and elsewhere, although the rules applicable to the two types of funds are not necessarily the same. Even so, the existence of a single supervisory body can be taken as a signal of future convergence in treatment, except where distinctions between the various methods of financing are duly justified.

With regard to the actuarial techniques used in defined-benefit (DB) systems—and with the exception of countries using the book reserves method, which is based on individual capitalisation (although it is possible to insure the reserves via collective retirement fund management, such as deposit administration)—collective capitalisation methods are possible almost everywhere (the Netherlands and Spain being two exceptions). In this case, as a rule no actuarial method is imposed, although certain traditions may exist in some countries.

Nevertheless, as vested rights became widespread in all of the countries studied, it inevitably triggered a return to techniques of individual calculation, since it was necessary to determine the rights accrued by each participant.

It was for obvious prudential reasons that most countries required institution of a minimum provision, as did the United Kingdom in the Pension Act of 1995. As a rule, reserves must minimally be adequate to

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cover current pensions as well as the vested rights of active participants and participants who have left. Here again, the idea is that of a snapshot of commitments, as opposed to the motion picture vision of dynamic long-term equilibrium. Reserves are generally computed on the basis of current length of service and wage levels, and rarely on the basis of projected earnings as prescribed in FASB 87 (Item 69).

In respect of individual capitalisation, mortality tables are the ones applicable in each country, although the use of more conservative tables is permissible. Interest rates of 4 per cent are applied to insured individual capitalisation contracts in Austria, Germany and the Netherlands, 3.5 per cent in France, 4.75 per cent in Belgium and 6 per cent in Spain. As stipulated in the third EU Directive, rates are sometimes linked to the yield on government bonds. These are maximum rates, whereas to compute book reserves, tax regulations require a minimum rate of 6 per cent in Germany and Austria and 5 per cent in Luxembourg, which poses a problem when reserves are insured (Item 16), since the reserves themselves must be calculated using a lower rate of interest.

On a financial level, many countries impose certain restrictions on investment. The general rule is to require reasonable prudence, with an emphasis on diversification, security and yield—the last two requirements not always being compatible. As a rule, investment in a single company (in the form of loans, bonds or equity) is limited to no more than 5 per cent. In some cases this ceiling may be exceeded for a self-administered fund that invests in the firm that created it—e.g. to as high as 15 per cent in Belgium and more in Finland for loans covered by credit insurance. In addition, some countries require a minimum investment in domestic bond issues—a requirement recently dropped in the European Union countries because of EU regulations.

A final point worth examining has to do with a prudential method that is sometimes used in conjunction with all of the others—compulsory insolvency insurance. Primarily, this is used in countries allowing the book reserves method to cover the reserves of companies that fail. To this end, Germany set up a Pension Guaranty Association (PSV) in 1974, modelled on the earlier Swedish system. It is interesting to know that the German system currently charges premiums equal to 0.08 per cent of the amounts covered.

Apart from book reserves, other countries have also introduced mechanisms to cover failures. In the United States, the PBGC currently charges a premium of $19 per participant and between 1975 and 1991 covered 1 659 failures for $8.3 billion, leaving a loss, net of contributions, of $4.3 billion. Bankruptcy cover is also provided for the compulsory supplementary plan in Switzerland (BVG) and has recently been introduced in the United Kingdom by the Pension Act of 1995.

Section 2. Prudential standards and asset liability management

95. Prudential standards relating to liabilities

The liabilities of any company have two main components: own funds (equity) and third party funds. In a commercial company, equity is provided by the shareholders, whether as an initial contribution or in the form of profits that they agree should be retained as reserves. In a non-commercial company, these can only be free reserves constituted initially from margins on previous business. In fact, it would be more accurate to speak of “free funds” rather than “own funds” in this respect.

For insurance companies, these free funds/own funds constitute the solvency margin needed to guarantee commitments, if obligations of results have been contracted. The European Union has established very strict rules for insurance companies with the aim of ensuring that the minimum amount of such free funds/own funds is proportional to commitments. The United States and other OECD countries have taken a similar approach under the acronym RBC (risk-based capital), the necessary margin of course increasing in proportion to commitments.

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Under European insurance regulations, the solvency margin may also include non-book items such as overstated liabilities, understated assets or, for life assurance undertakings, an amount equal to 50% at most of future profits. The latter is based on the average profits for the last five years and the average term to maturity of policies (maximum 10 years; life insurance directive, CEA coordination, Article 28).

An explicit solvency margin requirement for uninsured pension funds is not common at the present time. In Belgium, however, such a margin is required if the fund provides death or invalidity insurance or if it contracts obligations of result with regard to pensions (in this case it amounts to 4% of mathematical provisions, as for insurance companies, and it would be logical for this margin to include 50% of future “profit” margins, as for insurance companies).

In supplementary pension organisations, however, technical provisions (still often called mathematical reserves) are easily the largest liability item. On this point, and as regards supplementary pensions, it is important to distinguish between DB and DC systems. For DC systems, the provision corresponds simply to the capitalisation of paid-in contributions minus any coverage of risks stipulated in pension regulations. Contributions are capitalised at the technical rate provided for in the tariff when there is an interest rate guarantee or on the basis of the real return on assets when policies are unit-linked. In the case of defined contribution schemes, the liabilities are therefore always clearly defined.

Defining the commitments of defined benefit schemes is more problematical, leading to a tightening of the regulations that govern them in order to protect their members or the shareholders of the companies instituting them. Long-term trends are influenced by a large number of economic and financial parameters. The rate of interest on invested reserves is no longer the sole consideration; variations in wage rates, inflation, economic growth and employment also need to be taken into account.

In this case, technical provisions generally correspond at least to pension entitlements already taken up and to the acquired rights of currently active members on the basis of their length of employment and current salary, referred to by the acronym ABO (accumulated benefit obligation). Belgian rules, for example, refer to provisions for “existing benefit entitlement”.

For DB schemes, however, employers generally prefer to pay higher contributions than those that fund the ABO, since without this precaution their contributions would normally be expected to increase over time.

Numerous actuarial methods exist for anticipating the future increase in the charges on a DB scheme, leading to the constitution of reserves for “future benefit entitlement”, i.e., a fund for financing the future increase in payable benefits and hence the contributions needed to fund them.

A distinction can thus be drawn between two elements of the provisions of a DB scheme: a provision for “existing benefit entitlement”, which in a sense represents the short-term liabilities of the scheme, and a provision for “future benefit entitlement”, which on the current balance sheet represents a surplus in relation to current commitments. This second element of the provision constitutes the “free funds” of the pension system.

In a nutshell, then, the liabilities of private pension funds should include a portion of own funds (in the case of insurance undertakings) or free funds (in the case of uninsured funds). They make it possible to guarantee the solvency of the system; they should be proportional to the obligations of results contracted by the system and could be negligible if the only obligation is that of best efforts. There is no obvious reason why these margins should be calculated differently according to whether the fund is insured or not.

The other element of liabilities consists of technical provisions or mathematical reserves. Here too, uniform rules should apply to calculating the basic provision, the ABO.

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These remarks do not in any way apply to pension schemes financed from cash flow, where no provisions are constituted. In the EU, Article 8 of the Directive of 20 October 1980 on the protection of workers in the event of employer insolvency covers supplementary pensions amongst other things. It provides that Member States should take steps to protect workers’ pension rights in the event of their employer’s bankruptcy. This risk of bankruptcy, self-evident for schemes financed from cash flow, also applies to supplementary pension schemes funded by provisions booked to liabilities. In Germany, where this situation is very common, an employer insolvency insurance pool (PSV) has been created. Point 101 of the Luxembourg government bill on the subject is reported to provide for a similar measure, doubtless by drawing on the German pool, which is reported to have given its agreement in principle.

Broadly speaking, however, making payments from cash flow has long ceased to be a method for systematically funding supplementary pensions. In principle, international accounting standards require companies to state on their balance sheet, or at least in the notes to the accounts, any pension liabilities not assumed by an entity external to the company.

American standards (FAS87) are the most specific in this respect, since they aim to standardise actuarial methods for estimating companies’ pension commitments. These standards are gaining increasing international recognition, especially in mergers and acquisitions.

If a company fails to constitute adequate provisions, and even more so if it makes no provision whatsoever, its real value is overestimated by the same amount. Its balance sheet therefore needs to be adjusted according to its supplementary pension deficit. This is the case even if there is solvency insurance which covers only the employer’s insolvency and not a deficit of previous contributions that any future acquirer of the firm would have to assume.

All this shows the importance of ensuring that the liabilities of private pension funds are properly covered.

96. Prudential standards relating to assets

Pension fund assets consist of investments which may be classified in ascending order of risk as cash, bonds and equities. There are two main issues concerning assets:

the rules for limiting each type of investment,

the rules for valuing each type of investment.

One approach is to allow pension fund managers considerable freedom of choice. This is the “reasonable care” or “prudent man” principle that underlies the system in the Netherlands, the UK and the USA, i.e., the countries with the largest pension fund systems.

EU insurance directives impose certain quantitative limits on insurance companies’ investments which may be said per se to reflect the “reasonable care” or “prudent man” option:

5% maximum in the shares or debt securities of any single company,

10% maximum in unlisted securities (from technical provisions),

5% maximum in non-guaranteed loans,

3% maximum in purely monetary assets.

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The latter restriction is due to the need to seek a satisfactory return in order to guarantee the insurer’s long-term solvency, indicative of an attitude designed to encourage investments yielding the highest returns in the long term.

Proposed legislation in Belgium recently envisaged raising the limit of 5% in the securities of any single company to 10% in the securities of companies in a single group. This measure, doubtless inspired by the collapse of the Maxwell empire, seems to be pointless for normally constituted financial groups, where the risk of financial contagion between the subsidiaries of a group may generally be regarded as negligible.

Prudential rules concerning asset management generally include other limits as well, especially on investment in equities, real estate and foreign securities. Differences also exist between the rules for non-life and life business (the latter including pensions), since the term of commitments is significantly longer where pensions are concerned than in the case of non-life insurance. Consequently, insurance undertakings with pension commitments will give priority to long-term investments, unlike non-life insurers, who tend to place greater emphasis on the liquidity of their portfolio.

Within the insurance sector as a whole it is doubtless pensions business that has the longest time horizon, thus justifying long-term investments.

In its Green Paper, the European Commission lists the following national limits on pension fund portfolios (pillar 2):

Denmark: maximum 40% in “high risk” assets (equities, unlisted securities);Germany: maximum 30% in EU equities and 6% in non-EU equities; 10% self-investment limit;France: at least 50% in EU government bonds;Sweden: majority in bonds, debentures and loans;Japan: minimum 50% in bonds, maximum 30% in equities, maximum 10% in one company.

The second main problem of asset management is the valuation of investments, and especially of the securities which guarantee the commitments assumed by an insurance undertaking or private pension fund.

The broad rule for equities and real estate investments is to state them at their market value at the balance sheet date. For bonds, especially government bonds and similar instruments, European rules allow Member States to choose between market value and book value, the latter generally being an intermediate value between acquisition and redemption value.

On this point, in practice life insurance undertakings and autonomous pension funds, with the broad exception of British and American institutions, have hitherto preferred fixed yield investments to riskier investments. The proportion of bonds in private pension fund portfolios in 1995 amounted to 75% in Germany, 58% in the Netherlands and 63% in Japan, compared with 34% in the USA and only 11% in the UK (EFRP, 1996).

This divergence may perhaps be attributable to differences in methods for valuing equities and bonds. The option of valuing bonds at book value rather than market value means that balance sheets are cushioned against any great fluctuation on financial markets resulting from a rise in interest rates. Fluctuations are amplified as bond maturities recede, long-term bonds being precisely those with the highest yield.

The possibility of stating bonds at book value rather than market value is thus a second indication of the desire to encourage insurance companies to take a longer-term approach to investment.

However, this approach is justified only insofar as the institution can wait for its bond investments to mature and thus does not under normal circumstances have to sell them on the market before term. This highlights the full importance, to which we shall return, of a close match between when investments

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mature and when commitments to beneficiaries fall due. That is the purpose of asset/liability management (ALM).

This method of valuing bonds is of the utmost importance for undertakings and institutions which offer guaranteed interest rates and profit sharing on life insurance policies and supplementary pensions. As government bonds represent a very substantial proportion of the securities backing these commitments, a hefty rise in interest rates causing a sharp drop in bond prices would place such organisations in severe financial difficulty (less profit for policyholders to share, perhaps even difficulty in covering a higher level of mathematical provisions). The situation is totally paradoxical, since policyholders would normally expect to benefit when interest rates rise.

It is quite common for other rules to apply to uninsured pension funds. In Belgium, for example, bond portfolios must be stated at market value. Such discrimination, which has no economic foundation, should of course be abolished if autonomous pension funds also are to be given an incentive to take a longer-term approach to investment than is the case at present.

97. Investment in risky assets

The 3% limit on money market investments and the possibility of valuing bonds at book value rather than market value are two indications of the desire, especially in Europe, to encourage life insurance companies to take a longer-term approach to investment with a view to obtaining better returns.

Asset allocation is a fundamental problem for pension fund managers. Except in the UK and US, pension funds are often reluctant to invest in risky assets even though the long-term returns on such assets are higher, as we shall see.

The European Commission Green Paper on Supplementary Pensions in the Single Market states the problem very clearly, taking as an example a scheme designed to guarantee a supplementary pension equivalent to 35% of salary. All other things being equal, for a real return (i.e., net of inflation):

of 6%, the cost is 5% of salary,

of 4%, the cost is 10% of salary,

of 2%, the cost is 19% of salary.

An actuary might consider that the difference in cost at different rates of return is rather too high in the case of a private pension fund for which the average term of commitments is probably lower than in the example given. Broadly speaking, it may be supposed that each additional quarter point (0.25%) of real returns on assets reduces the cost of constituting pensions by 5%. For real returns of 6/4/2%, this extra return would produce a cost of 5/7.5/11.4% rather than 5/10/19%. The difference is smaller, but nonetheless confirms that higher rates of return significantly reduce the cost of providing supplementary pensions.

The European Commission quite logically concludes that low rates of return on pension fund and life insurance assets will lead to a loss of competitiveness in the European economy “and therefore have an adverse impact on the EU’s job creation ability”.

This is especially true if there were to be confirmation of a shift from the second pillar to the first with the aim of covering social security deficits, thus increasing the share of supplementary pension contributions in employers’ wage costs.

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It is important therefore to realise that although financial and actuarial theory proves that returns on invested assets rise as their time horizon extends, statistics show that returns on risky investments such as equities are higher still. A great deal of research has been carried out into the long-term returns from various investment strategies, all confirming that the long-term returns on equities are better than the returns on even long-term government bonds.

A study of this subject has been carried out at the actuarial sciences unit of Louvain Catholic University (O. de Tulle de Villefranche, 1988). The mathematical model is based on the systematic investment each year for forty years (the normal savings span in lifecycle theory) of a sum adjusted according to the retail price index. The sum is invested systematically in the same security, bearing interest in the same manner. It is then possible to calculate the 40-year real rate of return net of inflation on all investments made in this way. The model was applied to the 28 40-year periods beginning between 1921 and 1948, the first being 1921-1960 and the last 1948-1987. The chief interest of this research is that it provides a fairly realistic simulation of systematic saving over a working life, spanning very different economic climates during several periods between 1921 and 1987. It has the additional major advantage of not being limited to the recent era (1988-1997), when the benefits of investing in risky assets have become even more apparent.

The study looked at systematic investment in:

(A) Belgian government bonds (gross yield before withholding),

(B) shares in a Belgian insurance company,

(C) shares in a Belgian steel company,

(D) shares in a Belgian oil company,

(E) shares in a Belgian holding company with long-standing colonial and industrial interests.

Table 9 summarises the results. It shows that systematic long-term investment in risky assets, provided they are well-chosen and diversified, gives a substantially higher real return net of inflation than investment in fixed-yield securities. It also shows the “set-off buying” effect, whereby an investor taking a systematic approach to buying variable-yield securities will buy fewer when the price rises and more when the price falls, thus smoothing out financial fluctuations or historical accidents over a sufficiently lengthy period.

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Table 9 Real interest rate net of retail price inflation on regular investments according to various investment strategies in Belgian securities over 40-year periods (%)

Period (A) (B) (C) (D) (E) (F) (F) - (A)

1921-1960 - 1.07 7.94 2.06 Na 2.29 na na

1922-1961 - 0.74 7.80 2.09 4.24 2.73 4.92 5.68

1923-1962 - 0.07 8.00 1.03 4.93 2.73 5.22 5.29

1924-1963 0.21 8.64 0.87 5.87 3.33 5.95 5.74

1925-1964 0.20 7.98 0.00 6.33 3.10 5.80 5.60

1926-1965 0.50 7.55 -1.07 5.70 2.99 5.41 4.91

1927-1966 0.50 5.81 -5.27 4.66 1.49 3.99 3.49

1928-1967 0.67 5.78 -5.11 6.31 2.12 4.74 4.07

1929-1968 0.77 5.26 -5.05 6.75 2.12 4.71 3.94

1930-1969 0.70 7.86 - 0.78 6.13 2.18 5.39 4.69

1931-1970 0.87 4.32 - 0.95 7.54 2.47 4.78 3.91

1932-1971 1.09 4.93 - 2.15 8.13 2.29 5.12 4.03

1933-1972 1.00 5.40 - 1.74 9.44 2.48 5.77 4.77

1934-1973 1.03 5.66 - 2.53 9.97 2.34 5.99 4.96

1935-1974 0.65 4.39 - 3.36 6.58 1.30 4.09 3.44

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Table 9 Real interest rate net of retail price inflation on regular investments according to various investment strategies in Belgian securities over 40-year periods (%) (continued)

Period (A) (B) (C) (D) (E) (F) (F) - (A)

1936-1975 0.62 4.09 - 3.66 7.81 1.42 4.44 3.82

1937-1976 0.55 3.17 - 7.29 7.18 0.31 3.55 3.00

1938-1977 0.74 3.45 - 12.37 6.26 - 0.51 3.07 2.33

1939-1978 0.96 3.54 - 9.64 5.62 0.13 3.10 2.04

1940-1979 0.98 3.36 - 12.79 7.50 - 1.02 3.28 2.30

1941-1980 0.82 2.11 - 23.25 6.72 - 2.76 2.02 1.20

1942-1981 1.16 1.31 - 22.01 6.36 - 3.32 1.45 0.19

1943-1982 1.32 2.26 - 27.67 6.29 - 1.97 2.19 0.87

1944-1983 1.70 3.30 - 13.69 7.30 - 0.42 3.39 1.69

1945-1984 1.94 4.04 - 8.92 7.97 0.05 4.02 2.08

1946-1985 2.40 5.90 - 11.00 7.64 1.09 4.88 2.48

1947-1986 2.86 8.51 - 13.64 8.90 2.78 6.73 3.87

1948-1987 3.06 8.82 - 14.10 7.98 4.09 6.96 3.90

Average 0.91 5.40 - 7.25 6.89 1.28 4.52 3.61

Variance 0.90 2.22 7.93 1.37 1.89

With the exception of strategy (C), which would have involved continuing to invest systematically and solely in securities which have not paid any dividends since about 1960, the real return in Belgium on systematic investments over 40 years amounted to approximately:

1% (3% at period end) for government bonds,

5% (8% at period end) for equities.

A withholding tax has been applied to investment income since 1962. The interest rates in Table 2 are given net of this tax except for column (A), which shows gross rates. In net terms, the average for (A) would be 0.46% instead of 0.91% and the return over the last period 1948-1987 would be only 1.82% rather than 3.06%, thus giving risky assets an even greater edge.

For information, a column (F) has been added to Table 9, representing a combination of one third of the strategies (B), (D) and (E), which may be regarded as a relatively realistic diversification. The last column of Table 9 gives the difference (F) - (A) and shows that:

17. the real rate of return net of inflation has never been negative in strategy (F),

18. the rate has consistently been substantially higher than the real return of strategy (A), the difference between (F) and (A) being smallest for the period 1942-1981. It should be borne in mind that share prices reached a record low in 1981, causing the Belgian government to intervene to boost equity markets. Even then, however, strategy (F) was still preferable to strategy (A).

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This demonstrates that the differences in real rates of return mentioned in the Green Paper (the 6/4/2% scale) are far from unrealistic.

For private pension funds, the strategy of investing a substantial proportion of their assets in variable-yield securities is therefore one that merits serious consideration.

98. Loss of equilibrium

However, there is a major obstacle to investing a substantial proportion of pension fund assets in this way, unless the plan is a defined contributions scheme with no obligation of result in terms of a guaranteed return.

One essential feature of this investment strategy is that the yield on such securities varies as financial markets fluctuate. It would appear difficult, if not impossible, to devise a valuation method for equities similar to the method used in many countries for government bonds. Equities, unlike government bonds, have neither a maturity nor a final redemption value.

It therefore seems inevitable that they should be stated on balance sheets at their market value, thus giving an asset value that is bound to fluctuate. But in a defined benefits plan or defined contribution plan with obligation of result, liabilities are determined on the basis of an actuarial calculation which is in principle independent of the real return on the fund’s assets at any given time.

When assets fall below liabilities there is a loss of equilibrium which the fund can compensate in various ways. It can draw on its solvency margin, own funds or free funds or turn to the employer constituting the fund or to a reinsurance undertaking, although financial reinsurance can cause problems if certain precautions are not taken.

It is immediately apparent that such a face-off between fixed liabilities and assets which, being substantially invested in risky assets, can fluctuate considerably presents a major obstacle to this type of investment strategy and hence to higher returns in guaranteed rate DB or DC pension funds. This is doubtless another reason for accelerating the existing shift (see items 82 and 83) from DB schemes to DC schemes, especially when they are unit linked.

Arguably, the practice also constitutes an obstacle to the creation of new DB schemes, in new companies, for example. Compared with the pension funds of older companies which have been able to accumulate substantial free funds, those of new companies are unable to invest in equities to the same extent. Many British and American firms are currently taking a contribution holiday; in other words, the past financial performance of their pension funds has been good enough to allow them not to pay contributions, at least for a time. This can give rise to distortions of competition between old and new companies which could also stifle job creation by new companies whose supplementary pension costs would be higher if a more flexible approach to asset valuation was not possible.

A more coherent method of ensuring financial equilibrium would be to supplement the “book” balance sheet of a DB scheme with an “actuarial” balance sheet that included the discounted value of future income and expenses as well as current assets and liabilities.

The method is widely used by British actuaries and this type of balance sheet is shown in Table 10. It must be based on credible actuarial assumptions relating to interest rates, inflation, wages growth, mortality rates for workers and pensioners, workforce mobility and staff turnover.

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Table 10 Actuarial Balance Sheet

Assets Liabilities

A1 investments in fixed-yield securities L1 restated mathematical provisions

A2 investments in variable-yield securities

L2 provision for rights of current workers

A3 current value of future contributions for current workers

L3 current value of future rights of current workers

A4 current value of future contributions for future workers

L4 current value of future rights of future workers

A5 free funds if any (surplus) L5 deficit if anyIf A4 = L4 = 0 there is a closed loop, which is often the case for prudential reasons. With this balance sheet it is possible to determine the minimum contribution rate needed to achieve ultimate equilibrium. It is the contribution for which, in a closed loop:

A1 + A2 + A3 + A5 = L1 + L2 + L3 + L5

In an open loop, A4 and L4 are added to either side of the equation. As a rule, in fact, the real contribution rate is higher than the result of this equation, making it possible to constitute and increase the surplus A 5 or to eliminate the deficit L5.

In this dynamic approach, equilibrium is lost when projected total assets are less than projected total liabilities, generating a deficit L5 which has to be made good by raising contribution rates.

It is not without interest to note that for items A1 and A2, assets are valued at either market value, which seems to be the most prudent method, or on the basis of an actuarial valuation, the mathematical value, which discounts the future financial flows generated by these investments (interest, dividends and redemption on maturity). The same interest rate is applied as for contributions and benefits.

While still imposing an increase in contributions if the value of A1 + A2 falls and the free funds A5 are insufficient to cover the shortfall, the actuarial balance sheet method makes it possible to smooth out fluctuations on financial markets over time and hence to invest a larger proportion of assets in variable-yield securities while guaranteeing the scheme’s long-term equilibrium.

99. Asset/liability management

This approach clearly raises other problems relating to when liabilities become due and the possible realisation of the securities in which the fund’s assets are invested.

In the usual approach (see item 95), current liabilities (L1 and L2 in the actuarial balance sheet) are covered by the sum of A1 stated at book value and A2 stated at market value. Leaving aside the difference between the market value and book value of A1, this approach means that there is always a short-term book equilibrium between a fund’s assets and liabilities, as though the liabilities could become due immediately.

This can no longer be the case, however, if the projected actuarial balance sheet approach is used. It is of the utmost importance to ensure that benefits becoming due at a given date are indeed covered by the rhythm of contribution payments forecast in the actuarial balance sheet and by the possibility of realising assets. This is the ALM approach to any form of financial management. In this case, it ought to make it possible to determine the allocation of assets between bonds and equities, long-term and short-term

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securities, in such a way that, if asset values fall, commitments (benefits to be paid, forecast benefits) can be covered until the value of longer-term investments (risky securities) recovers.

This is one financial problem but there is another, that of the coverage of acquired rights if workers move to another employer or if the supplementary pension scheme is terminated. When a new pension fund is created, it is generally accepted in a DB scheme that pension rights acquired in periods of employment prior to the creation of the scheme are recognised. The same principle applies when an existing scheme is improved.

Prior periods of employment are generally covered by contributions paid over time. As a result, the acquired rights of current workers, based on length of employment and current salary (the notion of ABO, see sub-section X), may not yet be covered by current assets. British and American actuaries have therefore developed the notion of control funding, applied to L2.

In this system, available assets are divided as a priority between pensioners and the oldest workers, giving the latter 100% of their ABO up to a certain age limit. Workers below the age limit are not covered by any reserve, except possibly one deriving from their personal contributions.

This method can be further improved by allocating available reserves and contributions to the gradual funding of commitments, giving 100% of the necessary amounts upon retirement and a shrinking percentage at lower ages, such as 97% at 64, 94% at 63, 85% at 60, etc. The percentage is calculated in such a way that all available assets and contributions can be allocated.

The idea behind this method may be summarised as “letting time take its course”; in other words, the younger a member of a scheme, the more likely it is that reserves will recover if assets in category A 2

should lose value.

In conclusion, it may be said that:

19. investments in variable-yield securities give substantially higher returns than investments in fixed-yield securities (Table 8);

20. a 3 - 4% difference in real returns leads to substantial differences in employers’ charges, by a factor of 1 to 3;

21. the risks inherent in this type of investment may be limited in the long term provided that portfolios are sufficiently diversified;

22. pension schemes applying the prudential rules that concern them to the long term must take these approaches into consideration;

23. using ALM methods, it should be possible to avoid short-term accidents; actuarial methods such as the actuarial balance sheet and control funding should make it possible to manage schemes properly;

24. the long-term nature of commitments requires a “going concern” approach to portfolio management rather than an “immediate liquidation” approach.

Section 3. Considerations with regard to basic prudential principles

100. The most recent developments show a convergence between insured pension funds and self-administered ones, although differences—sometimes considerable—do subsist in certain countries. The

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question must therefore be asked whether it is logical for prudential rules to hinge on the method of financing or whether, on the contrary, they should be based exclusively on the legal and financial structure of the commitments involved.

In cases involving a performance obligation, we deem it logical that the managing entity be endowed with equity capital from which it could offset any losses in respect of its commitments; such is the purpose of the solvency margins prescribed in European legislation. This implies, inter alia, that for defined-contribution schemes there are two possible solutions:

application of a tariff with a guaranteed technical rate of interest, which entails a performance commitment. In this case, there must be an adequate solvency margin, and we feel that the most appropriate legal structure is incorporation as an insurance company or a mutual insurance association—since a non-profit organisation does not normally possess any equity capital—unless the initiating employer provides the necessary guarantee, backed up by a bank or insolvency insurance.

application of a tariff but with no guaranteed technical rate of interest, all contributions and benefits being linked to the value of a unit of account representative of the performance of fund assets (or any other comparable actuarial technique). In this case, there would be nothing to preclude incorporation as a non-profit organisation as well as an insurance company or a mutual insurance association, since the proposed guarantee is extremely limited—covering no more than mortality differentials or variance in respect of management overheads.

If a system involves defined benefits, however, we feel it necessary to make the following distinction:

If the technique used is that of individual capitalisation with a performance obligation, the situation is the same as described above for a defined-contribution scheme having the same obligation: there must be a solvency margin, meaning that the managing entity should be an insurance company or a mutual insurance association, or that the employer setting up the fund should provide a performance guarantee.

If the technique used is that of collective capitalisation, which can only be applied to employer contributions, there is normally only a best-effort obligation, no solvency margin need be required, and prudential rules must focus primarily on asset-liability management (ALM), i.e. a correlation should be established between existing assets and the necessary mathematical provisions. With regard to these provisions, a legitimate question is whether minimum provisions or individual rights calculated on the basis of actual years of service and current (in some countries, projected) earnings are really reasonable and whether the concept of aggregate equilibrium between reserves plus future contributions and total commitments should not be given top priority.

Should not a pension fund by definition be considered a going concern? Is the immediate termination assumption a realistic one, and does it not constitute a major obstacle to the practice of ALM—which is the truly prudential standard? Pension fund commitments being essentially long-term, it follows that fund investments should themselves be in long-term assets, such as equities. Moreover, all financial studies show that long-term investments, in equities in particular, deliver significantly higher returns than can be expected from shorter-term bonds. Furthermore, such an investment strategy would also seem preferable for society as a whole, the long-term investment of reserves being conducive to corporate expansion and thus to economic growth.

The problem with this sort of financial strategy, however, is that long-term investment involves risks arising from fluctuations in financial markets, which can experience periods of depression even if it still holds true that, over the long term, equity investments yield higher returns, provided that shares are chosen judiciously. Moreover, the opposite assumption—that of an irreversible decline in the value of a portfolio

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of nationally and internationally diversified equities—does not warrant consideration, insofar as it would imply an economic situation so catastrophic that no pension fund would survive, be it public or private—and, in the latter case, irrespective of the strategy for investing reserves.

The result of all this is that to maximise long-term return on investment, pension funds must make the bulk of their investments (as they do in the English-speaking countries [26]) in equities, which carries the risk of short-term fluctuations in market value. Prudential rules ill-adapted to this sort of situation can diminish yields to the detriment of pension funds and the employers who create them, and thus to current and future beneficiaries—not to mention the economy as a whole.

Three possible (and combinable) approaches to resolving this paradox can be outlined as follows:

1) Assets can be valued on a basis other than book or market value. It is common practice in the United Kingdom, for example, to value each pension fund asset in terms of the present value of the financial flows it is going to generate—interest and redemption of principal for bonds, dividends for equities, discounted at the interest rate used to calculate the fund’s long-term equilibrium. This method cushions the impact of market fluctuations.

2) Future contributions should be based on long-term equilibrium, as under the aggregate cost method (AGCM), which allows temporary shortfalls to be made up over a limited period of time instead of having to be covered immediately. This amounts in effect to the adoption of a going-concern assumption, rather than basing prudential rules almost exclusively on the situation that would exist if operations were to be terminated immediately.

3) These provisions could be supplemented by compulsory insolvency insurance to cover pension funds using the above methods against employer failure, while at the same time imposing the use of actuarial techniques and assumptions approved by the insolvency insurer.

Section 4. Convergence or Divergence

101. Concluding remarks

The constitution of pensions should be seen as based on two different but complementary principles:

solidarity (pillar 1), whereby each generation through its contributions agrees to meet the minimum social needs of previous generations in the expectation that subsequent generations will do the same, using the pay-as-you-go method;

precautionary saving, which may be collective (pillar 2) or individual (pillar 3), whereby each generation constitutes its own supplementary pensions, using funded schemes.

We have sought in this chapter to highlight the constraints and tensions that exist between these pillars of the pension system. Where the second and third pillars are concerned, the basic priority is to optimise returns. Consequently, leaving aside the first pillar, the widest possible market for the second and third pillars is a desirable objective. This means that financial institutions, banks and insurance companies must be able to compete fairly with each other on the market. Fair competition on free but regulated markets will make it possible to achieve the highest possible returns on contributions or premiums.

Moreover, everything suggests that adequate but reasonable prudential standards should be imposed across the board. The constitution of “niches”, with distortions of competition due to technical, social or tax factors leading to “situation rents”, could mask underachievement in terms of purely financial returns, leading to a possibly significant reduction in the overall efficiency of the system.

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To put it another way, if contributions or premiums cost only 80% in one scheme compared with 100% in another, the first scheme will remain competitive even at a lower rate of return. It is entirely reasonable to wonder whether such a situation is coherent.

All this goes to show that regulations and prudential standards should lead to the elimination of all distortions of competition except for restrictions relating to the legal status of financing supports.

The European Commission Green Paper (point 44) takes note of the CEA’s argument that equivalent prudential rules should be applied to pension funds, whether they are managed by an insurer or not, considering that there are four options applicable equally to the second and third pillar:

(1) making autonomous funds subject to the rules applied to group life schemes,

(2) adapting current solvency margin rules for group life schemes to “the framework currently applied to pillar 2” (doubtless meaning autonomous pension funds),

(3) defining new common EU standards applicable to all,

(4) accepting the differences that currently exist.

It is a valid question in the light of earlier comments, option 3 seeming to be the one that best addresses the issues raised in the present report.

In conclusion, let us note the following remark from the Green Paper (point 40):

“Any restrictions imposed on prudential grounds must be proportional to the objectives they may legitimately pursue”,

which clearly defines the limits on prudential rules if they are not to diminish the economic and financial efficiency of supplementary pension schemes without increasing the degree of social or legal protection they afford.

Chapter VI -- Current issues -- Conclusions

Section 1. Review of current issues

102. The mass of documentation we have looked at have enabled us to highlight a number of concerns common to many countries. It is moreover interesting to note that although the structures of pension schemes differ considerably from one country to another, the questions asked are much the same everywhere. Does this point to possible convergence in the fairly near future?

We shall begin by a brief description of these concerns country by country before, as far as possible, attempting a synthesis from which some conclusions can be drawn.

Referring particularly to documents [3] and [7] prepared for the 1994 AIDA Symposium in Sydney and by Swiss Life respectively we have, without going into too much detail, drawn up the following list:

Germany:

fears about financing the 1st pillar have led to progressively increasing the retirement age and contributions

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problems with court decisions on the 1974 Act requiring adjustment of supplementary pensions every three years

potential problems linked to running down of accounting reserves as a result of the ageing process

Australia:

determination to encourage the 2nd pillar to relieve the first

continue with start-up of the SIS legislation on superannuation funds, including non-discrimination M/F and part-time

introduce the possibility of supplementary personal contributions

discourage premature use of pension savings and equalise the tax status of pensions and life annuities obtained by capital transformation

Austria:

discussion regarding the development of the 2nd pillar

consequences of EU entry on 1 January 1995 with non-discrimination rules

discussion of tax discrimination between internal and external financing

Belgium:

creation of a demographic stabilization reserve for the 1st pillar

equal M/F retirement age for the 1st pillar

wide-ranging debate about privatisation

difficult application of the 1995 Act particularly on acquired rights in the 2nd pillar

discussion of tax status of 2nd and 3rd pillars

extension of social or solidarity contributions on the 2nd pillar

Canada:

at federal level gradual introduction of tax equality between the various types of RPP (pension plans), RRSP (retirement saving) and DPSP (deferred profit sharing)

in some provinces studies of the problem of indexing supplementary pensions

also at provincial level introduction of LIF (life income fund) systems of variable flow payment

growing overall complexity

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Korea:

problems of overall co-ordination of the pension sector with other social security, work accident and leaving allowance arrangements

Denmark:

concern regarding future funding of 1st pillar

specific fund-to-fund transfer problems

Spain:

a recent law forbids accounting provisions but the 1987 Act gives far-reaching powers to a review committee dominated by workers, making employers hesitant about development of 2nd pillar

obligation of full individualisation of reserves

United States:

gradual increase of retirement age

continuing moves towards DC plans with an increasing degree of investment choice

debate regarding possibilities of using these plans for various kinds of expenditure prior to retirement

proposal for a Section 404A in the tax code on contributions to plans abroad

Finland:

concerns regarding future funding of the 1st pillar

France:

uncertainty regarding future yield of social security and ARRCO-AGIRC pensions

problem of limiting adjustments

questions as to introduction and role of capitalised pension funds

Greece:

difficulties of reducing the social security deficit

uncertainty as to the potential development of 2nd and 3rd pillars

Ireland:

possible trend towards an obligatory minimum 2nd pillar

increasing complexity of legislation (e.g. 1990 Pension Act) encourages the move from DB to DC

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Italy:

funding of 1st pillar raises insoluble problems. There is talk of a third reform in a few years’ time

the present pension fund system is unsatisfactory in fiscal terms

Japan:

gradual increase in retirement age since the social security reform in 1994 (65 years for men born as from 1949 and for women born as from 1954)

Luxembourg:

continuing generous development of the 1st pillar owing to budget surpluses, but concern regarding the longer term

problem of cover in the event of inadequate balance sheet provisions for liabilities

review the tax status of direct insurance

New Zealand:

increase in retirement age from 60 to 65 years in 2001 with a system providing interim income for the most elderly

designation of a pensions’ commissioner

need to encourage the 2nd and 3rd pillars

Netherlands:

funding of the 1st pillar, studies of contributions to be paid by pensioners

new (1995) and very complicated legislation on pension sharing in the event of divorce

problem of possible contracting-out in the case of 2nd pillar sectoral funds (European law?)

DB evolving towards DC plans

Portugal:

a new social security Act has reduced pensions for high salaries

hence the need to develop 2nd and 3rd pillars

Sweden:

increase in the retirement age

impact of the budget deficit on social security

Switzerland:

problem of financing the 1st pillar

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discussion of taxes, particularly cantonal ones, to be applied to pensions and 2nd pillar capital to offset tax reductions due to compulsory contributions being taxed deductible since 1985 (BVG)

United Kingdom:

application of the 1990 Act providing for obligatory indexing up to a maximum of 5 per cent for deferred and immediate pensions

non-discrimination M/F and part-time

tightening of prudential measures following the Maxwell scandal and the report of the Goode Committee.

Section 2. Synthesis of main trends

103. Having regard to the above and to what was said in Chapter II a number of main trends can be identified:

1) Firstly, there is widespread apprehension regarding the ability of primary and supplementary pay-as-you-go schemes to meet commitments. This leads to the idea of promoting the creation of capital reserves gradually to offset the progressive fall in yields from pay-as-you-go schemes.

The constitution of substantial reserves (investment in goverment securities) for the 1st pillar has been accomplished in the United States and Japan while in Belgium priority is apparently being given to faster reimbursement of the enormous accumulated public debt, nearly 130 per cent of GDP, with the long-term interest saving offsetting the pensions deficit. Note that in both cases these methods do not relieve the burden on the next generation since pensions are to be at least partially financed by real or notional interest on taxes paid by that generation, rather than any immediate increase in social contributions.

Moreover in nearly all the countries concerned, including the United States and Japan, development of the 2nd and 3rd pillars tends to be seen as the best way of building up the reserves needed for the future in a way that will promote future economic growth. With their wide experience in this field, the financial and insurance sectors have a crucial role to play here.

2) A general tendency is also seen gradually to increase the retirement age and make it the same for both men and women. The continuing increase in longevity (at age 65 it is currently increasing by nearly one year every eight years) makes this indispensable. But in turn it is likely to require measures to at least partially maintain the oldest workers in the labour market or to provide transitional income as in New Zealand or elsewhere in the form of pre-pensions.

It is probable that the idea of a period combining part-time work and partial and progressive pension payment (what the Geneva Association calls the 4th pillar of pension funding) would make it possible to raise the normal retirement age and facilitate future financing of benefits promised (see item 28 in fine and item 75). Numerous studies seem to be under way on this subject in various countries.

3) Legislation applicable to social security pensions and private pension funds has continued to increase in recent years, particularly in the 1990s, in view of the fact that major reforms have recently been undertaken in practically all countries. It is also seen that introduction of these

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reforms has generally encountered enormous difficulties often due to the absence of any overall view of the problems: social, technical, fiscal and accounting considerations do not always go well together.

4) A new interest is noted in most of the countries studied in complementary pension plans with defined contributions, notably owing to the growing weight of the above-mentioned regulations, primarily targeted at systems where employers have committed themselves to specific, albeit limited results, i.e. defined benefit schemes.

This trend will also be reinforced by changes on the labour market, in career profiles and presumably by the idea of a flexible retirement age, e.g. by arrangements for gradual retirement.

5) The complexity of tax legislation has moreover continued to increase in many countries and choices to be made by enterprises and taxpayers become increasingly more complicated. However, a certain tendency is noted towards unification and simplification, but protection of prior acquired rights no doubt explains why considerable complexity remains.

6) A trend is emerging to offset the negative impact of the 2nd pillar on tax revenue by the introduction of deductions from retirement benefits, as is to be studied in Switzerland. The same is true of the extension or introduction of social contributions on retirement benefits under consideration for the 1st pillar in the Netherlands, or effective for the 2nd pillar in Belgium.

7) A certain tendency is also to be seen towards convergence of regulations applicable to private pension funds whether or not they involve resort to the insurance sector. Increasingly often insurers are proposing collective retirement fund arrangements (item 20) with collective capitalisation, e.g. in the form of DA Deposit Administration, for schemes with defined benefits, arrangements very close to autonomous funds.

In schemes with defined contributions more and more insured plans are to be found in unit-linked form, with an obligation to achieve results being replaced by an obligation to provide resources and so facilitating adoption of this kind of insurance.

8) Where capital payments are possible there is at present a trend on the part of the authorities to prevent savings being used before retirement (Australia and United States) and to encourage (or at least not to discourage, e.g. by tax measures) the payment of the pension (Australia). In France a determination can be seen to confine the possibility of receiving a capital sum on retirement to the 3rd pillar only.

Section 3. By way of conclusion.

104. This report has provided some evidence on the wide range of solutions adopted for the financing of retirement in the various countries investigated. When starting to draft the report we were at first convinced that it was vital to look first at the structure and specific features of the 1st pillar since the links between that pillar and the other two always seemed to us obvious. It is moreover interesting to note in passing that the 3-pillar philosophy is of practically universal application, to such an extent that none of the countries studied depends solely on benefits under a pay-as-you-go social security scheme or on a pure funded scheme either at enterprise level or for people on an individual basis. Some degree of solidarity through a basic scheme is to be found in all countries. In this respect it will be interesting in time to consider the results of the Chilean experiment where, after a transition period, pensions are to be financed through capital funding alone.

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To be relatively concrete, we did not hesitate to use quantitative data in our studies, notably to try and see where the limits to solidarity lay in each country, i.e. the line separating the 1st pillar from the two others, the B1/AE ratio. On this basis we tried to estimate the consequences for the respective development of the three pillars, particularly the second, private pension funds. We are perfectly well aware that the imperfections and gaps in the available statistics make the production of hard and fast figures a risky business. But we nevertheless believe we have identified general trends that are not devoid of interest as to the respective roles of the three pillars in general, and of that to be played by the private sector, whether financial or insurance.

The period that followed the Second World War was marked by economic and demographic growth on a scale that humanity had undoubtedly never known before. In such conditions, those of the Samuelson paradox, the financing of retirement on a pay-as-you-go basis seemed self-evident and led governments in many countries to develop 1st pillar benefits beyond what was probably reasonable. For nearly 20 years economic growth has returned to a level closer to historical reality since the first industrial revolution, and the demographic trend has gone into reverse nearly everywhere in the developed countries.

This being so, we are going to evaluate to what extent pay-as-you-go funding, i.e. based on solidarity, is feasible and beyond that point develop the 2nd pillar, private pension funds, and the 3rd pillar, individual savings. In these conditions, it is highly desirable that the laws of the market economy function as well as possible and that the various potential pension providers, whether in the financial or insurance sector, can obtain adequate net yields from the funds invested.

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Note No. 1

The meaning of the parameter B1

105. We felt it was important to focus on a parameter that could be used, insofar as it was possible to do so, to delineate the area in which pay-as-you-go, i.e. solidarity, would prevail over capitalisation. This is tantamount to situating the border between the first pillar of retirement benefits and the other two.

As explained in Item 32, this is a simple matter when the basic scheme is wage-related and provides for a pension equal to a uniform percentage of salary, up to a certain ceiling. Inasmuch as pensions of this type are always financed on a pay-as-you-go basis, this limit, designated B 1, is in fact equal to this earnings ceiling.

For basic schemes that are also wage-related up to a certain ceiling but pay out a decreasing percentage of salary, we proposed that B1 be taken to equal the level of earnings at which the basic scheme pension is equal to exactly 50 per cent of those earnings. A replacement rate of 50 per cent of pay can be generally acknowledged as a minimal objective for a basic pension.

For this same reason, we proposed, in respect of countries in the study that apply a flat-rate system, that B1

be taken to equal the level of earnings at which the basic State pension provides replacement income of 50 per cent.

Lastly, for countries that have instituted mandatory supplementary schemes, and only if those schemes are financed on a pay-as-you-go basis, we also applied the same principles as above, based on the schemes’ respective benefits and ceilings.

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Note No. 2

Use of regression lines

106. A large number of parameters affect the aggregates featured in the study—the level of capitalisation, net household savings, the development of life insurance, etc. We nonetheless deem it useful, whenever possible, to try to show the influence that some of these parameters could have on others. Such demonstrations are well known to statisticians as “regression analysis”.

This is the technique that we applied to Figures 1 to 5, well aware that the wide variety of situations prevailing in the various countries rendered this sort of analysis problematic, and the standard errors and correlation coefficients cited in the body of the report would suggest that this is indeed the case. It can be noted, however, that the graphs’ overall aspect can be suitably conveyed by the x-coefficients of the regression lines, i.e. the coefficients of the independent variable. What is significant in our study is not the values of the coefficients but the slopes of the regression lines—either upward, indicating positive correlation, or downward, indicating negative correlation.

Moreover, it can be noted with regard to this last point that the fact of having excluded certain countries from the regression analysis in no way diminishes its significance, since the positions of these points on the graphs generally follow the same direction as the limited regression.

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