Key risks resulting from eurozone crisis for DC schemes
27 August 2012
The uncertainty around what outcomes the ongoing eurozone crisis might bring means employers and trustees need to take preventative action to protect their pension scheme members’ financial savings, says Mercer. The firm has highlighted four potential risk areas from the eurozone crisis that have direct implications for defined contribution (DC) pension plans, along with some suggested actions that could help scheme sponsors and trustees mitigate these risks.
“There has been much analysis of the current problems in the eurozone and it’s becoming clear that the path to resolution will be bumpy with a series of dangerous episodes,” said Tony Pugh, European head of DC consulting at Mercer. “Outcomes will be contingent on a combination of many factors, such as bank or insurer stability, politics and market responses, and are impossible to forecast with absolute certainty. Risks are likely to be on the downside and market relief short-lived.
“As the period of the crisis extends without a near-term solution in sight, companies are becoming increasingly interested in the potential risk exposure of DC pension funds and what measures they might be able to take to protect their employees’ retirement savings. Each scheme will have different risk exposures so a thorough analysis based on potential outcome scenarios is the best place to start.”
Despite the uncertainty, Mercer has identified a checklist of issues that trustees and scheme sponsors should review. A summary of these is given below:
Investment risk: Continued market volatility could severely impact those schemes with an over-reliance on growth assets such as equities. And after witnessing historically low yields, many government bonds are no longer seen as the safe haven assets they traditionally were. Mr. Pugh said: “Schemes should review their long-term investment strategy on an on-going basis to ensure it is appropriate. Risk mitigating strategies such as increased diversification, for example to non-traditional asset classes, and communicating to members the importance of diversified portfolios, should be considered.”
Annuity pricing risk: Low bond yields have contributed to the steep rise in annuity prices, which in turn will translate into lower incomes in retirement for DC members. In many markets there are significant price differences between providers, so sponsors and trustees should look at how they can help members secure the best possible deal, for example through an open market adviser.
Risk of inadequate benefits: As the crisis shows no signs of abating, sustained low contribution levels combined with poor investment returns, high annuity rates and falling State benefits means that for many employees, benefits will be inadequate upon retirement. This is turn is likely to lead to a higher proportion of employees deferring their retirement – resulting in challenges for employers including higher cost of insured benefits, blocking of promotion opportunities, as well as internal and external reputation damage. Eventually, employees could start placing a higher emphasis on the level of employer contribution to DC plans when choosing which firm to work for.
“Trustees and sponsors should establish defined objectives for their DC plan and analyse what impact having inadequate plans in place might have on their business. To stay competitive it’s also important to do some benchmarking against competitor plans,” said Mr. Pugh. A recent survey by Mercer showed that employer benefits provision is at odds with employees’ needs, particularly around provision of alternative savings options. Mr. Pugh added: “Providing employees with alternative ways of saving might not only better serve employee needs and help with diversification, it could also deliver better value for money.”
Provider risk: As the crisis is particularly impacting financial institutions, it is important that sponsors and trustees consider whether their DC provider is at risk. Increased focus is needed on this risk and what safeguards and compensation plans are in place if a provider were to become insolvent. Unfortunately there is often a lack of clarity and few case studies to demonstrate what would happen in practice should a provider collapse. Nonetheless, trustees and scheme sponsors should be investigating this aspect and giving consideration as to their potential exit plan if their provider is considered at risk.
Mercer has also identified multinational governance as an important area to consider in light of the crisis. Mr. Pugh said: "It is particularly surprising that few multinationals are taking the lead in controlling the risks to employees and employer. Global and regional head quarters can add value by assisting local operations review existing DC arrangements and their inherent risks, as well as offering guidance on better solutions.
“Whilst we are some years into the crisis, with no sign of an early end, employers should act now to protect employees’ DC retirement benefits," Mr. Pugh concluded.
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