In the meantime, negative interest rates have become a phenomenon in real terms. The meltdown in interest rates has considerable consequences for occupational pensions, also in respect of liquidity requirements.
The low interest rate environment, persisting now for many years, has also fuelled an enduring trend to reduce risks in existing pension commitments for employers through appropriate restructuring. New commitments are targeted to the provision of an attractive benefit for employees, whereby both the costs and risks for the employer are to remain manageable. By contrast, legacy commitments often stipulate high interest rate guarantees or generous benefits based on final salary. The pension obligations arising from these commitments can present a major burden for companies today. In addition, the low interest rate environment sheds light on a whole new set of risks, in part also for commitments that were generally assessed as risk-free in the past.
Effects of low interest rate environment on direct pension commitments
Companies with pension commitments funded via provisions have felt the effects of the low interest rate phase on their balance sheets for some time now. Although steady declines in the discount rate have no impact on the amount of pensions to be paid for commitments funded by provisions (i.e., pensions not covered by capital specifically reserved for this purpose), falling interest rates do lead to a continuous rise in pension provisions with a corresponding negative impact on KPIs, annual profit and dividends.
By contrast, liquidity requirements that are higher than originally expected can arise for direct pension commitments for which reinsurance policies have been concluded to cover obligations. The main reason for this is the significant decline in profits arising from reinsurance policies that has been evident since 2000. If the returns on these policies are less than originally forecast, this results in employers having to fill the gaps for the relevant commitments through other means.
Subsidiary liability for indirect schemes
In general, the life insurance sector is currently having to contend with low market interest rates, as many legacy agreements are based on high guaranteed interest rates which can no longer be generated on the capital market. This problem mainly concerns regulated pension funds (Pensionskassen), as these calculated their benefits on a higher interest rate than the official maximum actuarial interest rate in the past. It is therefore no surprise that several Pensionskassen have already had to reduce their benefits and are concerned with restructuring efforts.
As employers are liable for the pension benefits promised through so-called subsidiary liability even if these are not paid directly by the employer where a financing vehicle (for instance Pensionskasse or Unterstützungskasse [support fund]) is the intermediary, employers are required to compensate for any reductions in benefits using additional funds from company assets. In the past, this obligation to assume liabilities was solely of a theoretical nature for insurance-based provision for occupational pensions. Such commitments were routinely classified as quasi risk-free defined contributions for which no recognition of provisions in the balance sheet was required. Many companies have already become painfully aware that this is no longer generally the case today.
Longevity risk is also increasingly becoming a focal point. While various reference tables have long been in use in English-speaking regions, in the past the Heubeck reference tables (currently the Heubeck 2018G reference tables) have almost exclusively been used for the valuation of pension obligations in Germany.
Extensive source material is compiled to derive the Heubeck reference tables to represent the group of beneficiaries of occupational pensions as a whole while providing for as much general application as possible. Depending on the composition of the population of pension beneficiaries, the Heubeck reference tables are not, however, equally suited to all situations. For instance, it is empirically proven that higher incomes (pension benefits) tend to be associated with higher life expectancy. It is therefore possible that the standard Heubeck reference tables underestimate longevity risk for certain groups of beneficiaries. That means that pension benefits would need to be paid over a longer period than expected, which has a corresponding impact on accounting and financing. In this context, sensible instruments could be, for example, cash flow analyses using different assumptions regarding the longevity of pension beneficiaries.
Handling the issues outlined above in practice will depend on the specific situation of each company. Some companies explicitly adhere to direct pension commitment schemes and deploy professional asset-liability management to steer the design of funding depending on the structure of pension obligations, frequently combined with a contractual trust arrangement to relieve the balance sheet. Other companies outsource direct pension commitments to a pension fund (past service) and a support fund (future service) or outsource pension obligations to a company for pensioners. Frequently, it is also considered to close plans or reorganise them in substance or to switch over to an external pension provider. A combination of various measures often proves to be the most suitable solution for particular companies.
The low interest rate phase and its consequences for occupational pension schemes affects companies on the balance sheet and financially. Companies should bear this in mind also when considering future liquidity requirements, focusing particularly on the following questions:
- Which pension commitments exist within the company?
- How are these funded?
- How will pension provisions and the financing instruments allocated to them develop on the balance sheet and financially?
- What is the payment profile for pension benefits in the coming years?
- What are the options to limit an undesirable development?
- In the case of external pension funds such as Pensionskassen or reinsured support funds: what is the financial situation of the pension provider? Are reductions in benefit entitlements or even benefits to be expected? If this is the case, should this be planned prospectively or should courses of action for handling occupational pensions be determined?
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Source: KPMG Corporate Treasury News, Edition 114, September 2021
Authors: Dr. Claudia Veh, Director, Deal Advisory Pensions, KPMG AG; Michael Nagel, Senior Manager, Deal Advisory Pensions, KPMG AG