INSIDER

Life’s lessons can be applied to pension reform

The UK’s London Pension Fund Authority issued a green paper this week outlining the key ingredients needed to build a better scheme and its successful implementation by 2015. In all corners of the world building a better pension scheme is on the agenda. What then are some of the universal principles for success that all funds can adopt regardless of geography?

In the Netherlands, Australia, the UK, the US and Asia, pension scheme structure is front and centre of political and individual scheme agendas.

In the UK, the Local Government Pension Scheme is having its own separate discussion regarding employee contributions, having been excused from the Lord Hutton recommendations of a 3 per cent employee contribution increase, because of its funded nature.

One of the attributes of the paper is its intention to try and stimulate debate – rather than act as a blueprint – on the key ingredients of a new local government scheme and the practicalities necessary for its implementation.

The problem with a lot of reform, of course, is there are legacy issues, and across the globe most of the go-to models for pension governance and sustainability have been built from the ground up. Ontario Teachers, NZ Super and NEST are just a few examples.

Regardless – as there is no escaping heritage – there are a number of ideas that can be adopted by funds when fundamental change is afoot.

Apparently changing jobs, getting married, getting divorced, pregnancy, and moving house rank as among the most stressful activities you can do in your life (I’ve got them all ticked off, so I’m armed to pontificate!)

It seems there is some commonality in relieving the stress in these situations that can also be applied to other large-scale projects, such as developing a best-practice pension scheme.

Firstly, with any instrumental change spend a lot of time making the decision.

The pension schemes that are global best practice have all spent a great deal of time, as long as it takes actually, agreeing to a definable set of beliefs that can also be translated into practice.

For instance, NZ Super outlines not only its fund values, investment beliefs, and responsible investment framework but also has a vision statement for its aspiring culture. This is all about team work.

While a deadline is a fact of life, give the process enough time to be considered and inclusive.

Similarly, conduct exhaustive consultation. (Find me a woman who hasn’t consulted her entire network, or at the least her close circle of friends, before changing jobs, getting married, getting divorced, moving house, and even deciding on whether to have a baby.)

One of the more endearing aspects of this industry is its consultative and collaborative nature. And that should be embraced.

Funds should share their experiences, learn from past mistakes and take and give advice on what works.

At the same time an understanding of individual circumstances is paramount, which means responsibility and accountability are key attributes of successful reform.

Each individual participant in pension reform – from the employer, including government, fiduciary, employees, unions and service providers – need to be made accountable.

Arguably no funds could have more critical legacy issues than the US public pension funds. But even within that community there a couple of lessons to be learned about successful structure. A recent National Institute on Retirement Security (NIRS) paper “Lessons from well-funded public pensions: an analysis of six plans that weathered the financial storm”, identified specific design lessons for other public pension plans.

  1. The most fundamental principle in ensuring a plan achieves a 100 per cent funding ratio is ensuring the plan sponsors pay the entire amount of the annual required contribution rate each year.
  2. If a plan is considering increasing employee contributions, it may consider structuring the employee rate so that any cost volatility is shared between the employees and employers. This can be done by implementing an adjustable employee contribution rate, or having a relatively fixed employee rate that pays for a specific portion of the long-term expected pension cost.
  3. A prudent COLA structure. Ad hoc COLAs can be granted in a sensible and responsible way (for example when the plan is well-funded, amortise it straight away); and automatic COLAs can be provided at a modest level, eg half of CPI.
  4. All the pension plans had measures to prevent pension spiking. Spiking can be minimised in three ways: the final average salary (FAS) that determines the pension benefit cannot include a one-time payment at the time of termination; the growth rate in total salary in the final year or two, cannot exceed a certain percentage; the FAS can be capped.
  5. Economic assumptions – including the overall discount rate, the inflation rate and the real rate of return – are appropriate and achievable over the long term. Four of the six plans examined had a real return expectation close to or well below 4 per cent.