Addressing Prior Pension Obligations
Pensions and Labor Restructuring
Pensions: Implementation Steps
This section examines the issues and choices that must be addressed in assessing the feasibility of privatization and in resolving the existing pension obligations during implementation.
Pensions essentially involve the commitment by an employer to provide resources intended to be converted to income following the retirement of covered workers. This commitment can be as simple as an obligation to forward a specified portion of a worker's pay to an individual savings account (for example, to a defined-contribution plan or provident fund) or the far more complex responsibility to fund and administer a program that will provide a monthly payment to replace a specified portion of a worker's final salary for the remainder of the worker's life (a defined-benefit plan based on final salary). In many circumstances the cost of these obligations represents the single largest long-term financial obligation of an enterprise. How this obligation is addressed will be a key determinant of the market value of an enterprise and will be critical to its long-term viability. There are several steps involved:
Step one:
The first step in this process is to obtain a comprehensive understanding of all of the potential pension commitments that currently exist. Pensions are an integral aspect of labor negotiations and work force management. Although this is typically a formal process, perceptions and expectations are often as important as formal legal agreements. Care must be taken to be as thorough as possible in obtaining a full picture of the existing pension system.
Pension agreements may be contained in forms ranging from national laws covering all workers, collectively bargained agreements between workers and trade unions, formal plans outlined in legal documents executed by an employer, and informal agreements or acknowledged practices by an employer. Many countries do not have well-developed labor codes or pension regulatory regimes that establish standards for pensions. The extent to which any of these obligations is binding will depend on the laws and traditions applicable to individual circumstances. It is likely that some important practices and expectations will not be well documented.
At a minimum the relevant national laws and documents describing schemes for civil servants, provident funds, or any employer-specific arrangements will have to be obtained and carefully reviewed to assess the extent of an employer's pension obligations. It is generally advisable to consult with officials of government-operated pension schemes, employee representatives, and any staff responsible for an enterprise's human resources or personnel functions to identify any undocumented agreements or practices that are relevant. A thorough familiarization with any regulatory requirements having a specific focus on funding requirements, vesting rules (requirements for the irrevocable right to benefits when certain conditions are met), and procedures for the resolution of benefit disputes is advisable. This process should result in a complete inventory of potential pension obligations.
Step two:
The second and likely far more difficult step will be to develop reliable measures of the scope and cost of existing pension obligations. This step can be divided into two components: (1) the value of pension obligations accrued to date (sometimes called the accumulated liability or the accrued-benefit obligation) and (2) an estimation of the future and magnitude of pension obligations (variously referred to as the periodic costs or projected-benefit obligations, among other terms).
If the pension obligations are solely defined as contribution in nature, valuing the commitments to date may be as simple as determining the value of the various accounts and making judgments about the potential expense of fulfilling the contribution formulas in the future. These expenses usually can be readily expressed as either a fixed amount per period, usually a month or year, or as a percentage of wages.
The most critical aspects of the process for definedcontribution plans usually will be to determine the extent to which contributions to individual accounts have actually been made as promised and to identify the extent to which assets shown in account balances are actually present. This process nearly always will require engaging the services of a reliable financial accountant to conduct a thorough audit of the records of accounts to verify that (a) the accounts have been maintained properly and (b) that the assets are present as required or indicated.
Common problems likely to be encountered are sponsors who delayed forwarding required contributions or who substituted promissory notes or other "paper" obligations (perhaps even "shares" of the enterprise) for cash contributions. This is especially common when enterprises face problems raising working capital or other liquidity issues so that particular attention should be given under these circumstances.
Legislation and plans are the essential starting points for a review of pension agreements.
An additional challenge will be to determine that the value of the assets held in accounts is accurately represented. Investments may be shown at their purchase price or some type of "book value," which may not indicate their current value. In many circumstances the accepted accounting treatment may require these approaches, so particular attention to valuation methods will be needed to obtain an accurate assessment. Considerable future problems can result when the actual value or the "market value" of assets is at odds with the value shown in workers' or a pension fund accounts, even if it is consistent with applicable financial accounting practices that may require assets to be carried at their purchase price until actually sold. It is very important to understand potential differences and obtain a current value in these circumstances where the actual value may be less, especially if there is a possible obligation of the pension sponsor to compensate for any shortfall.
Some countries may have established periodic audit requirements for pension funds. Unless there is an extremely strong system of auditor quality assurance and such an audit has been done very recently, it is generally advisable not to rely on an existing audit for these purposes. Even the most developed systems with strong compliance measures experience significant problems with the timely forwarding of pension contributions and the reliability of their financial statements. When enterprises face cash flow problems or when managers face significant uncertainty about their future employment contracts, pools of assets in pension funds often are among the most vulnerable to fraud, theft, or other manipulation. A recent and independent financial audit is therefore essential in nearly all circumstances.
Another common challenge in evaluating definedcontribution plans is the assessment of severancetype arrangements or other contingent future liabilities. Provisions providing one-time payments on the attainment of a specified age or on the termination of employment may be incorporated into pension plans, contained in national laws, included in individual employment contracts, or simply a matter of tradition and expectations. The latter especially may be an issue among senior managers. The cost of these provisions can be of equal or sometimes greater value than the regular contribution requirements and should be included in any assessment of future expected costs.
"Book" and "market" values of pension plans may be very different.
The process for defined-benefit plans is partly parallel because it also includes a similar need to obtain a reliable accounting and valuation of any funds that have been set aside for pension purposes, thus imposing a similar need to undertake a reliable audit. In addition to this, however, is perhaps the most difficult and challenging aspect of dealing with pension issues–valuing the accumulated and future liabilities.
Almost without exception this requires the services of a professional actuary with experience specific to pension schemes. This is a process with two major elements: (1) obtaining very specific information about the employment history, wages, and demographics of the group of workers covered by the pension plan; and (2) arriving at reasonable assumptions regarding future patterns of employment, investment returns, and the life expectancies of the covered workers. The valuation of definedbenefit liabilities, because they often extend decades into the future, is highly sensitive to the accuracy of the underlying information and assumptions, thus perhaps making the development of these assumptions the most important aspect of the process.
Countries with a long experience of defined-benefit pensions may have standards of practice or legal requirements for many of these factors. However, these are unlikely to exist in developing economies. Standards from other countries, because they are based on specific experience with investment returns and life expectancies among other key factors, generally are not transferable. Often a starting point for these assumptions can be derived from factors used by national pension systems, but in the end an assessment of reasonableness on a case-bycase basis will be needed. In most cases the judgment of a professional actuary will have to be relied on for these determinations. If there is not an established and reliable actuarial profession in a country–which is often the case–the magnitude of the costs and associated future financial risks may make incurring the expense of engaging the services of an established international firm a prudent course of action.
Step three:
In order to fully and accurately assess the current status of pensions, estimates are also needed of the value of supplemental or contingent benefits. These benefits basically are additions to the regular benefits paid at normal retirement age and will typically include severance arrangements, provisions for which allow pensions to be paid at an age prior to the regular retirement age often triggered by labor force reductions, and additional benefits paid to workers in dangerous or difficult occupations. Because they often are not formal obligations until some future event occurs, these kinds of benefits frequently are not included in the accounting for pension obligations. They may, however, be legally enforceable and may represent a substantial portion of the current pension obligations (for example, privilege pensions in Central and Eastern Europe–see box 5.12). Special care must be taken to identify all of these obligations in the initial inventory of pensions and to estimate the future magnitude of their costs. Assigning some probability of these benefits being paid and deriving a measure of the current liability are often major parts of the work of an actuarial evaluation.
In some countries, particularly the transition economies, public sector employees were usually given "pension privileges." These privileges could be enhanced retirement benefits, retirement at an earlier age than private sector workers, or a combination of both. Privileged pensions were widespread in these countries. For example, in Ukraine more than 25 percent of pensioners are younger than the minimum retirement age because they were able to retire early under privileged arrangements.
Privileged pensions are granted for one of two main reasons: to compensate for the lower wages paid to employees and to compensate for the special type of work that the employee does. A typical example of the first category is whitecollar civil servants; the second category would be typified by airline pilots or coal miners. Most transition countries are reforming their pension systems with three typical outcomes for privileged pensions:
Hungary
The government effectively abolished all privileged pensions when the country introduced its new state pension system in 1999, with the compensation being a pension payment to a voluntary scheme. So a PPI investor in Hungary would only have to decide whether it would maintain the level of voluntary contributions that the government was currently paying. Although this is relatively easy, there are other issues. For example, workers who are civil servants can withdraw their benefits from a voluntary plan tax free. Naturally they would be reluctant to give this privilege up, and a prospective employer may have to negotiate the continuation of this arrangement when PPI occurs or possibly have to increase the contribution rate to maintain the after-tax benefit. For both the implementing agency and the PPI investor, however, this is preferable to negotiating the total package with workers and unions.
Russia
The implementing agency and the investor face some complex legislation relating to pension privileges. The situation is complicated by how long the employee was working in the privileged pension position but, generally speaking, employers have to make an additional contribution to compensate for the loss of pension privileges. The amount of contribution is subject to negotiation and the vehicle for the payment is likewise complicated. It is possible to pay contributions in lieu of pension privileges either to the Russian pension plan or into a licensed voluntary pension plan. The law gives the choice of plan to the employer, but a new PPI investor is likely to be under some pressure to establish a voluntary pension plan in order to receive the privileged pension contributions.
Assessing the status of current obligations will yield two key measures of the overall financial status of pensions. The first of these measures is often referred to as the accumulated- or accrued-benefit obligation. This is essentially a measure of the current value of funds set aside or previously paid as contributions in relation to the expected value of the pension benefits promised. This amount can either be expressed as a percentage or other ratio or as a net value. Pensions with a negative ratio of assets (or aggregate contributions) to future benefit obligations are commonly referred to as underfunded or are said to have pension arrears. Although there are international moves to improve the quality of pension disclosure in financial accounts (see box 5.13), many enterprises in developing and transition economies will lack good information on their pensions. The scale of pension obligations and problems of underfunding may therefore not be fully apparent until revealed in the PPI process.
Whether a pension is part of a national or civil servants' system operated on a PAYGO basis or covers only the workers in a single enterprise, the funding status must be evaluated carefully. The collection of contributions from public enterprises is often lax and there may be substantial amounts of past contributions owed that are not accurately accounted for. Few countries have well-developed requirements for the prefunding of defined-benefit plans, and even when these are present the assumptions used for determining the required level of assets may be considerably at odds with reality.
Funding shortfalls also can be present in some defined-contribution arrangements where the fair value for the assets is less than the value of accounts. Severance payments or informal obligations are rarely funded in advance. When done properly, a full measure of the accrued funding status presents a full measure of the financial obligation the enterprise is likely to have to resolve at some point and often can be a major aspect of the evaluation of the future demand on cash flows as well as overall financial solvency. The measure of the accrued funding status is likely to be the single most important number derived from an evaluation of pensions and it provides the basis for the key strategic decisions discussed in the following sections.
The second element of the funding status is the development of a measure of future or projected pension-benefit obligations. This element provides a measure of the expected levels of future costs that would be incurred to maintain the existing pensions. There are two potential aspects of this. First, most of a projected obligation will comprise the costs associated with additional periods of employment by the covered workers. These costs will include the contributions required for defined-contribution plans and PAYGO systems or the additional years of work that will factor into the benefit formulas of defined arrangements. It is extremely helpful to distinguish between the various contributing factors for the projection (that is, employment patterns, mortality expectations, and the like) as it is developed because these factors will specify the costs and savings of alternative pension strategies.
A second element, usually much smaller, is the projected increase in wages or salaries that would raise the ultimate level of benefits even if no additional years of work were covered under the arrangements. Although it adds complexity, it is helpful to distinguish between the two elements because they will enable a more precise evaluation of the costs of options for addressing future pensions, as discussed in subsequent sections. Although it should be calculated separately, this second component is usually combined with the accumulated liability to derive the funding status.
The international accounting standards (IAS 19) for pension benefits, introduced in 1999 by the International Accounting Standards Board, require that contributions in a definedcontribution plan be recognized as expenses. In contrast, the standards for defined-benefit plans have become more stringent, aiming to fully expose pension liabilities, and state that:
Source: International Accounting Standards Board Web site: http://www.iasb.org/) "IAS 19: Employee Benefits."
There are three approaches to resolving unfunded pension liabilities.
PPI investors will be extremely wary of becoming involved in circumstances where large financial obligations for previously promised pension benefits are present or may arise in the future. This makes the evaluation of the status of pensions as outlined above an essential early task in the PPI planning process. Evidence that all prior pension obligations are fully addressed, either through paid-up contributions or assets set aside that are sufficient to cover their anticipated value, will substantially diminish investors' actual or perceived risks, thereby removing a significant barrier to privatization. Conversely, the presence of unfunded or significant future obligations requires the development of a strategy to address them. There are three potential types of strategic approaches with many variations and combinations possible:
Reduce Accrued Pension Obligations
The lowest-cost approach to resolving past pension liabilities obviously is to reduce the magnitude of the liability. The viability of this approach is likely to be determined by a combination of legal constraints and the assessment of potential consequences to labor or government relationships. The simplest method obviously is to renounce any obligation or commitment to previously earned pensions or to the portion of those that are in arrears or unfunded.
The capacity to do so will be determined by the legal constraints, which should be an integral part of the inventory of pensions discussed above. Prior pension obligations can be reduced through a retrospective modification of the benefit formulas, including steps such as:
The implementing agency should, however, recognize that some of these steps may be explicitly prohibited by law or may be vulnerable to a challenge under commercial or labor codes.
The advisability of such approaches is likely to be determined by the impact on labor relations and the extent to which government agencies administering national or civil servants' plans are willing to permit entities to withdraw workers from participation and eliminate any future liability for contributions that are in arrears. Workers in public infrastructure entities, especially those included in civil servants' schemes, are likely to represent powerful political constituencies and strongly resist such steps. Public pension schemes operating on a PAYGO basis and experiencing both short- and long-term financing problems also are likely to oppose such approaches.
Freeze Past Obligations
An intermediate approach to addressing past obligations is to freeze the existing obligation at its current level and take steps to address it in a manner that is viable for the future. In this approach the past pension obligations are honored, but additional benefits do not continue to accrue or they accrue at a different level or in a form more affordable or aligned with the anticipated needs of the future. The separation of accrued and projected components during the evaluation of liabilities should provide a basis for judgments about the potential cost reductions of such an approach. This decision is closely associated with the determination of an appropriate prospective pension arrangement because closing down existing pensions in this manner has consequences for the future design.
Alternatives for resolving liabilities include development of a schedule for amortizing any shortfall over a period that matches a projected future funding stream, paying lump-sum settlements to affected workers in exchange for the settlement of the obligation, "laying off" the liability through a contract with a life annuity provider or in some cases even permitting a public entity to take over the pension obligation in exchange for an agreed-on fee or future series of payments. In cases where there is considerable uncertainty regarding the capacity of an enterprise to fulfill future obligations and remain a viable concern, workers may be willing to accept one-time cash payments of lesser present value than the benefits they forgo in the settlement of future pension rights.
This process can be considerably complicated when a guarantee of pension benefits has been provided by a government agency or when there is an attempt to withdraw from a civil servants' or other publicly managed defined-benefit plan that may be operated on a PAYGO basis. In these cases a negotiated settlement of future liabilities that is well in excess of the value of contributions to date may be required.
Fully Fund Any Shortfall or Arrears
The least controversial and disruptive, as well as the most direct, method of resolving existing pension obligations is simply to pay their full cost on a present-value basis. If this is financially viable and desirable it may be accomplished in a variety of ways:
There are five sources of finance to meet any shortfalls in existing pension obligations.
Some PPI programs have created special funds to finance the costs of retirement. In the privatization of Mexico's national railway, a trust fund was set up to finance the retirement benefits of those workers who retired prior to privatization. This fund was negotiated between government and the labor union, and included part of the privatization proceeds and public funds from fiscal sources. The company transferred the pension liabilities to the federal government (López-Calva 2001).
López-Calva 2001 (a PPIAF case study).
In 1998 Tanzania's privatization agency, the Parastatal Sector Reform Commission (PSRC) embarked on the privatization of Tanzania Telecommunications Company Ltd. (TTCL). An initial review revealed four pension plans in which employees were enrolled, and significant unfunded pension obligations that arose primarily from the East African Postal and Telecommunication Pension Fund (EAP&TPF) of the former East African Community (EAC). These liabilities presented a major problem, threatening to derail the privatization. They had been transferred to TTCL when EAP&T was separated into telecommunications and postal operations in 1994.
The government agreed that the privatized TTCL should transfer its employees to a new accumulation plan(s) and that unfunded liabilities would be removed from TTCL's balance sheet. To facilitate this, a new company called Simu 2000 Ltd. was created. It took over TTCL's unfunded pension liabilities and was required to ensure that the future pension obligations from these older pension plans are met. Simu 2000 Ltd. took over existing EAP&TPF assets plus noncore TTCL assets, in exchange for also taking over future pension liabilities.
Simu Ltd. was mandated to establish a small management team of no more than five employees, and to arrange for the sale of some of the assets and the transfer of proceeds to the National Social Security Fund (NSSF). The NSSF invested the proceeds and paid a fee of 7.5 percent of the total sum invested. Simu 2000 Ltd. was required to meet the monthly payment of pensions to the existing ex-EAP&T pensioners, and an initial advance was provided by the PSRC to cover this cost for three months and the initial administrative cost of setting up Simu 2000 Ltd.
Source: Parastatal Sector Reform Commission, Tanzania; Adam Smith Institute.
"Over the protests of the seven direct descendants of the former Japanese National Railways, the Diet [Japan's parliament] approved legislation in October 1998 [for] a 60-year plan to pay off the ¥27.8 trillion ($205.9 billion at ¥135 = $1.00) worth of debt that remains from JNR's 1987 privatization. Although Tokyo will shoulder most of the debt, the seven rail companies created from the now-defunct government railroad will be forced to take on ¥180 billion ($1.3 billion) worth of unfunded pension liabilities owed to former JNR workers now employed by them. The repayment plan has caught the attention of American shareholders of three of the Japan Railway firms as well as some U.S. legislators.
At the time JNR was privatized in 1987, it had ¥37.1 trillion ($274.8 billion) worth of red ink on its books. The seven companies that took over JNR's passenger and freight rail operations agreed to assume ¥14.5 trillion ($107.4 billion) of the debt, while the rest–¥22.6 trillion ($167.4 billion)–was transferred to a new company, JNR Settlement Corp. JNR Settlement was supposed to whittle down the debt by selling off JNR assets, especially prime real estate holdings. The company also held all shares of the seven JR operating companies and so benefited when the three strongest– East Japan Railway Co., West Japan Railway Co., and Central Japan Railway Co.–publicly listed their shares during the past two years. Because of falling real estate prices and other factors, JNR Settlement not only has been unable to reduce its handed-down debt but has seen it grow to nearly ¥28 trillion ($207.4 billion).
The ¥4.3 trillion ($31.9 billion) in pension liabilities will be taken over by a new company, Japan Railway Construction Public Corp., which, in turn, will derive income from selling JNR Settlement's real estate assets, offering more shares of JR companies to the public and forcing JR Group firms to pay ¥180 billion ($1.3 billion) of the cost.
The JR companies feel that Tokyo is being unfair in forcing them to pay an extra share of the pension liabilities. When their private pension plans were absorbed into the government's pension system in April 1997, the administrators of the public plan said that the JR Group's pension scheme was under funded by ¥940 billion ($7 billion). JNR Settlement agreed to absorb ¥770 billion ($5.7 billion) of the liability, and the seven operating firms took on the remaining ¥170 billion ($1.3 billion). The septet now says that the Tokyo government is reneging on the deal by making them pay another ¥180 billion ($1.3 billion).”
Source: Choy 1998, pp. 6-7.
