Addressing Prior Pension Obligations
Pensions and Labor Restructuring
Pensions: Implementation Steps
Eligibility and vesting rules require careful scrutiny.
A successful privatization will usually require restructuring the pension scheme to take account of the different concerns of workers, investors, and government and to align the new pension arrangements with the long-term requirements of a privatized enterprise. This section sets out the key considerations and potential alternatives in designing and implementing pension arrangements, including consideration of incentives to attract and retain workers, the level and pattern (cash flow) of expenses, and strategies for funding and investment. Whatever options are chosen for resolving existing pension liabilities, the pension scheme will be an important aspect of the operation of the restructured entity. Should the implementing agency set terms for future pension schemes, which would become a condition of the PPI contract? In general, that should be avoided as far as possible, and the PPI investor should have discretion to determine pensions arrangements within statutory requirements. The way in which pensions are restructured will affect how investors value an enterprise and assess its long-term viability. Providing investors with the widest array of choices and flexibility will therefore greatly enhance the attractiveness of an entity for privatization.
The extent to which this is possible will depend, however, on the nature and difficulty of negotiations among the work force, trade unions, and government. The Lufthansa Airlines pension review, for example, required agreement between the government and the company; and when British Coal was privatized, bidders were required to accept a new pension plan (see box 5.16).
When the United Kingdom privatized its coal industry, past benefits accrued (and the consequential liabilities for funding) remained the responsibility of the government. Investors bidding for the coal mines were, however, required to participate in a new pension arrangement that had been negotiated previously between the government and stakeholders, including the employees (trade unions). This was an accumulation plan but the investors had no say over the contribution rate. The new plan was only open to retained workers who had been members of the old (closed) definedbenefit schemes. New employees engaged by the investor after privatization were able to participate in a third, completely new, plan that the employer established.
Source: Adam Smith Institute, personal communication; DTI 1993.
If the implementing agency is negotiating a future pension plan, it is essential to consider carefully such issues as the following:
If the implementing agency will be involved in restructuring the pension plan, this is a checklist of some key issues.
Pensions are generally the largest element of compensation arrangements beyond the payment of wages and salaries. Although the average cost will be between 5 percent and 15 percent of a total compensation package, depending on the nature of the pension design and age of the worker, pension costs easily can exceed the wage bill for certain workers. That makes the design of the pension program on a going-forward basis a major issue in work force management.
There are essentially two main issues here: (1) the nature of the pension and (2) the level of benefits or generosity. Contemplating the replacement of an existing pension program will need to take into consideration both the potential effects of a change in expectations and an objective assessment of the future needs of the organization. Concerns about retaining key workers or limiting the adverse effects of difficult labor negotiations may significantly limit the movement toward what might otherwise be an appropriate design.
The basic decision of benefit design is the choice between a defined-contribution and a defined-benefit system. This is a question of matching the attributes of design to the requirements of the enterprise and the work force. Some of the key characteristics of each type are listed below.
Defined-contribution plan:
Defined-benefit plan:
These characteristics make each type of pension appropriate for different work force management objectives.
Defined-contribution plan:
Defined-benefit plan:
There are various potential combinations of the two basic designs that can merge aspects of any of those characteristics. One approach that is gaining acceptance in a variety of settings is a hybrid design in which workers are credited with a fixed amount in an individual account that accumulates with investment earnings during the working years. At an established retirement age, this account is converted into a monthly benefit. These types of arrangements may enable an enterprise to achieve many of the advantages of a defined-contribution pension in attracting workers and providing significant incentives to retain valued workers who are in their high-productivity later years of employment. The most important point is to recognize that neither model has any particular inherent advantage but rather a set of characteristics that should be aligned with anticipated needs.
The two models also impose differing financial aspects that must be consistent with the objectives and constraints of the ongoing enterprise. In the aggregate, if the generosity of the pension is the same, both models should entail a similar present value of costs. The timing and pattern of costs, however, may be significantly different. The capacity of an enterprise to meet the cash flow demands of the short term may be an extremely important consideration in selecting a pension design.
Defined-contribution pensions involve constant and predictable cash flow demands. With workers' accounts usually credited with actual investment earnings, sponsors are not exposed to volatility in financial markets. Defined-benefit pensions involve the sponsor committing to a future expense that may vary significantly, depending on employment patterns or the earnings on any assets set aside to fund the plan. Although this arrangement may defer cash flow demands to a later date, those demands are typically far more volatile in their cost and cash flow requirements. If there is a requirement or effort to prefund these demands, poor investment performance may impose future expense shocks and changes in assumed interest rates may make annual funding requirements extremely volatile. The differences are as follows.
Defined-contribution plan:
Defined-benefit plan:
Decisions will also have to be made regarding a strategy to fund future pension benefits. In a few cases strategy may be dictated by law, although in most circumstances involving privatization there is not likely to be a legal and regulatory framework for pensions that imposes significant requirements. Defined-contribution pensions generally involve payment of the full pension expense during the period in which the commitment is made. Individual accounts should be established for each participating worker, and sponsors will have to take a significant responsibility to ensure the integrity of the funds through oversight and periodic auditing.
The most challenging issues are likely to be decisions about the investment of the funds, whether these decisions are to be made by the sponsor or whether a limited menu of choices will be provided to workers individually. In nearly all circumstances the level of development of capital markets and the lack of financial literacy among workers will require that any assets be held in very safe, professionally managed portfolios that are professionally managed. In countries that have developed a system of licensed pension funds as part of a broader reform (as will be discussed in the following section) this should be a relatively simple choice. In other circumstances, sponsoring entities will likely need to choose an asset manager and establish portfolio limits.
Defined-benefit pensions, however, require far more complex decisions. The sponsor will have to decide the extent to which there is a capacity to set aside funds in advance. Funding defined-benefit pensions on a PAYGO basis may move expense and cash flow patterns into the future but can expose sponsors to untenable risks in circumstances where the benefit formulas create rapidly accelerating or volatile pension expenses. Factors such as unanticipated patterns in wage growth, inflation, or the future need to restructure the work force may create large and unexpected pension costs. It is therefore advisable for the sponsor of a defined-benefit arrangement to estimate pension expenses as they accrue (using the services of a professional actuary) and to fund them on an ongoing basis. These actions will prevent the build-up of unsustainable liabilities that can drive otherwise profitable enterprises into insolvency if not properly managed.
Funding for future pension expenses should be separated from the other activities of the sponsor and managed in accordance with a predetermined and disciplined investment strategy. This result is best accomplished through the services of professional asset managers but will necessitate the formulation of a general strategy. Developing this strategy is usually an area in which engaging the services of competent consultants is advisable. A well-formulated investment strategy can mean the difference between a successful pension restructuring and one that exposes the enterprise to enormous financial risks in the future. Success in this regard is nearly always a process of balancing expense against potential risks.
Some common strategic approaches involve the following:
Defined–benefit plans present a greater challenge than do definedcontribution plans.