A Recession Might Be Ahead, But Pension Plan Surpluses Give Multinationals Options
December 7, 2022
The level of available funds and capital is always an important consideration for businesses — but as the odds of a global recession grow, it may soon become critical. Pension plan contributions could be a critical consideration for organizations operating in Europe as they look to save on spending.
One element of cost control will be understanding pension plan contribution requirements in the European countries where companies operate.
But first, a bit of good news: a global corporate pension deficit of approximately $1 trillion in 2019 – 2020 has now nearly vanished, with many pension funds now in surplus. As they eye their pension plan obligations, employers will have a potential advantage in countries where pension plans are largely experiencing those surpluses. Among other things, higher surpluses provide an opportunity to take steps to reduce pension plan risk.
“As we enter a potential global recession, cash is going to be critically important to most CFOs,” says Paul Rangecroft, chief executive officer of Aon Wealth Solutions. “Understanding what ‘required pension contribution’ means in each country is going to start to become critically important to big multinationals.”
Data from the European Insurance and Occupational Pensions Authority (EIOPA) show that the excess of assets over liabilities at European pension plans increased from 181 billion euros at the end of 2020 to 416 billion euros one year later. A growing number of U.S. pension plans have experienced a similar surplus increase, with corporate defined benefit plans at their highest funding rates since 2007.
The increase in surpluses presents plan sponsors with a variety of options, including reducing investment risks, increasing pension benefits, reducing contributions or de-risking plans by transferring the risk to insurers or other pension consolidators.
The Inflation Challenge
As inflation surges around the world — it reached a record 10 percent in the Eurozone in September — it poses a potential challenge to pension plans, particularly those in countries where benefits are indexed to inflation, thus increasing liabilities.
“We have very high inflation rates in Germany,” says Rafael Kroenung, CEO of Wealth Solutions at Aon Germany. “And this is reflected in the pension increase rates within the valuations of pension liabilities for companies.”
Even if inflation slows in 2023 and 2024, required pension indexation in Germany will likely remain high for the next two to three years. In that environment, there is a risk that German employers will have to make some additional pension contributions. “When we look at the direct pension promise in Germany, we don’t typically have funding requirements. So it is unlikely additional cash is going to be required right now.” says Kroenung.
In the Netherlands, inflation has already exceeded 14%. While inflation does not impact the funding situation of pension funds directly, the rise in interest rates has caused the average funding ratio of pension funds to increase to 127% in October. “After many years of no pension indexation, we see that pension funds will start indexing pensions this year,” says Frank Driessen, CEO of Wealth Solutions at Aon Netherlands. “Many pension funds will increase pensions between 5 to 10%, but this is still insufficient for retirees to compensate for the sharp inflation.”
Pension funds are exercising restraint in indexing anticipating a major change in the pension system in the Netherlands expected in 2023. Defined Benefits plans must be converting to Defined Contribution by 2026 based on the expected new pension law. “All the accrued pensions should be converted to Defined Contribution plans in coming years, whereby additional compensation for legacy participants will be needed,” says Driessen. Pension funds must have sufficient buffers to achieve a smooth transition.
Addressing International Economic Change
In Switzerland, economic conditions will likely reduce statutory pension plan surpluses, but this should not necessarily prompt the need for an immediate response. Jean Netzer, accredited pension actuary at Aon, notes that in Switzerland, pension plan boards have the discretion to adjust the parameters used to calculate plan liabilities.
“From a funding perspective, we can expect most pension funds to reduce the level of surplus they had at the beginning of the year, but pension funds are being careful to not overreact to the situation. For the moment, the same level of investments and strategy can be maintained but the times ahead remain challenging and will require tight monitoring,” says Netzer.
Meanwhile, central banks continue to raise interest rates to help tame inflation. The European Central Bank, the Bank of England and the Federal Reserve have all increased rates by 75 basis points in recent weeks. This development should be positive for pension plan sponsors as it flows through to higher bond yields reducing liabilities.
U.S. plans face similar economic dynamics, including the threat of recession, stock market downturn, surging inflation and rising interest rates.
“The difference primarily is that the funded status of U.S. plans, for the most part, do not immediately reflect the benefit of a sharp rise in interest rate when looked at on a minimum funding basis,” says Rangecroft. “Whilst similar dynamics are happening, plan sponsors should consider potential cash contributions requirements against renewed opportunities to transfer liabilities to an insurance company.”
Weighing Pension Plan Opportunities
Higher surpluses offer plan sponsors the opportunity to reduce plan risks. One choice might be to purchase annuities from insurance companies that transfer liabilities for some or all plan participants. There also might be opportunities to restructure plan investments to reduce risk.
In the current environment, companies should take advantage of improved pension surplus positions and consider opportunities to reduce or remove pension risk while their situations remain favorable.
Understanding the Local Climate
As multinational companies prepare for the possible impacts of a recession and consider reducing pension risks, they must consider the fact that risks and opportunities might vary across the various European markets in which they operate and proceed accordingly. It’s critical that companies understand the differences in their pension plans’ status and funding requirements in the countries in which they operate.
In a challenging economic climate, understanding what’s required in terms of pension plan contributions will help organizations make the best possible decisions about reducing pension risks and managing cash.