In Germany this situation has been turbo-charged. While companies in the UK have largely stopped allowing the accrual of new benefits, Germany has many more open schemes.
While UK companies have actively encouraged members to transfer out, Germany is not as far down this road. To advisers tasked with assessing the merits of these transfers on an individual level, part of what needs to be accounted for is the ability of a scheme to meet its liabilities and the effect that could have on the viability of the parent company. We thought it might help to look at more extreme example and Germany is certainly that.
It’s not a great time to be a German pension fund manager. Interest rates in the eurozone are nailed to the floor. This has meant yields (the interest received yearly) on loaning money to the German government (via ‘bunds’) have consistently hit all-time low after all-time low.
This hits our German pension fund manager in two ways – first, bunds are unlikely to be of much help in the search for return-generating (or interest-yielding) assets. Second – and more importantly, the current available bund yield is the anchor for the ‘discount rate’ used in calculating pension liabilities. Say what? I’ll do my best to simplify below.
Imagine I bought shares a long time ago in a company called Berkshire Hathaway and now I’m a multi-millionaire. I’ve asked Heesen to build me a 100ft yacht – they are going to call mine Pay-out (creative, I know). We have agreed that I will purchase it on 20 January 2030 at a price of £10 million once it has been built.
Unfortunately, I only have £5 million in my bank account today – so in order to make sure I can pay the £10 million for Pay-out I will need to turn my £5 million into £10 million by 20 January 2030. Luckily, interest rates available at my local bank are exactly 7.2%, and 7.2% annualised over ten years will double my initial investment! My future liability is effectively zero (the difference between what I have promised to pay and what I can reasonably expect to have in 10 years’ time).
Unfortunately, the bank cuts interest rates from 7.2% to just 4.15% the next day. That means my £5million deposit at my local bank will only generate £7.5 million in ten years’ time – I will not have enough to pay for Pay-out! I now have a liability of £2.5 million (25%) assuming the interest rate stays at 4.15%. There are only three things I can feasibly do to make up the difference –
- Invest in riskier assets (hoping to make a better return)
- Ask someone else for money
- Stick my head in the sand for ten years (ie denial)
The interest rates in the yacht analogy represent the ‘discount rate’ – a reasonable guide for the returns an investor can expect over a certain time period, and therefore a key component for calculating future liabilities. German pension funds use bund yields as the basis for this. The discount rate based on this currently sits at 1.97%.1
The conundrum German pension fund managers face is how to ensure they can deliver on their pay-out promises to pensioners. Their liabilities (the gap between what they have promised and what they can reasonably expect to deliver) continue to grow as the available yields on German bunds continue to nosedive.
So what can they do?