4 minute read 9 Jun 2020
How the COVID-19 pandemic impacts pension plan funding

How the COVID-19 pandemic impacts pension plan funding

By Frank Lapeirre

EY Belgium Strategy and Transactions Associate Partner

Dedicated to furthering clients' transaction processes. Passionate about developing our talent. Loves quality time with family and friends.

4 minute read 9 Jun 2020

Mitigating funding risks to safeguard your employees’ pension benefits.

The COVID-19 outbreak created significant turmoil on financial markets. Combined with the current uncertain economic climate, pension plan funding is under severe pressure. Yet, employees are relying upon their employers that their pension plans will continue as normal. And despite trying times, employers are still obliged to continue making contributions in line with pension plan terms.

For the past fifteen years the Belgian government has encouraged companies to invest in the second pillar pension coverage for employees. It’s the employer who is responsible for financing these pension benefits. A pension plan is typically financed through a corporate pension fund or a group insurance contract according to which the employer pays contributions to build up a pension reserve that later will be paid to the affiliated employee. Due to the decline in interest rates over the past years, many corporations revised their investment strategies to seek a higher return on investment for their pension plan assets. But a higher return, usually comes with increased investment risks.

Decrease in value of pension plan assets

The BEL20, as many financial markets around the globe, was hit hard by the economic impact of the COVID-19 pandemic. In March 2020 its index registered a sharp fall of 35%. And it’s only now that we are seeing a slow recovery. As a result, companies with pension plan assets invested in the market, saw the value of their assets decline, while their pension plan liabilities continued to build up, impacting their overall liquidity.

Combined with the overall business impact on economic activity due to the lockdown and the need for short-term liquidity, some organisations may now struggle to secure their (short-term) pension contributions.

Defined benefit versus defined contribution pension plans

To determine as an employer the financial impact on your company’s pension plan it’s important to keep two things in mind.

  1. Are you investing in a defined benefit or defined contribution pension plan?

    The financial impact mainly affects defined benefit plans, because these plans guarantee a specified payment amount when the employee retires. This means the employer is responsible for bridging the gap, if necessary, between the returns realised on the investment and the fixed pension commitments made to the employee.

    With defined contribution plans, on the other hand, employees and employers can contribute and invest funds to build up savings for retirement. The employer has no obligation toward the account’s performance beyond the 1.75% legal return. Consequently, there’s less impact on this type of pension plan.

  2. How are the pension commitments financed?

    The financial impact on the value of pension assets will be higher for pension plans that invest in equities, bonds, real estate and other high-risk financial instruments. Think about pension commitments based on a branch 23 insurance contract or corporate pension funds. These types of contracts create additional liquidity needs, because employers need cash to meet the near-term pension benefit commitments and have to comply with regulatory requirements as well. 

How do you tackle pension plan challenges?

A good place to start is to analyse if your actuarial calculations and historical assumptions, like discount rates and your expected return on assets, are still valid. Discount rates have been extremely volatile recently. At the beginning and end of March these rates showed an increase of around 100 bps to 1.7%, which reduced the net present value of pension plan liabilities. However, discount rates are meanwhile moving back to the level of 31 December 2019 (0.84% on 1 May 2020). This increases the pension plan liabilities, whereas the pension plan assets are still below their value of end 2019.

Also look at the impact on the balance sheet liability, income statement and cash flow if you are adapting historical assumptions. Additionally, ensure to check if the total contribution for your pension plans will be impacted in the coming year and if additional contributions will be necessary to compensate a potential asset shortfall. 

Staying ahead

In these volatile economic times it’s crucial to stay ahead of bad financial surprises. The investment strategy of a pension plan needs to be carefully reviewed to ensure proper financing of current and future liabilities. In addition, optimising your pension benefits can decrease the employer’s financial exposure. Especially companies with defined benefit plans, need to analyse the financial impact of the COVID-19 pandemic and take necessary steps to mitigate funding risk. Companies that proactively defend their pension plan asset allocations will undoubtedly take an important step in safeguarding the future of both their organisation and their employees.

Optimising the balance between risks and revenues

Connected Capital Solutions help clients drive inclusive growth by focusing on their capital and (transaction) strategy through to execution to drive fast-track value creation.

EY’s actuarial and pension experts go beyond actuarial calculations and historical assumptions. Our integrated teams support employers with a clear view on the quantitative and qualitative key pension issues, implement complete employee benefit strategies, and design pension plans tailored to your needs. 

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Summary

Pension plan funding is under pressure. Due to the economic shockwaves of the COVID-19 crisis, pension plan assets are declining, while pension plan liabilities continue to build up. Companies need to proactively defend their pension plan asset allocations to avoid financial surprises.

About this article

By Frank Lapeirre

EY Belgium Strategy and Transactions Associate Partner

Dedicated to furthering clients' transaction processes. Passionate about developing our talent. Loves quality time with family and friends.