Pension Markets in Focus 2023

4. Increase in interest rates improved the sustainability of some defined benefit pension plans

Members of traditional defined benefit plans are generally guaranteed to receive a benefit based on the length of employment, an accrual rate and their final or average salary. A decline in the value of pension assets is not expected to have a direct impact on the benefits that people will receive in defined benefit (DB) pension plans. The sponsor of the plan (generally the employer) is responsible for covering any gap or shortfall between the amount of assets in the plan and the liabilities arising from the promise, generally through additional contributions.

Changes in inflation, interest rates and labour market developments can affect the present value of the benefit promise that some sponsors offer in the pension plan they set up for their employees. The evolution of employment rates and wages can affect entitlements and future benefit payments when the benefit formula is based on the length of employment and wages. Also, these future payments are liabilities for DB plans and need to be expressed in today’s terms to calculate the amount to be held as technical reserves to cover these promises. The lower the discount rate is to express these future payments in today’s terms, the higher the estimation of liabilities is. This discount rate can be tied to the evolution of interest rates.

Liabilities of DB plans have been rising over the last two decades as interest rates fell. Figure ‎4.1 shows the increase in liabilities and their volatility. They are volatile when they are sensitive to changes in the parameters and assumptions underlying their calculations. However, in a context of low and falling interest rates for many years, the liabilities tended to rise for DB plans in all reporting jurisdictions.

Figure ‎4.1. Evolution of the liabilities of defined benefit plans in selected jurisdictions, 2001-2022

Base: 2021 = 100

 

Note: For more details, please see the methodological notes in ‎Annex C.

Source: OECD Global Pension Statistics.

Statlink

Liabilities dropped in most reporting jurisdictions in 2022 as interest rates rose. Some of the sharpest drops occurred in the United Kingdom (12%) and the Netherlands (22%) where future obligations of the plan are expressed in today’s terms based on market-based rates. The increase in interest rates lowered the estimated value of future obligations.

However, in jurisdictions where the calculation of liabilities is with a fixed interest rate, the change in interest rates did not affect the value of liabilities (e.g. Finland (3%) and Iceland (3.5%)). Pensionskassen in Germany also have to use a fixed discount rate under the local Generally Accepted Accounting Principles (GAAP) to calculate liabilities. Therefore, in these countries, the change in interest rates did not affect the valuation of liabilities, which remained broadly at the same level in 2022 compared to 2021 (such as in Finland and Germany) or even increased (such as in Iceland, by 2%). In Switzerland, although this is not mandated, some pension funds maintained their technical interest rate as it was to value the liabilities for plans in benefit primacy (i.e. where benefits are based on tenure and last salary), which may partly explain the overall increase in liabilities in 2022.

Therefore, the financial sustainability of DB plans improved in some jurisdictions despite the fall in assets, as liabilities fell as well. Liabilities of DB plans fell more than assets in Luxembourg, the Netherlands, Norway and the United Kingdom (Figure ‎4.2). By contrast, the funding ratio of DB plans worsened in jurisdictions where the liabilities remained the same or slightly increased (e.g. Germany, Iceland, Finland, Switzerland and the United States). Liabilities are valued differently depending on the jurisdictions and methodological choices regarding discount rates, future mortality improvements, and approach with respect to current and future members, which probably contributed to the different evolutions of the funding ratios across jurisdictions in 2022 as in previous years (OECD, 2023[4]).

Figure ‎4.2. Funding ratio of defined benefit plans in selected jurisdictions, 2021-2022

In per cent

Note: For more details, please see the methodological notes in ‎Annex C.

Source: OECD Global Pension Statistics.

Statlink

Assets in DB plans in most reporting jurisdictions would have been sufficient at end-2022 to cover the liabilities arising from the benefit promise. The funding ratio exceeded 100% at end-2022 in all reporting jurisdictions except Iceland (28%) and the United States (64%). However, the aggregated funding ratios at end-2022 may hide disparities in the solvency of the many DB plans that exist within each country.

Some DB plans with improved funding ratios have been looking into the possibility to lock-in the gains by going into buy-out and transferring their assets and liabilities to insurance companies. The number of buy-outs has been rising in the United Kingdom and the United States for instance.1 There had been concerns over the potential challenges this rise in pension risk transfer could entail (e.g. on the supply side through supply-chain bottlenecks) but this does not seem to have been a problem in practice according to some of the insurers operating in this market.2

Notes

← 1.  Lane Clark & Peacock LLP (lcp.com) (for the United Kingdom); LIMRA (for the United States)

← 2.  No capacity issues in the buyout market, WPC told - Pensions Age Magazine