Under the Supplementary Pensions Act (WAP), an employer must guarantee a minimum return on the employer’s and employee’s group insurance contributions. For the premiums paid before 1 January 2016, the average guaranteed return is 3.25% on the employer’s contributions and 3.75% on the employee’s contributions. After 1 January 2016, a variable minimum return between 1.75% and 3.75% that is set annually applies. The low quotation of the long-term linear bonds (10-year OLO) made the minimum return evolve to the lower limit of 1.75%. After 2012, that evolution of the 10-year OLO created a situation where the Branch 21 products were no longer sufficient to comply with the WAP. The WAP imposes a higher interest rate than insurers are able to guarantee.
A Branch 23 investment fund carries no interest guarantee from the insurer and is characterised by a higher than expected medium-term average return. “However, a small difference in return makes a big difference in the long run,” says Wim Lourdaux. “An investment of 1 million euros in shares yields 5 million euros at a 5.2% rate of return after 40 years. With bonds, that return is limited to 1.8 million euros after 40 years. Returns on shares remain well above the average inflation.”
But what about the risks? Branch 23 has no capital guarantee, and therefore negative returns are possible, while, unlike in Branch 21, the risks fall on the employer. Studies by Vanbreda Risk & Benefits show that when entering Branch 23, volatility is higher, but then gradually decreases. High and low returns offset each other, and the volatility of the average return steadily decreases. Portfolio accrual through monthly premiums also reduces volatility. As an employer, it is important to consider the risks: the uncertain commitment between 1.75% and 3.75%, the uncertain return of investment funds, and the uncertain investment horizon. However, the effect of periodic premium payments and the build-up of buffers levels out those three uncertainties. The fact that the risk falls on the employer gives rise to some interesting reflection. In this respect it is important to thoroughly explore the various options within Branch 23.
- Option1. Individual capitalisation without employee choice
In individual capitalisation, an employer pays premiums to an insurer, which then passes them on to the individual contracts of the members. The return on these premiums is also passed on to the individual contracts. In a system with individual management, the choice from the range of investment funds with different risk profiles may or may not rest with the employee. “In our opinion, individual capitalisation with employee choice of funds is not a balanced alternative,” Katrien De Keuster clearly states. “The employee may invest in the riskiest fund and still keep the WAP safety net. As an employer, you have no control over the choice of fund, while you are obliged to bear the losses.” In individual management without employee choice, the employer chooses the fund. Profits continue to be awarded individually to the members’ contracts, while losses are still borne by the employer.
- Option 2. Collective capitalisation
In collective capitalisation, the employer pays the premiums to the insurer in a single amount. That amount, along with the return, is put into one financing fund. If a member retires, for example, the amount is taken from that large fund. “We believe that collective management is the most balanced alternative,” says Katrien De Keuster. “Since the profits are collective, the employer may also use them to offset any deficits or losses.”
In collective management, an employer can opt for different mechanisms. In the case of a cash balance, the employer aims for a balance between achieving returns and granting returns. He can specify in the pension plan what return he wants to grant to the members. If the actual return is higher, this creates a buffer that he can use to offset deficits in the group insurance plan. If the return is lower than specified in the pension plan, the employer must make up the shortfall from that buffer if necessary. Conversely, if the buffer becomes too large after a few good years, the employer may opt for a one-off premium or a one-off additional return for the members. The employer may also use the buffer to pay the next contribution.
A second collective management mechanism divides the additional return between employer and employee according to an allocation key. A portion above the WAP goes to the employee; another portion goes into the employer’s buffer to be used in the event of shortfalls relative to the WAP return.
To explain the differences between Branch 21 and Branch 23, Wim Lourdaux and Katrien De Keuster present a fictitious example. Low returns as in Branch 21 lead to underfunding that causes a shortfall of 19 euros on a one-off premium of 100 euros after a term of 20 years to meet the WAP guarantee. After 35 years, that becomes as much as 42 euros. “The grass won’t grow by pulling it,” says Wim Lourdaux. “When we look at the further evolution, we cannot force anything. In view of the low interest rates and the influence of the new European solvency rules that apply to insurers as of 1 January 2016, insurers are investing less in shares and primarily in linear bonds. Insurers are reluctant to give high interest guarantees in the future, while profit sharing is coming under pressure. That cocktail increases the risk of deficits for the employer.”
However, if we apply the same example of a one-off premium of 100 euros to higher returns, we see surpluses emerging: 22 euros after 20 years and 54 euros after 35 years. In this context, we assume a not unrealistic average long-term return of 2.5%. This is a relatively prudent investment strategy. With more risk and higher expected average returns, the surplus increases accordingly.
Given the range of options within Branch 23, this form of investment may be a suitable alternative for group insurances. Partly because of the ability to build a buffer and thus build up reserves in time to offset any subsequent shortfalls with respect to the WAP obligations. Investing in group insurance is always done with a long-term horizon. By making periodic deposits in Branch 23, you spread the risk at entry. Suppose a stock market crash happens to occur at that time, that risk is levelled out. The choice of risk profile also determines the spread. Last but not least, the employees benefit as well: it is an additional asset to get more profits within their contract.
