Defined Benefit Pension Scheme and Housing Markets Changes: Reflection in 2008 Financial Crisis in the UK
Literature Review
Introduction
The unforeseen and dramatic events of the 2008 financial crisis that spread into 2009 and the economic recession that followed hit the corporate DB pensions schemes hard. The immediate impact was evident in plan funding rates, which experienced a dramatic drop in equity prices, followed by a gradual increase (Warshawsky, 2011). The decrease was accompanied by an initial sharp rise in corporate bond yields, followed by a gradual decline. An increase in pension plan liabilities accompanied the gradual fall of returns. The government insurer of pension plans was also struggling financially, necessitating a new regulatory approach to pension plans and other financial sectors affected structurally by the crisis. However, the financial crisis’s long-term impact was due to the high-risk investments in other economic sectors other than the financial industry in the form of ripple effects.
According to Warshawsky (2011), such long-term impacts affected the impact of decision-making strategies for the corporate DB plan sponsors, who are critical in determining investment policies, pension plan designs, and sponsorships, and contribution plans. Furthermore, it impacted the government’s decisions to mitigate the situation through funding relief to pension plan sponsors. Since the funding reliefs from the government were temporary, shortfalls arising from the crisis remained within the financial systems. Their eradication from the schemes was dependent on the subsequent development of the financial markets, which showed strong signs of recovery in the new regulatory environment before the impact of Covid-19. One of the long-term proposals was the introduction of a flexible, structured plan with changes in government regulatory approach since the risks of the financial crisis affected both the defined benefit and defined contribution schemes.
The authors found out that the values of assets such as houses in the housing market dropped drastically due to the shock in the stock market arising from the crisis. Subsequently, the interest rates used to value the liabilities of pension schemes also rose; however, the interest rates declined gradually in the post-2008 crisis period. As a result, there was a decline in the plans’ funding status because the plans sponsors moved their investments from equities to optimize their investment portfolios, but later, the funding plans started increasing in the post-crisis period (Warshawsky, 2011). Besides, the government initiated not only regulatory and legislative guidelines as a relief to the impact of the crisis but also offered financial relief.
Theoretical framework
Dudley (2018) notes that the 2008 financial crisis exposed weak points on the banking structures in the developed economies in western economies. A pattern of excess risk-taking in investments coupled with a lack of sufficient liquidity and capital buffers to protect against risky ventures. In addition, the bank structures’ prudential framework was determined to be weak and inadequate to protect the banks against risky investments. Governments have since responded through regulators and have demanded resolution frameworks that are more explicit, more demanding liquidity and capital standard, and more robust supervision of banks and other financial institutions(Dudley, 2018). The operating environment has also changed with more scrutiny from stakeholders, and increased competitiveness from international financial businesses with better refines risk management strategies.
The financial crisis led to the evolution of the banking sector by initiating changes in the banking market structure and capacity. The crisis brought an end to an impressive run of strong growth in the backing based on high-risk investments in advanced economies. Metric indicators show that the banking market slowed down compared to other economic activities in the post-crisis period (Dudley, 2018). However, it can be noted that the decrease is attributed to a reduction in business volumes but not as a result of company exiting markets.
The baking business model has also shifted significantly with banks and other lending institutions focusing on low-risk businesses and more traditional less capital-intensive activities such as commercial banking. Dudley (2018) explains that they have shunned complex and risky activities such as shares and securities trading, which are also capital intensive. As such, financial institutions have changed their asset portfolios and diversified their revenue mix with banks relying on customer deposit funding. In particular, banks have become more selective in their investment strategies and prefer to invest in international banking ventures to enhance their competitiveness. Lastly, the increased regulations have led to sluggish growth compared to the pre-crisis period leading to cost-cutting measures within the financial sector.
Empirical review
Impact of the crisis on pension schemes
Countries that utilized smoothing techniques in the pension plans regulation recorded significant unfunded liabilities in the DB Pension schemes, which led to massive losses in asset values. For instance, the private pension plans and other personal plans in the OECD jurisdictions reported a loss of up to $5 trillion in less than 11 months in 2008 (Tower and Impavido, 2009). In addition, pension plans reported reduced yields, which worsened the situation by increasing liabilities. As a consequence, the aggregate funding ratios dropped further due to the implication of the crisis and the impact of increased liabilities.
The impact of the financial crisis on DB pension plans
Pension plans are designed to meet the long-term objectives of stability, viability, and security of the benefits of members. Traditionally, DB pension plans have been complementing other pension plans in the United Kingdom since they offered high security to its members after retirement. However, in the private sector, their role has declined significantly in the United Kingdom, with more than 73% closed to new entrants. They are progressively being replaced by defined contribution plans where the individual bears the pension-related risks during their active working days. However, the financial crisis has exposed the DC plans since the contributors are exposed to the risks in the market, endangering their retirement savings.
The DB plans were struck by 2008 financial with about 20% reduction on the value of their assets. As a consequence, the funding levels of the schemes dropped and remained low despite the turn around of the economy. The impact was more profound on the DB plans compared to DC plans due to their nature, which guarantees a defined contribution to their members. As a response to the financial crisis, the United Kingdom government enacted regulations that offered flexibility to pension funds and sponsors to meet funding requirements and other associated regulations.
In particular, the United Kingdom relied on the existing flexibility within the funding regime to provide a means for re-assessment of the recovery plan already plans and facilitates the possibility of back end loading. As such, this kind of flexibility did not necessitate the need for legislative measures. Furthermore, the United Kingdom government enacted pension protection regulations to protect the benefits in case the plan sponsor files for insolvency. This protection was necessary due to the increased bankruptcy of plan sponsors caused by the deterioration of sponsor finances during the financial crisis.
The regulations were designed to encourage deficit reduction by plan sponsors by contributing during times when their finances are stable; besides, the plan sponsors can build surplus contributions when their financial outlook is good. The regulations also seek to give plan sponsors more control on cost and risk management, dampen volatility, and maintained predictable costs.
Impact of the financial crisis on the European household
The authors discuss the impact of the crisis on the average European household by considering the key indicators that determine household wellbeing and income, such as wage dynamics and unemployment rates. In turn, the dynamics of these key indicators impact other factors such as household indebtedness, expenditures, and savings dynamics, which respond to the prevailing economic conditions. According to Mielcová (2011), quarterly and annual data from 2000 to 2010 indicated that the United Kingdom households decreased their liabilities and mortgages when compared to their European counterparts, such as the French, who increased their loans instead. More so, the data indicates that after the financial crisis, households increased their capacity and willingness to save.
The data further indicates that unemployment rates increased after the 2008 financial crisis, while the dynamics of other vital indicators remained unchanged. For instance, the household wages remained on the upwards trend while household consumption expenditures correlated with the unemployment rates (Mielcová, 2011). However, unemployment trends preceded household consumption rates.
Effect of the crisis on older households-
During the 2008 financial crisis, the prices of financial and real assets fell drastically, leading to a high impact on household incomes in the form of wealth holdings. As a consequence, individuals close to their retirement ages were worst hit since they had accumulated vast amounts ow wealth but had very little time to work to improve the value of their wealth, leading to an increase in their liabilities due to a decrease in their net worth (Banks et al., 2012). However, results show that the shock was moderate due to factors such as the data collected not being linear; thus, much rounding of probabilities was utilized.
Funding DB Pension schemes
The funding regime of defined benefit pension schemes has undergone a revolution in the past 12 years. Over these years, the financial market has been hit by significant turbulences, including the 2008 global financial crisis and a low-interest record rate (Cowling et al., 2019). This paper discusses methodologies and approaches developed over these years concerning the pension regulations that were enacted over the same time. According to Cowling et al. (2019), the end minimum funding requirement in 2001 and the introduction of the specific funding requirement in 2005 have led to the development of scheme-specific pension funding actuarial methods in the market.
The authors (Cowling et al., 2019) focus on investigating how the new scheme-specific pension funding actuarial methods meet the objectives of securing members’ benefits and financing benefits when they are due. They take a look at the history of the framework that has been used to fund DB pension schemes in the UK. They also investigate how the regulation of structures of DB funding has evolved across the world about the economic theory behind DB funding schemes. Cowling et al. (2019) then explore the relationship between investment, funding, and employment agreements to establish the DB funding scheme’s objectives and framework. Lastly, the paper highlights some of the challenges faced in the process of modeling a funding framework and suggests some feasible approaches that can be utilized in developing a DB pension funding framework.
The paper concludes that theoretical evidence in the United Kingdom supports pension scheme funding based on matching assets with a known or predictable stream of cash flow, such as bonds. The authors further conclude that basing minimum funding strategies on budgeting approaches is always susceptible to poor performance during difficult financial times for Pension schemes where the assets and liabilities are poorly matched (Cowling et al., 2019). They recommend that a better minimum funding standard can be achieved when the assets and liabilities are better matched. However, the paper fails to discuss the housing market changes in reflection to the 2008 financial crisis.
Risk management in DB Pension funds
This paper takes a broad scope into western economies such as Netherlands, Germany, the united states, and the United Kingdom, in the quest to determine the driving force of risk management practices at DB pension funds (Franzen, 2010). It starts by illustrating that risk management in the DB pension funds management is derived from developments in modern financial management. The author focuses on the recent changes in regulations and accounting practices governing pension funds and their sponsors to determine the impact occasioned by the changes on the single-employer sponsored DB pension funds. It seeks to contribute towards knowledge creation on financial decision making by analyzing the DB pension risk management aspects.
Franzen (2010) presents a cross-country comparison that shows a comparative analysis of pension management systems. The author found out that the capacity to take risks is central to the management of DB pension funds. Franzen (2010) further discovered that risk management has become more sophisticated; however, the risk is more driven by the regulatory and accounting environment challenges than the specific risk profile of a particular pension scheme. The paper utilized in-depth interviews of pension market players and their advisers to retrieve data for analysis.
The paper concludes that stakeholders have become more risk-aware after surviving the financial storms of the financial crisis. In addition, DB pension funds have adapted modern risk management tools borrowed from other sectors within the financial markets to improve their systems (Franzen, 2010). Also, the author noted that DB pensions learned that painfully in the crisis that risk management does not reduce the risk. Some of the shortfalls pointed out by the study include the fact that there lacks a consensus on the risk needs of pension funds, and the tools used are ill-adapted to meet the needs of pension funds (Franzen, 2010). However, the study does not discuss the impact of the 2008 financial crisis on the housing market. It also focuses on other countries other than the United Kingdom, thus making its scope too wide for this study, which is interested in the United Kingdom only.
Innovative methods of Pension Fund governance
Clark and Urwin (2010) explore the risk posed to pension schemes across the globe by financial crises such as the 2008 global financial crisis. They note that the United Kingdom is of particular interest because many participants of defined contribution pension plans incurred losses while private DB plans closed down. The study seeks to explore ways of mitigating these adverse effects through plan governance, which is identified to have a link with the performance of the fund.
The authors investigate the impact of institutional changes on the governance and the methods of mitigating the impact of institutional and financial environmental changes. The paper further explains that the mitigation measures are taken to adapt to change determined partly by the budget available for governance that entails commitment, expertise, and time (Clark and Urwin, 2010). They found out that the UK governance strategies on pension schemes have been adaptive to the UK corporate governance practices. Specifically, the authors focus on three governance innovations, which include pension buy-out, transformation decision-making, and fiduciary management (Clark and Urwin, 2010). Lastly, they highlight some of the UK best practices of pension governance that can be adapted by institutions facing challenges to deliver their pension promise.
The paper recommends greater transparency in the management of pension schemes by enacting public disclosure of fund activities and characteristics to allow a stakeholder to push for changes when necessary (Clark and Urwin, 2010). The authors recommend the appointment of independent chairs of boards to enhance the effective impartiality in the discharge of decisions. The study further suggests that the management of the pension schemes should surpass the trustee’s knowledge and understanding and enhance the decision-making process by improving trustee competency. Clark and Urwin (2010) conclude that these measures can help enhance pension management despite its composition of a complex web of inter-generational long-term commitments. However, their work fails to discuss the impact of the financial crisis on the housing market and how the impact affects pension schemes.
Research Methodology
Introduction
This paper utilized a literature survey as the preferred method for investigating the impact of the 2008 crisis on DB pension schemes and the housing market in the United Kingdom. Literature was preferred because it offered a mixed research approach investigation and analysis of data collected since data was collected from the various sections of the literature chosen for the survey. It also readily availed both qualitative and quantitative data for the topic under study, thus broadening the scope of understanding the topic. They also provided other critical information such as the prevalent data collection methods, the dominant data analytical tools, and the approaches utilized for concluding the topic under discussion; such information helped eliminate sources of literature that were surveyed.
In addition, the literature survey approach was versatile since it served as a data collection tool and a methodology simultaneously; thus, it availed the advantages of both qualitative and quantitative literature reviews. The survey was a form of a collection of case studies that provided scientific information on the impact of the financial crisis that could be utilized to make scientific conclusions. Lastly, the methodology was cheaper when compared to other data collection methodologies that could guarantee such quality of data that the secondary sources availed. The secondary data was easy to analyze since it was already in a refined form; however, such data has the disadvantage of errors carried forward from the primary data, limiting the accuracy of the study.
Research design
The research survey method has many steps that are implemented for effective retrieval and analysis of data, which, in turn, have further sub-steps in each of the steps, thus making the design framework a meta-framework. The meta-framework entailed seven steps which included the exploration of the topics as the first step, which explored many titles on the subject matter and identified the common academic direction of the topics to align the survey with the dominant academic views; the second step was the initiation of the survey based on the identified topics from step one. The third stage entailed the collection and storing of information from the surveys and organizing it to identify trends and the general thought of the authors. At the fourth stage, information was sorted out for relevance and reliability for making conclusions based on predetermined criteria.
In the fifth step, an allowance was made for the expansion of the study to include input from expert sources on the direction of the survey; the data was compared against other secondary data sources of similar studies to investigate their conformation to theory. The data was then synthesized and analyzed in step using utilizing data analytical tools. Lastly, the data was presented through a compilation of a report that utilized the data presentation tools.
The above steps employed a comprehensive approach to the literature survey since they entailed a multidimensional approach for each step; each step had other mini-steps that accounted for the various dimensions that affected that particular step. The steps were independent of each other and followed no laid down chronological order. As such, the research could move back and forth across steps to enhance the review process and utilize tools from other steps. More so, the steps provided an opportunity to develop new leads for the survey as they occurred; thus, good sources of data were further investigated to seek more data and other closely related data.
The steps were iterative as the need arose since the survey was cyclic; progressing from one step to another and going back to previous steps for refinement of the new data collected; this cyclic nature was essential for the alignment of the study to the objectives and refinement of the data collected. Leads identified in the course of the data refinement cycles were referred to early steps for further investigation to determine whether they met the criteria of admission as data sources.
The literature survey utilized synergies in implementing a holistic approach to the survey by including as much information from many different media of different backgrounds. The approach aimed at developing a comprehensive survey that brought on board ideas from the many different financial sector specialties and academicians. The inclusion of a wide source of information sources widened the survey’s scope beyond the traditional sources of economic reports. Where applicable, the survey utilized the dialectic approach, where it considered intertwining different philosophical ideas to improve the outcome of the analysis. Furthermore, the survey created more synergies by utilizing qualitative data to mine for more quantitative data. In particular, this was important since the qualitative understanding of the concepts paved the way for understanding qualitative data and the analysis that followed. Lastly, the synergy created was enhanced by the balancing of bias sources in the sources by contextualizing them for their audiences.
The literature survey was conducted in phases that grouped the seven-step into three phases for ease of implementation. The first phase was the exploration phase, which entailed the first series of investigative steps of the survey. It was meant to consolidate the research objectives and the topic-specific objectives by exploring the differences and similarities to implement an optimal implementation approach. The phase also entailed the preliminaries of the study by investigating the key terms and principles utilized by professional and academic literature in the business reporting sector. Consequently, the key terms identified were utilized in search of databases with the relevant data that was necessary survey; on the other hand, the key principles were utilized to sort out the databases for the most appropriate sources of information. At the same time, the key terms and principles were utilized as identifiers for storing sources collected and sorted from the databases. The first phase of the study was the longest.
The second phase constituted the interpretation of the data collected from the first phase through the implementation of synthesis and analysis pathways. In this phase, various tools were utilized for evaluations, interpretation, and synthesis of the selected sources and developed meta-inferences. The meta-inferences are derived from the different sources that are processed to develop a coherent conclusion.
The third phase included the compilation and communication of the findings through appropriate presentations, such as reports and graphs. It aimed at making the findings of the literature survey available to other scholars to contribute to the cycle of knowledge creation. The report was compiled in different media to make available on different platforms to reach a wide range of audiences.
References
Banks, J., Crawford, R., Crossley, T. and Emmerson, C., 2012. The effect of the financial crisis on older households in England (No. W12/09). IFS Working Papers.
Clark, G.L. and Urwin, R., 2010. Innovative models of pension fund governance in the context of the global financial crisis. Pensions: An International Journal, 15(1), pp.62-77.
Cowling, C.A., Fisher, H.J., Powe, K.J., Sheth, J.P. and Wright, M.W., 2019. Funding defined benefit pension schemes: An integrated risk management approach. British Actuarial Journal, 24.
Dudley, W.C., 2018. Structural changes in banking after the crisis. Comittee on the Global Financial System, pp.1-125.
Franzen, D., 2010. Managing investment risk in defined benefit pension funds.
Mielcová, E., 2011. Impact of financial crisis on European households. In Conference Proceedings of 13th International Conference on Finance and Banking, Ostrava, Czech Republic, October.
Tower, I. and Impavido, G., 2009. How the financial crisis affects pensions and insurance and why the impacts matter (No. 9-151). International Monetary Fund.
Warshawsky, M.J., 2011. Corporate defined benefit pension plans and the financial crisis: impacts, and sponsor and government reactions.