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Thursday 16 August 2018

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EFAMA backs life-cycle default for PEPP following academic study

Written by Natalie Tuck
12/02/18

The European Fund and Asset Management Association (EFAMA) has backed the use of a life-cycling default option for the Pan-European Personal Pension Product (PEPP), following an academic study by the SDA Bocconi School of Management.

The study, commissioned by EFAMA, asked the school to consider consumer protection and the design of the default option of a PEPP. The Association believes the results are a useful academic contribution to the debate on whether the PEPP should offer a default investment option with a financial guarantee, or whether the default option can rely on a life-cycling technique, consisting of reducing the proportion of risky assets in the PEPP portfolio as retirement approaches.

The school concluded that the inclusion of life-cycle investment strategies as a default option in the PEPP is economically desirable for consumers, who would benefit from superior returns and comparatively low risk compared with bonds, over a long investment horizon. The study also illustrated the advantages of life-cycle investment solutions in terms of risk mitigation and performance enhancement.

Commenting, SDA Bocconi School of Management professor Claudio Tebaldi said: “Research in the emerging field of household finance has led to the emergence of a new way of approaching consumer financial regulation, which has important implications for the regulation of financial products. Our study, which belongs to this area of research, aims at contributing to the current debate on the type of default option that should offered by a pan-European Personal Pension Product.

“More explicitly, our paper has two main goals: i) to offer a guide on how to improve policymakers’ understanding of household retirement saving behavior and ii) to provide an illustration of the important advantages that life-cycle investment solutions may offer in terms of risk mitigation and performance enhancement.”

The study conducted a series of simulations based on historical returns data for the period 1969-2012, which was marked by the two oil shocks, and increasing and decreasing interest rates and inflation rates, and for the period 1992-2012, characterized by falling interest rates and inflation rates. The first period is referred to as the “old normal” and the second as the “new normal”.

The results presented evidence of the robust level of capital protection offered by life-cycle strategies. Under the “old normal”, the majority of savers in a life-cycle strategy can expect a real rate of return greater than 5.9 per cent over a 40-year accumulation period, compared to only 3.3 per cent in a product with a guarantee.

Under the “new normal”, the majority of savers in a life-cycle strategy can expect a real rate of return greater than 5.1 per cent, compared to only 1.2 per cent in a product with a guarantee. Shortening the length of the accumulation period does not alter the results significantly. By way of illustration, under the new normal scenario, the real return of the guaranteed strategy reaches 1.4 per cent in 50 per cent of the cases, compared to 5.8 per cent for life-cycle strategies.

In addition, the study found that life-cycle strategies ensure that 99.9 per cent of the savers end up with an accumulated pension wealth greater than the inflation-adjusted capital invested, under both a 40- and 20-year accumulation period.

The study also clearly demonstrates that the emergence of the “new normal” economic and financial landscape after the global financial crisis, coupled with the Solvency II constraints, has had a significantly adverse impact on the returns offered by life-insurance products offering a financial guarantee.

EFAMA president William Nott said the Bocconi study confirms that life-cycle investment strategies are a “powerful tool” for delivering high real rates of return and managing risks, not just investment risk but also inflation risk. “We strongly believe that these strategies should qualify as a default option for the PEPP.”

In addition, EFAMA director general Peter De Proft said: “We hope policymakers look both at the net return offered by life-cycle strategies, and at the return loss caused by a financial guarantee over a long investment period. The potential of the PEPP in reducing the pension gap lies in its ability to generate return and retirement wealth; life-strategies are able to strike the right balance between return generation and capital protection”.



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