Lessons from the financial crisis

Peter De Proft, director general of The European Funds and Asset Management Association (EFAMA), asks what the events of 2008 signify for pensions?

Some argue the financial crisis may be the hardest since the 1930s. With its origins in the subprime mortgage market segment, the effects are starting to suffocate the real economy. Pensions financed through employer contributions, individual savings and public expenditure are caught in the eye of the storm.

The implications on the future of pensions are wide. A number of challenges face stakeholders, fraught with tough choices involving important trade-offs that need to be considered by governments, individuals and the EU. In essence, they are between short-term concerns and long-term benefits, as well as between risk and return. Although it is too early to draw final lessons from the crisis, a number of ideas on how to respond, and preserve the delicate balance between choices to be made, are purely common sense.

The crisis has increased pressure on already strained public finances. The cost of state-backed responses is enormous in relation to GDP, further limiting the possibility that member states can cope with the projected increase in public pension and health care spending resulting from ageing populations. There will be a need to contain the rising costs and the generosity of the public pension systems will be curtailed.

To limit the potentially dramatic consequences on retirement incomes and social cohesion, governments must encourage households to increase their participation and contribution levels in pension schemes. In addition to tax incentives, a variety of measures can stimulate individuals to join pension plans, such as automatic enrolment, increased flexibility of pension products, clear information on the expected amount of public pensions as well as adequate financial education and advice.

The risk factor
Individuals must not underestimate the consequences of demographic change on public pensions and should allocate a larger proportion of their income to retirement saving. Another useful measure is more pension savings products that span a wide risk-return spectrum and address different risk appetites. Whilst risk-averse individuals may consider it worth reducing or even eliminating the investment risk, others may prefer to accept some risk for higher average returns.

Asset managers are instrumental in developing cost-effective investment solutions. As for the sharp losses endured by stock markets, simulations, based on historical return characteristics, show that holding at least some equity in the asset accumulation phase can have a positive impact on retirement wealth for the majority of participants in pension schemes, i.e. the loss potential is very limited when the accumulation horizon is long. This provides individuals with a strong incentive to start saving for retirement early in their careers.

In an integrated market, the European Commission also has an important role strengthening pensions and reducing their vulnerability to financial crises. Building upon its objective of creating a single European market for financial services in general, and the IORP Directive in particular, the Commission should set out to create a regulatory framework for pan-European pension products. This would boost pension savings by reaping the advantages of increased competition and economies of scale, while fostering job mobility and economic growth across Europe.

In 2005 EFAMA developed the European Personal Pension Account concept, which can embody all the ideal characteristics of a pension solution in terms of portability, flexibility, security, transparency and efficiency EFAMA will present an updated version of its proposal in 2009 with a view to stimulating further the debate on the future of European pensions. For more information, see EFAMA 2008: Defined contribtion pension schemes – Risks and advantages for occupational retirement at www.efama.org

WRITTEN BY PETER DE PROFT, DIRECTOR GENERAL EFAMA