Risk management across Europe
Written by Paul Bonser and Matt Wilmington
Nov / Dec 2009
The "holy grail" of European pensions is becoming a practical reality after
years of dreams and false starts. It is now possible to include local employees working in any of the 30 European Economic Area (EEA) countries in a funded pension vehicle that is established in another EEA country of preference. For plan sponsors and their schemes, this all leads to creating a new dimension in innovative financing and risk management solutions.
At the last count, there were 76 registered cross-border pension funds located in seven EEA countries and covering employees in over 20 other EEA countries. While many of these contain small groups of often internationally mobile employees, the number is set to increase in the coming months as several multinationals launch new pan-European pension plans targeting local populations in multiple countries providing both defined benefit (DB) and defined contribution (DC) pensions.
Insurers and financial service providers are also entering the cross-border market as demand increases. Barriers to establishing pan-European plans are more "perceived" rather than real, and so far none have proved insurmountable. The key to successful cross-border plan implementation lies in effective communication with stakeholders.
In contrast to asset-pooling, pan- European pension plans offer the possibility to pool liabilities as well as assets in one vehicle and enables companies to manage cross-border pension risk effectively.
Pension Risk: safety in numbers?
Pension risk can be a strange creature, and one which has generally been considered in individual country silos.
No doubt this is partly as a result of local pensions accounting disclosures - for example, why would the finance director of a Dutch subsidiary be concerned with the risk in the Greek pension plan, when his bonus is entirely dependent on the Dutch profit & loss figures? It is also partly due to a lack of opportunity for genuinely pooling risk. We hope pan-European plans will help provide the opportunities which have been hard to come by
Risk management on a cross border scale
However, we are seeing increasing numbers of the most advanced multinationals beginning to look at pension risk and its management on a global basis - and reaping the rewards from doing so with a much more streamlined, integrated and efficient risk management process.
This is partly a reflection on the greater degree of centralisation apparent at corporate level, but also a realisation that opportunities may be being missed by managing risk on a country by country basis.
Understanding the ways interest rates, equity returns, inflation figures and other risk factors interact cross-border and how they apply differently to plans in different countries due to local market practice or legislative rules, is critical to this efficiency in risk management. The economies of scale and natural hedges (imagine the Dutch plan buying a pound to euro hedge at the same time as the UK plan is buying the opposite..) which become apparent when considering risk cross-border, are allowing leading multinationals to get more risk management "bang" for their ever more precious "buck".
Finally, in taking a high level and global view, opportunities to take advantage of regulatory arbitrage present themselves; employers can enjoy the benefits of taking risks where the reward is justified and available and avoid taking risk where the downside is severe or the upside is enjoyed elsewhere. Why would I take investment risk in the UK when the upside is generally enjoyed by the members and the downside borne by the employer when I could have a more symmetrical risk profile by taking the same risk in Germany?
Pan-Euro to the rescue..So how can a pan-European plan help? In short, many of the benefits of managing asset and liability risk on a cross-border basis come as standard; efficient risk management by default is a happy by-product of implementing a single vehicle covering a number of DB and DC members across the region.
We must recognise that a certain level of risk taking will be essential so that employers can afford the promises they have already built up. As we set out earlier, a key influencer on the type and structure of that risk will be the regulatory environment in which it is taken. A pan-European plan will, in effect, allow an employer to choose the most appropriate funding and investment regime for its particular circumstances.
Whichever regime is chosen to host the plan, by operating a pan-European plan rather than a series of individual plans, the risk reducing diversification benefits (as a result of assets held in many jurisdictions and liabilities measured relative to different markets) become consolidated into a risk measurement framework. This ensures that risk management can be carried out much more easily in the interests of the plans as a whole - and time, effort and money is not wasted in competing strategies. Not only will wasted strategies be eliminated, but whole new strategies can suddenly become affordable where once they were way beyond the budget of some of the smaller countries as they are applied across the whole region.
Access not only to simple economies of scale, but also to products which may be ordinarily out of reach in many jurisdictions can be provided in the pan-European environment. Longevity - a risk with very little upside for employers wherever they are based - being a case in point. We have already seen the first longevity hedge announced in the UK, with many more sure to follow. Providers are already looking to expand their range into countries such as the Netherlands, Switzerland and Germany where it is only a matter of time before transactions become commonplace in these locations too. The real prize, for both employers and providers, will be access to longevity hedging right across Europe: employers will have the ability to reduce their exposure at a sensible cost, providers will have access to a much more diverse population - reducing their risk, and hence cost of their products. Even without such products, a larger and more diverse plan population can go some distance to eliminating many of the uncontrollable demographic risks faced by plan sponsors right across the region.
In addition, having the pension assets and liabilities together in one place makes it much easier to manage investment risk by defining and implementing holistic Europe-wide investment strategies which can then be expanded more easily into effective global investment and custody strategies.
Along with the other benefits of managing and operating defined benefit liabilities on a European basis we see significant opportunities for employers to add pan-European to their risk management toolbox. Some small defined benefit pan-European plans already exist, and we expect the number to increase in the very near future. As market practice develops and more multinationals start to reap the benefits of establishing pan-European plans, the CFOs of Europe's multinationals will begin to realise the real possibilities on offer for coordinated cross-border risk management.
Written by Paul Bonser and Matt Wilmington, senior
consultants in Hewitt's International Benefits Practice