Structural improvements

Every industry goes through periods of intense navel gazing and internal scrutiny. Across Europe, pension providers are currently going through such a phase.

Franklin Templeton investments director of performance analysis and investment risk Wylie Tollette says: “Almost every pension provider in Europe that we’ve spoken to is currently engaged in some form of re-examination of the design of the scheme as a result of the financial crisis.”

The impact of the financial crisis depends on the country’s location. There is a clear delineation between the pensions industry in the north and the south of Europe: southern European countries are still heavily reliant on the state to provide pensions while in the north pensions tend to be more heavily balanced towards employer sponsored provision.
Government bond yields in northern European countries have fallen to historically low levels while those in the south are at high levels reflecting investor nervousness about the scale of sovereign debt and the strength of their economies.

Some northern European countries, such as Denmark, operate defined contributions schemes with funds that offered a guaranteed annual return. But as bond yields have fallen in recent years so to have the guarantees.

AllianceBernstein head of UK DC investments David Hutchins says: “As the gap between the guaranteed return and the yield on bonds has narrowed, it made it harder and harder to generate any returns as a higher proportion of the portfolio has to be locked up in fixed income investments.”

As a result, these guaranteed return funds have fallen out of favour. In Denmark, as in other countries in Europe, there has been a move towards lifecycle or lifestyle products.
These products invest in higher risk financial products when investors are younger and gradually shift across to bonds as the member approaches retirement. This approach allows younger scheme members to gain the benefit of higher returning assets like equities and then lock in these gains by transferring across to fixed income products as they get older.

There is considerable debate within the industry about the best approach to take to these products. Many of these funds can take a very mechanistic approach to the transfer of assets and simply buy fixed income assets when a certain age is reached without taking any account of the current market conditions.

The latest generation of these types of products are called target date funds and give an active manager some discretion about when to buy and sell different assets to make the most of market movements.

In other parts of northern Europe, however, a different form of defined contribution scheme is more prevalent. In the Netherlands, for example, collective defined contributions are the norm.

In these funds, the employer pays in a fixed amount of money and the scheme member is given a pension promise but that promise is con-strained by the money in the fund.
Hutchins says: “This system is similar to a with-profits fund. The risk is shared collectively among the group with money effectively transferred around the group, with younger members often transferring money to older members.”

But collective DC schemes have run into problems recently, with some Dutch funds recently cutting pension payments by 10 per cent.

Pitmans Trustees managing director Richard Butcher says: “Collective DC schemes work where there is a constant stream of young members joining the scheme. But the current demographic trend in Europe is that there is a dwindling supply of young workers while the elderly proportion of the population continues to grow.”

Hutchins agrees: “The opaque nature of the Dutch collective system may not be sustainable. I think there is a strong possibility we will see this country move towards a more transparent and hence traditional DC system.”

Exactly what shape the European DC scheme of the future will look like is still hard to predict, but there are deep flaws with the current system.

Butcher says: “The current conventional system is akin to driving while looking at the pedals rather than looking at the road. There’s too much focus on how what level of contributions should be paid rather than what outcome the scheme member wants.”

Butcher is in favour of a managed DC model: “Rather than focusing on what contributions should be paid in, scheme members should be asked three simple questions: ‘When do they want to retire? What income do they want? What margin of error are they prepared to accept?’”

Using the answers to those questions and a stochastic model, it would be relatively simple to produce the right type of investment portfolio to ensure the best probability of achieving their goals.

While it’s important to design the right investment strategy, building the retirement pot is only one part of the equation: this then has to be used in the most efficient manner to provide a retirement income.

The traditional use of the retirement pot in a standard DC scheme is to use it to buy an annuity to provide a life-long retirement income. The current low interest rate environment, however, makes annuities very expensive and many pensioners are reluctant to invest in an annuity.

Mercer global DC leader Fergal McGuinness says: “Over time the traditional idea of buying an annuity will fade from view. People will need to use their nest egg in a more flexible way where large expenses in retirement years such as longer term health care needs are paid more by the individual.”

Hutchins concurs: “People want to have some control over their money; they do not simply want to hand it all over to an insurance company.”

But Hutchins does point out that an annuity does have some very obvious benefits: “It will provide you with an income until you die. It shifts the longevity risk away from the scheme member onto the insurance company. And from a government’s perspective, it stops those who retire from burning through all their cash too quickly and ending up as the state’s responsibility.”

Rather than getting rid of annuities altogether, it would make more sense for retirees to simply buy them a little later on, at around the age of 75.

Nilsson concurs: “Retirement flow in the future will be different. People are more likely to work at a reduced rate and need a small supplemental income. Then they will move towards full retirement later on. There is a lot of sense in not buying an annuity early on in your retirement.”

There is a need for standardised but more flexible solutions. The price of the annuity falls significantly when bought as a deferred annuity at retirement with effect from, for example, 75. This creates the need for other solutions up to that age that combine certainty of income with flexibility and value for money, says Nilsson.

It will be very important for employees to keep a very close eye on these developments. McGuinness says: “I think the future of Europe will increasingly be related to individual savings with DC plans a central part of that. The reality is that individuals will have to deal with retirement related risks themselves in the future so the evolution of DC schemes and savings plans is extremely important to the wellbeing of the future retirees of Europe.”

Over time, the difference between northern and southern Europe could disappear; there is already pressure for reform as part of the Troika negotiations.

“Social security systems are being scaled back in the wake of the crisis to an affordable level. DC schemes have been operating in Spain for many years. The Portuguese have a small but rapidly growing DC market. This is encouraging as national regulators and the population at large will have the relevant experience and understanding of the systems should they be used more in the future, which is likely,” says McGuinness.

At first glance, the European pensions industry seems bewilderingly complex with its plethora of different systems and regulatory environments. But all countries face the same problem: an ageing population and a need to use the available cash more effectively. Every country may be coming from a different place but it’s increasingly likely they will converge on a similar solution.

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