Mutuals to the fore
The enormous potential the European Federation of Investment Funds sees for mutual funds in pension provision is outlined by Adam Lessing
The problems of the European state pension systems have, in the past 10 years, reached alarming proportions. In response to the perceived risk of unsustainable public deficit levels needed to finance state-run schemes, both the European Union and the individual European states have started to take action.
After initial reforms of state pension systems aiming essentially at a reduction of payments, the global trend is now towards new, funded, supplementary pension systems to offer a partial replacement for the necessary current and future benefit reductions in the public systems. There is, as yet, no unified solution and, specifically, no Europe-wide supplementary pension scheme.
For the European mutual fund in-dustry the topic is of major importance. Vast sums of money, equivalent to a multiple of the current total assets under management in the industry, will be invested in new funded schemes. For the industry as whole, the question is whether the European fund industry will be able to follow a US-style development, where retirement accounts are the major growth engine for mutual funds, or whether these funds will pass the industry by.
On a Europe-wide level, the policy issue now confronting the EU and the various European states is evident. Among the several possible choices for pensions systems, a policy choice has to be made.
On an individual country level the issue is still the choice of an optimal, additional supplementary pension system. The current problems of the first (and of existing second) pillar systems suggest that a new system should have:
q portability, and
q risk/return flexibility
The recommendation for transfer neutrality" is based on the roots of the current crisis. The pension crisis evidences the limits of the state's ability to effect intra- or inter-generational transfers. In terms of structure for a new pension system, this condition of transfer neutrality eliminates pay-as-you-go systems since PAYG systems have as a necessary effect a direct intergenerational transfer. A new system must be a funded system and indeed there is wide consensus in all countries that new systems be established on the basis of funding only.
Another major recommendation for new supplementary pension systems is "portability". The argument for portability is based both on changing employment patterns, which require employees to be able to change in and out of jobs or even employment without losing their pension rights. Portability also reflects the EU's concerns about the restrictive effect of supplemental pension systems on the free movement of persons within the union. We believe that portability can easiest and best be achieved through "ownership". Once the pensioner owns the fund which he accumulates for his pension, his transfer into a new job or another European country no longer jeopardises his future retirement benefits. While similar effects can be achieved through individualised accounts in pension funds, this is a highly complex way of achieving an inferior result.
Ownership at the same time allows the EU's concerns about security to be addressed since - there being no in-stitutional holder of the assets - the security risk is reduced to a custodian risk. It also in effect solves the security issue of information since, once individual ownership is achieved, checking the value of accumulated funds is unproblematic.
A side effect of full ownership is, however, the need for the system to be a defined contribution (DC) system. While this is fully in conformity with the current trend across Europe, where more and more occupational plans are moving to DC, this conflicts with another stated goal of the Commission, the desire for solidarity.
Lastly, the recommendation is for the new system to allow flexibility in the risk-return structure. Under the assumption that the system must be a DC system, the insured must have a choice in terms of risk-return structure and to be able to adapt the risk-return structure to his changing circumstances.
The recommendation of a funded, DC, ownership-based system with full risk-return flexibility leads to a system based on individual ownership of mutual funds as the basis for future retirement income. The models that can be used for such a structure are of two basic types: models akin to the US 401(k) and Individual Retirement Account (IRA) structure and models based on the German Pension Mutual Fund (Pensions-Sondervermögen - see boxes).
A number of continental European countries, such as Germany, have very little or no experience in widespread individual investment in risky assets. A pure IRA or even 401(k) model, al-lowing full freedom of asset allocation would most likely be considered too risky by governments. If implement-ed, it would most likely lead to over-conservative and thus under-performing investment as evidenced by current investment patterns. For countries with such an investment pattern, a model which proves a more "paternalistic structure", such as the German fund with its preset investment limits and the responsibility for the overall asset allocation with a fund manager might prove to be better adapted. For countries such as the UK, with a long history of individual equity investment, more open models such as the 401(k) might prove more adequate.
Based on currently issued documents, it can be assumed that the EU has abandoned the idea of a single, Europe-wide supplemental pension plan. Accordingly, the focus must be on the co-ordination of the newly established domestic supplemental plans in such a way as not to impede the freedoms of capital movement, free movement of persons and of provision of services within the EU.
To this end, the major necessary development on the EU level would be a system of co-ordination of cross- border transfers of supplemental pension rights. Such an approach could be modeled on the existing regulation 1408/71 and lead to a catalogue of mutually recognised supplemental pension schemes. For such "recognised schemes" payments into the system and from the system could be subjected in each case to national treatment. Tax effects could be harmonised along the lines of existing OECD model treaties on double taxation operating on the double system of tax refunds or tax allowance.
As a result of such a system, individual European systems could be set up to include notonly nationals but also foreign (Euopean) retirement in-vestors. This would lead ultimately to both performance competition and economies of scale necessary to lead the European mutual fund industry into the 21st century. The next five years will be crucial for the European mutual fund industry. The potential market for mutual funds in the area of pension provision dwarfs the current total mutual fund market. In Germany, for example, the largest potential market for pension funding assets in Europe, the total market of DM703bn ($397bn) mutual funds compares with DM8,500bn, estimated funding needs for pension reserves. For Europe, the same relationship holds, with total current mutual funds at $1,400bn and total unfunded pension liabilities at about $15,000bn.
While it is clear that total funding of the European pension fund liabilities is not currently an option and that even partial funding can only be carried out over a substantial period of time, the sheer potential total market size makes any move in this area of huge significance for the industry. A recent study by a US investment bank estimated the total money flows into the European equity market at over $140bn yearly. Like the impact of retirement plans on the US mutual fund industry, retirement provision could become the major source of funds for the mutual funds industry in the next century.
Adam Lessing is vice president of the European Federation of Investment Funds (FEFSI) and managing director of Oesterreichische Investmentgesellschaft in Vienna. This article is based on an address to the FEFSI meeting held in London last month"