Why Danes are sub-optimising
Hasse Nilsson looks at the challenges facing Danish plans
Among the few EU-countries having seriously dealt with the issue of a greying population and the concurrent need for a funded, comprehensive pension system, Denmark has come a long way.
From 65 years of age, all Danes are entitled to a minimum state pension plus additional social welfare benefits depending on overall individual income level. Although resting on principles of solidarity, these unfunded benefits are shrinking relative to the second layer of the pension system – The Danish Labour Market Supplementary Scheme (ATP), which is a fully funded mandatory occupational scheme comprising in principle all wage-earners. Introduced in 1963, more than 80% of the entire population are members of ATP. Contributions from employers (one third) and employees (two thirds) are fixed amounts per employee, regulated by parliamentary decisions. In 1998, Parliament consented to a mandatory additional annual contribution of 1% of annual gross income for all wage earners. The objective being to enhance the overall level of retirement benefits, but most importantly – to satisfy a need for fiscal tightening.
Combined, the state pension and ATP provides for an average annual retirement benefit of between d10,000 and d15,000.
The third level of the system comprises mandatory occupational retirement and disability arrangements through a large number of cross-industry pension funds, labour market pension funds and schemes with pension insurance groups. Roughly 90% of Danish wage-earners are covered by these fully funded schemes, with contributions varying from 4 to 20% of salaries. The labour market pension schemes represent the lower end of annual contributions, due to their recent establishment (1991). Contribution levels are, however successively being increased as an integrated element of periodic collective bargaining, stipulating an overall contribution level of between 15 and 20% of salaries by year 2010.
The Danish system is topped by individual schemes through banks and insurance companies. Tax incentives have however been reduced substantially over the past decade as a Parliamentary majority has favoured mandatory streamlining of retirement benefits!
All funded schemes carry a guaranteed rate of return on premium reserves of between 2% and 4%, and at present most pension funds are overfunded with free reserve levels ranging between 20% and 35% of liabilities, partly reflecting liberalised placing rules, international diversification of assets and buoyant capital markets throughout most of the past decade.
In summary, the vast majority of Danes can look comfortably forward to their otium, obtaining annual retirement benefit levels between 60 and 70% of their respective final salary levels.
So what possible challenges could be facing Danish pension funds? Although most pension funds seem to have a pretty fair idea about the structure of their assets and liabilities, only a few institutions have developed and maintained a structured and disciplined approach involving true risk and sensitivity analysis. In other words, they are sub-optimising.
The use of readily available technology tools and data in terms of asset-liability and asset allocation models is modest, compared to Anglo-American as well as Dutch institutions, who generally maintain a far deeper perception of their clearly defined risk profile – a crucial factor to the asset allocation optimisation process.
Technology and data also plays a vital role in the analysis and inclusion of appropriate asset categories in the asset mix. Although Danish funds have gone through a process of asset diversification over the past decade, alternative investments, emerging market investments, international property, private equity, hedge funds, commodities and so on, are rarely included, partly due to lack of technology tools to collect and analyse information in the context of professional asset allocation studies.
Similarly, Anglo-American funds are further up the learning-curve in the use of advanced technology and data, when monitoring investments over time. Advanced performance measurement and comparative analysis from a total fund perspective, are less widespread among Danish pension funds.
This also includes the way external managers are selected and monitored. The more systematic approach experienced in the US and the UK, often coached by consultants, is a rare case in Denmark, where a combination of acceptable performance and a set of soft values are preferable to for instance “optimal preparation”, “appropriate universe definition” and “stringent performance selection criteria”.
Although most institutions tend to agree on the overall objective of their pension funds - to maximise asset returns net of costs given a well-defined risk profile based upon the structure of liabilities, reserve position and legislative regulations and conditions, it is noteworthy that cost issues in a broad sense do not attract more attention. Especially costs associated with the management of assets are often not well analysed and compared with foreign colleague organisations. Similarly with the pros and cons of external management versus internal management, not to omit custody fees and trading costs.
There are several reasons for the abovementioned distinctions. Firstly, one should never underestimate time-lags of replication. It does take time to ‘reinvent the wheel’. Secondly, Danish pension funds are typically not corporate sponsored pension schemes as in the US and the UK, where the sponsor is extremely focused on cost-effectiveness and accordingly emphasises financial control and close monitoring, including a high degree of out-sourcing. Trustee boards of cross-industry and labour market pension funds in Denmark are elected from member organisations rather than recruited from corporate management, and are accordingly relatively less experienced in asset management issues.
Thirdly, nor are Danish pension funds exposed to competition, although certain comparisons of results are publicised. Innovation and costcutting are accordingly not imminent.
Conventions also makes Danish pension boards far less receptive to consultants than their colleagues overseas, consequently prolonging the information gap.
Furthermore, the set of regulations monitoring the pension sector do not contain virtual incentives to optimise asset allocations and cost-effectiveness, but reflect primarily ‘minimum requirements’ in terms of solvency margins, reserves etc.
Finally, the Danish tradition for taxing everything possible, positioning Denmark as a clear number 1 in terms of overall tax burden among the western countries, has not made life easier for the Danish pension fund sector. Tax rules are changed regularly – tightened, necessitating reallocation of assets. Since 1998, returns on equity holdings are being taxed by 5% on a mark to market basis, just as returns on interest bearing instruments are taxed by roughly 28%, also on a mark to market basis. In addition, Danish pension funds are effectively prevented from exploiting the international market for pooled investment vehicles, because of tax discrimination. It would be welcomed, should the Danish Parliament decide to put pension tax legislation into a European perspective.
Given the present political aim in securing almost identical retirement benefits to all Danish wage-earners on a fully funded basis, and given the fact that this is already a reality for especially the group of small and medium-sized individual academic pension funds, for example, lawyers and economists, engineers, agronomists, medical doctors , architects for example, there should be strong arguments – economies of scale - for a concentration towards fewer pension funds. Total assets of this ‘group of seven funds’ are around l15bn, which at present are administered and managed individually with varying degrees of out-sourcing, despite rather similar liability structures and so on.
The advantages of amalgamation are obvious, although actuaries, investment executives and trustee board members are likely to produce a long list of counter-arguments:
p Streamlining of benefit structure.
p Advanced analysis and management of assets using sophisticated technology.
p More attractive working environment for the hiring of skilled staff.
p Professional boards.
p Stronger bargaining position versus external managers, securities trading companies, custodian banks and authorities (national and international regulators).
The ultimate result will be better returns to existing and future retirees, net of costs.
A number of issues to be addressed by most pension funds, and maybe even more by Scandinavian/Danish pension funds, are issues related to corporate governance and social responsibility. Codes for a holistic approach are becoming topical alongside initiatives for a new political agenda.
Hasse Nilsson is chairman of Alcifor Advisory Associates in Denmark