ARCHITECTS OF THE MILLENNIUM
We interview key figures at some of the leading pension schemes which have been instrumental in bringing the funded pensions industry forward in Europe. A number of these funds are recent, while others are long established, but all can be regarded as part of the foundation of pension funding in their own countries and the inspiration for others determined to go the same route, so truly they are among the architects of the European pensions industry as it heads into the new millennium. Hugh Wheelan discusses their aspirations and concerns.
“For investment, there is only one trend really – the Anglo-Saxon way”
Jean Frijns, chief investment officer at Dfl300bn (e136bn) Dutch civil servants’ pension fund ABP, says the major debate facing the fund in the millennium is what the future structure will be in the light of the possibility in 2001 that employers can opt out of the present centralised system.
“As a huge fund with a large diversity of sponsors from central to local government, universities and individual schools, there is both a great willingness to continue with the common scheme, but on the other hand from the side of the employers there is also considerable interest in individual top-up schemes and greater differentiation. Younger employees, in a move which is quite understandable, are also looking for more individual choice in their retirement provision and seeking to put part of their contributions into a defined contribution arrangement. At the moment it is far from clear in which direction and at what speed these developments will continue. Certainly the biggest challenge for all funds is how to accommodate these changes.”
Frijns says he believes ABP will stay together as one big fund on the basis of a common scheme with top-up funds brought in for separate employers. “We could go either way from there though. These could be separate funds managed by ABP, which is probably the most likely outcome, or the assets could be managed as one big fund. It will either be one fund/multi-scheme, or multi schemes managed by one fund.”
In the Dutch market Frijns says both the country’s industry-wide and corporate pension schemes face their own challenges. “Industry-wide schemes will have to prove their added value in the coming years, and for the company schemes the challenge will be whether they are big enough to manage their assets in-house or to have to outsource to investment managers.”
Frijns adds that in the Netherlands these are by no means theoretical issues either, noting that the strength of the competition from the country’s banks and insurers for the pensions business is “huge”.
He also points out that the STAR agreement in the Netherlands tends to make industry-wide scheme managers overly cautious in their investment. “You could wonder whether this is in the best interest of the participants. The additional danger, of course, is that if a fund does not meet its STAR criteria it can be split up. Any employer within the fund can pull the trigger here even if the other employers don’t like it. Therefore, any industry-wide pension fund is confronted with event risk. There would seem to be less risk, but in effect there could be more.”
Frijns says he is still struck by the enormous differences between pension schemes and investment styles around Europe. “For the future I still see the dominance of DB schemes in the UK and the Netherlands, perhaps in combination with more DC as well. In the rest of Europe, although I see more pension schemes and a lot of growth, I believe it will mostly be on a DC basis. For investment, there is only one trend really – the Anglo-Saxon way. It may take more time in Germany than in the Netherlands, but in the end it will prevail.”
Frijns does not believe that such changes can be forced through by the European Commission in Brussels though. “Change must be brought about in individual countries. The big multinational companies will play a much more important role in this than politics.”
‘Competition is healthy but, like a vitamin, you shouldn’t take too much’
Karel Stroobants, deputy general manager at the e445m Brussels-based VKG pension fund for doctors and dentists, believes that for all European pension funds the main millennial challenge will be to put in place the right asset allocation strategy in the low yield environment which he thinks Europe may be heading for.
“Low yield is nothing if it is higher than the minimum acceptable return rate. We think that will be OK, but there is always the danger of what I call the ‘Japanese scenario’ which is a long low yield period lower than the minimum acceptable return rate.
Stroobants sees a second challenge for the fund in the fact that schemes are now working in a more competitive environment. “We are gradually moving towards the competition factor that exists between pension funds in the second pillar of the Dutch pensions system. If a fund is not performing well the employee will be able to take his money elsewhere.”
He warns against the principle being pushed too far though. “We have to get used to this idea within the second pillar – keeping the essential solidarity element but looking more towards competition aspects. Some competition is healthy, but we must remember that, like a vitamin, you shouldn’t take too much.”
For Belgium, Stroobants sees the main issue as a push for progress in terms of overall market professionalisation such as asset liability management. “We should not be just looking towards withholding taxes and the previous Belgian approach of going through Belgian banks and mutual funds for investment. Professionalisation is the mission we should try to keep up with.”
Secondly, he points out that Belgium will soon see industry-wide pension funds in the pensions arena once the royal decree is finally published. “This is a good thing but it is also tied in with the DB/DC debate for Belgium and the European market as a whole,” says Stroobants. “It is easy to go DC and of course there is no risk for the employer, but we have to pose the question whether this is just like third pillar schemes? What is the identity of second pillar plans and what is the added value?
“ An employer can choose mutual funds to invest in. They are professional partners which can talk with the banks providing mutual funds. But where is the word ‘solidarity’ in all this? Do we want to put all the financial risks on the shoulders of individuals - do we know what we are doing here? Do the public know what we are doing here, and who accepts all the consequences?”
Discussion is taking place on these issues between the Belgian government and unions. Stroobants says he sees long-term problems on the horizon should DC become the vehicle of choice for the future. “At the moment with performance levels of 15% per annum the DC arguments is good, but if we do this for low income workers it is dangerous.”
The Belgian authorities are also considering personal income tax on contributions to pensions and mutual funds, with study work to begin in the first quarter of 2000. For Europe, Stroobants believes the overriding issue is the decision to be taken by the European Commission.
“I am optimistic that something positive will come out this year and I believe some of the suggestions in the De Ryck report such as viewing the pension fund as a going concern and the introduction of a flexible minimum funding requirement depending on a scheme’s asset/liability profile will be introduced. I don’t see any great dangers ahead, although I am not optimistic on the issue of tax harmonisation with in the EC. The thing we should hope for the most is a minimum amount of interference on pensions from the commission side.”
“Our constituents have no experience of losing money – it is a question of education”
Santiago Fernandez, chief executive at the e3.4bn Madrid-based Fonditel pension scheme for telecommunications workers says most of the challenges for the scheme approaching the millennium are internal. “We have pretty much completed the Europeanisation of the fund, having set ourselves Euro-zone for the geographical benchmark.”
He notes that the approach has paid off quite handsomely so far. “Of course we can’t be sure what the markets will bring next year. However, we know that statistically one of these years we are bound to have negative returns, which is foreign to our experience so far as a young pension plan.
“ We know what the markets might do and that we are vulnerable.”
Fernandez says the fund is diversified to a satisfactory degree and that it is fairly conservative in terms of our exposure to riskier asset classes. “Because we have set ourselves lower and upper investment limits we tend to be slightly below average in our equity and duration exposure. That doesn’t mean – as recent months have proven, that you can possibly be out of risky assets, because when they perform they are up 15%. Because we are a DC plan and our constituents have basically no experience of losing money, we know the experience will be bad. It will be rather like children discovering there is no Father Christmas. It will be a question of education.”
The fund is invested at a level of 35% equities, 65% bonds with 70% in Eurozone currency and up to 30% non-Euro-zone currency. The equity split is 75% euro-zone, with the remainder predominantly US and UK and small plays on Japan and emerging markets – carried out predominantly on a bottom-up basis rather than any country or market allocation.
In Spain, Fernandez says, the last gasp of legislation in terms of the long debated externalisation of pension liabilities has now been seen. “It is a bit of a boring issue because it has been discussed for ages, but in fact the basic problem remains. How do you actually get second pillar occupational pension schemes running when no-one seems to have an interest in setting up pension plans? Older companies and the privatised former state entities do have schemes but there is no thrust to do anything in companies which are less than 15 years old.”
Fernandez believes this denotes a fundamental flaw in the legislation which he doesn’t see changing because the government is no longer talking about pensions. “Remember, if you are thinking about the generous Spanish state pension system, it is debateable whether it is worth the average Spanish worker contributing to a pension plan. Only higher income employees might want to do so, which means pension funds are still very much the exception.”
On the European level he adds that the resignation of the Commission this year put all the supplementary pensions initiatives brought forward by Mario Monti to one side. “I am afraid we are back to square one on the issue. I think we may make some progress on the prudent person investment rule and on some kind of level playing field for investment in Europe. However, I think this may remain within government offices and in academic circles rather than become concrete pieces of legislation or have money actually committed towards it. I’m not particluarly optimistic about the future though.”
Fernadez sees no major landslide changes ahead in terms of issues like the DB/DC debate in Europe. “In reality almost the totality of new pension schemes being set up are DC, but on the other hand the majority of the large UK and Dutch DB schemes are performing very well.”
He believes the crux of the question may not be how a scheme is set up, but whether DB schemes heve been benefitting from the exceptional returns of the last two years. And he sees the main future challenges as greater pension fund input on social and corporate questions.
“I’m not sure whether I am seeing it yet, or whether I just want to see it – but I think I would like to see some change in continental Europe on the issues of socially responsible investment, shareholder value and the possible participation of large pension funds in company boardrooms. It is not a linear change at the moment, but I do think the debate is heating up. When it erupts it is bound to bring about great change.”
“Getting politicians to understand that less is more will be the real problem”
Bengt Edström, pensions manager at the Skr4bn (e425m) pension fund of Swedish energy giant Vattenfall is succint about the challenges facing the recently created fund in the new millennium: “To get in to the market and still manage risk!”, he exclaims.
In terms of the task ahead for the Swedish market from a pensions perspective, Edström believes the most important question is whether the unions should, in a more open EU, have a place in setting the terms for retirement levels.
“Or should it be up to the bigger groups like Ericsson, SCA, TelenorTelia, SAS, SKF, Lux and others to take care of the development themselves in co-operation with the workers of these groups? Will Swedish unions adapt to this change or keep fighting the old battle based on Taylor-influenced settings?”
For Europe as whole, he believes the modernisation of the labour market will also be the crunch issue. “Getting politicians to understand that less is more – a modern term that seems to actually mean something in this context – will be the real problem. The influence of unions and any adjustment in the labour market in Europe may be politically impossible to change (in terms of mobility etc) for a long time,” says Edström.
“Our major concern would be low real returns and ‘real’ means relative to wages”
Niels Kortleve, director of investment strategy at the giant Dutch PGGM pension fund for health, mental and social welfare employees, with assets in excess of e45bn, explains that the scheme’s biggest challenge is its operations and systems – both on the pensions and asset management sides.
“We really want to bring the IT equipment here up to state-of-the-art-standards. On the asset management side we will also be moving into two external administration board systems; one for treasury management and one for direction of the portfolio – to be implemented next year and in 2001.”
Kortleve says the possible impact of lower returns on pension premiums to be paid is also a major priority. “Maybe it won’t be that much of a problem as long as low returns on the asset side come at the same time as low inflation and low wage rises. Our major concern would be low real returns, and ‘real’ means relative to wages.”
Kortleve says the fund has already implemented a plan to slowly increase pension payments from the current level of 6% of wages to around 10% over the course of a decade: “It is a slow but thorough process.”
The fund is also undergoing a major review of its asset allocation strategy which will be reviewed by the board in March. And the recent award of PGGM’s first SRI mandate is indicative of a desire to learn more about this investment style from asset managers, says Kortleve.
In the Netherlands he points to the STAR regulation as a major challenge to the country’s industry-wide schemes going forward.STAR proposes that if industry-wide pension plans underperform relative to their benchmark then groups of people and companies can switch to another pension fund.
“We are working on internal ways to get a better grip on the risk we are running and how we can manage that,” Kortleve explains. “Also we want to have a better understanding of the current regulation and how that might be improved. We are looking at this issue along with other pension plans and the VB industry-wide pensions body.”
For Europe he adds that the main fear is possible changes in EC regulation – especially if they result in any kind of investment restrictions. “The UK and Dutch investment scenes are of course very different to many other European countries. For example, we are very progressive in our equity allocations, particularly in terms of splitting investment between Euroland and Europe. Our strategic allocation is 55% in equities and if there were a ceiling such as 50% imposed, and we have heard rumours about this coming out of Germany, France and Italy, then investment could become difficult.”
In the long run, Kortleve says he thinks the issue will be smoothed over, but notes that in the short term the Commission has the difficult task of finding a path between the more freely organised Anglo-Saxon/Dutch approach and the rest of Europe. “It is likely we will see a set of flexible rules which don’t definitely have to be applied to begin with, but which funds will have to move towards. This could take at least 10 years though.”
Alistair Ross Goobey
“20–30 year-olds will have to pay twice: once for their own pension, once for their parents”
Alistair Ross Goobey, chief executive at UK pension fund manager Hermes, owned by the BT Pension Scheme, which runs over £45bn (e72bn) in scheme assets for both BT and the Post Office, says that with the Post Office about to merge its pension schemes Hermes is awaiting the reappraisal of the fund’s investment strategy.
“BT has indicated to our trustees that is more concerned with minimising the long-term cost of pensions provision rather than volatility in its contribution rates. As a consequence, the BT scheme’s strategic asset mix is more equity oriented than before the Pensions Act – despite the super-maturity of the scheme.
Ross Goobey points out that the greatest future threat to any defined benefit (DB) pension scheme is its possible long-term cost to the sponsor. “Should the investment risk be too great for a sponsor to bear it will move towards defined contribution (DC) schemes – where the investment risk is transferred to the employee; unfortunately, in most cases, a DC scheme will not have high enough contributions from employer and employee to offer the levels of pension a traditional DB scheme has been able to offer.”
And he is sceptical about the UK government’s stakeholder pension plans’ ability to meet the country’s retirement needs. “No matter how well-intentioned the government’s stakeholder pension provision is, it cannot offer the level of income in retirement that will satisfy the reasonable expectations of the population. Both the existing state pension and ‘S2P’ (state second pension) will find it impossible to match the benefits of a defined benefit scheme with normal levels of contribution.”
In Europe Ross Goobey believes that every country which has not funded its state pension entitlement will face serious choices over the next few years. “Italy has already addressed some of them, but France and Germany still seem to be going in the wrong direction – reducing pensions age while not cutting expected benefits. It is likely that the current generation of 20–30 year-olds will have to pay twice, once for their own pension funding, and once for the unfunded pensions of their parents. Fortunately, most seem prepared to cough up.”
He notes that the millennium is not going to affect Hermes’ asset allocation in any way but points to other issues such as the cost of, and need for, constant upgrading of IT systems in investment management, as definite concerns.
“Due to the new investment environment in Europe, historical track records are worthless”
Dieter Klein, group head of pension asset management at the DM7bn (e3.6bn) pension fund of BASF AG, the German parent company of the global chemical giant BASF Group, says the millennial change itself is not changing anything within the fund. However, the gradual switch within the scheme to a European approach following the euro launch is still a work in progress.
“We are making the move from domestic bonds to Euroland bonds and on the equities side we are replacing domestic investments with pan-European mandates.
“Our equity structure is broadly internationally diversified with specialised regional mandates in the US, Europe and Japan, complemented by emerging markets and Pacific ex-Japan. It takes time to select the appropriate benchmarks and the suitable money managers for the desired products – because the universe of managers we choose from includes not only domestic houses but also foreign houses.”
Klein says a major issue for the fund is that equity investment is now at the 35% limit allowed by German law. “From a strategic asset allocation point of view this is our biggest challenge at the moment. When you look at other funds which operate under the prudent man rule they all have much higher equity allocations. In a low interest rate environment our hurdle rate still needs to be met, which forces us to increase the equity allocation. The problem is we are not allowed to.”
Klein hopes that the recommendations of the Gerke commission in Germany concerning prudent investment rules and tax deferred pension contributions, as well as the introduction of DC schemes, soon come to fruition in Germany, but is not overly optimistic about the determination of government officials. “ What I do hope is that if domestic Germany does not do something, then an EC directive will force member states into action.”
Comparing the pension funding methods in Germany he points out that the book reserve method is still the most tax-efficient way for companies to build up retirement provisions. “If a company has good investment projects which can make the required rate of return – why should it outsource everything?”
Klein also notes that on a European level it has become more difficult to select the right manager as a result of investment banking mergers and the inevitable adjustments of investment processes due to the euro introduction. “Increasing merger activity among money managers is causing organisational and personnel changes and jeopardising the efficiency of the investment process and team stability. Due to the new investment environment within Europe historical track records are worthless. A solid track record based on the new investment process needs to be built first by money managers”
City of Zurich Pension Fund
“We expect to see new regulations replace the current asset allocation definitions”
Armin Braun, CIO at the Sfr6bn (e4.4bn) pension fund for employees of the city of Zurich in Switzerland says the main target for the fund in the new millennium is to increase the levels it can invest in non provisional assets such as private equity and hedge funds.
“We hope that we can increase the level of our commitments in private equity up to 5%, which would mean moving to a full asset provision licence. This would also allow us to invest in foreign real estate.”
Braun says the fund is seeking the increased diversification into higher risk securities because it has become difficult to make sufficient investment forcasts in traditional asset classes. “The investments in non-provisional assets is the only way we can see to have more diversification.” The fund is also looking to increase its foreign equity holdings from the present level of 14.1% up to around 20%.
And he notes that many in Switzerland are still awaiting the lifting of investment restrictions. “This is one psychological barrier which we hope will be lifted in the first quarter of next year. We expect to see new regulations replace the current asset allocation definitions – although it has been possible to get around this. Funds will then be able to go above the present levels without problem.”
Siemens Kag, Munich
“I don’t think anyone has tested the moral obligation for companies behind DC”
Peter Scherkamp, managing director of Munich-based Siemens Financial Services/Investment Managers (SKAG), says that in the new millennium the global demographic issue of longer life and the growing acuteness of the funding question for retirement provision will dominate.
“The DB/DC debate in Europe is starting to swing towards the latter - as seen in the US. We are not 100% sure which is the better approach to take, because as a portfolio manager and a corporation responsible for the funding if you look at the opportunities it looks better to be on the DB side. You can play the role of long-term investor paying out 6% and probably do something for the overall company’s overall profitability at the same time. However, if you are a company CFO focusing on risk it looks more attractive to go DC and place the risk on the individual – and the individuals are willing to take it for the time being.”
He notes though that a downturn in the market will certainly put strain on the DC shift if it is overdone. “I also don’t think anyone has tested the moral obligation for companies behind DC. There is a potential liability without any legal authority which no-one seems to have a clear hold on. DC is not a no-brainer.”
Scherkamp says Siemens is modifying its German pension arrangements to bring them closer to DC models used in the US, although he notes that changes will probably result in hybrid plans. “Funds will be more tailored to the client.”
Another issue will be the need for ever higher returns, Scherkamp points out. “There will be increasing pressure to yield more and close the pensions gap from this end. So in Europe equity portions will rise, and there is already pent-up demand.” He notes that issues such as investment restrictions on insurance companies will undoubtedly be raised as a result – both in Germany and other parts of Europe. And he adds that the German problem of financing pension reform, which he says is the first question posed by the country’s politicians when the issue is mentioned, seems as far off as ever. Notably, he argues that Europe in the new millennium could learn from the US economic experience.
“I think much of the current US surplus is coming from taxation of wealth from the increasing number of people able to invest in capital markets.”
Scherkamp also warns that the pensions game in Europe for multinationals will become more competitive – best location wins, with regulatory heavy countries left behind. “If you have one currency and free flow of labour and services then big corporations simply look for the best place to run their business. I don’t think governments have quite understood this yet. More responsive countries like Ireland and Luxembourg will win out because they can address the real needs of companies for co-ordination across boundaries.”
ESB Pensions Scheme, Dublin
“Each generation will exhibit its own patterns. Planning for the future will be complex”
Brid Horan, general manager pensions of the Dublin-based e2.5bn ESB Pension Scheme, says the big challenge facing the fund is to ensure that it meets the needs of a changing industry: “both from an investment perspective, provision of member services, and responding to changes which may arise in the external pensions environment.”
These national changes introduced in relation to post retirement options for self-employed workers during 1999 may, Horan says, impact on occupational or employer-sponsored schemes in the future. “This could radically change benefit design and investment needs.”
For Europe, Horan believes the major challenge will be to provide secure incomes and quality of life for ageing populations. “This will call for an integrated approach to financial issues such as pension design and funding, both state and private, and to social issues such as housing policy, health and long-term care.”
In addition, she says the overall effects on society of the changed age structure of the population should be considered. “This should take account of the fact that in 30 years’ time, today’s 40 to 50 year olds are unlikely to mirror the attitudes and needs of today’s 70 years olds, as each generation will exhibit its own unique patterns. In short, planning for the future changes will be a complex exercise.”
Troels Gunner Gaard
“In Europe we need to see more confidence in the currency as well as economic stability”
Troels Gunner Gaard, chief investment officer at Denmark’s second largest scheme the Dkr60bn (e8bn) PKA fund for public, social and health workers says the most important challenge for the fund is the move away from domestic investment to a much larger degree than today.
“This will mean we need to have an improved risk spread on the portfolio, because we will be investing a larger portion in foreign equities and bonds – a process which we have started already. We will also have to introduce the full back office capabilities for this.” The fund is invested predominantly in domestic bonds with 40% held in equities and 5% in real estate. The equity split is 60% in Danish shares and 40% overseas.
Gunner Gaard says the new equity approach will be on a global basis. “We also want to improve the technology we have at the fund to increase the level of knowledge behind our investments and give better models and systems.”
The Danish market outlook, he says, depends very much on the future economy. “Provided we experience stable economic growth without much higher levels of inflation then we expect to see fairly decent investment returns on domestic bonds in the coming year. Forecasts for domestic equities are fairly good also and there is a strong chance they will pick up after this year’s bad performance.”
The big pensions discussion in Denmark at the moment is how to keep more people in the Danish labour market, he adds. “There is a basic need for people to stay in it these days. Smaller numbers of workers are being employed and there are more people in retirement with less government expenditure coming forward.”
Gunner Gaard says he is unsure whether any impact will be made by government discussions to be held in 2000, but sees necessary progess arriving in future years. “In Europe we need to see more confidence in the currency as well as economic stability,” he points out, adding that discussion is starting again in Denmark on acceptance of the euro. “Another interesting issue is the increasing issuance of corporate bonds, because, while the pick-up is very attractive, the credit risk is something European investors are not particularly used to.