Challenges in the form of regulation and lower expected returns mean Belgian pension funds must seek economies of scale and improved governance, writes Karel Stroobants
After world record coalition negotiations lasting more than 540 days, a new government was formed in December 2011. It will come as no surprise that the word "pension" is mentioned frequently in the extended Government Declaration.
The new government got off to a good start. One of the first measures adopted by Parliament in December was pension reform. The speed of the decision process surprised everyone, including the social partners, and was followed by a national strike on 30 January 2012.
What are those measures?
A first package of measures concerns the first pillar pension, the statutory pension.
Although the statutory retirement age in Belgium has not changed, measures to stimulate an effective increase in the retirement age were launched. Applying for early retirement has been made more difficult and a higher number of active years will be needed to achieve a full statutory pension. Savings have also been realised in the way public employee pensions are calculated and favourable regimes have been abolished. The question is whether these measures will lead to an effective increase in the retirement age.
A second set of measures refers to the second pillar, the supplementary pensions.
Although not all social partners are convinced that the second pillar is a necessary supplement to the statutory pension, the government has expressed the intention to democratise supplementary pensions further by finally ensuring that everyone will enjoy access to this pillar - currently only about 66% of the active population has access to supplementary pensions.
Details are not yet known and some fear the introduction of an additional first pillar, in which the funds would be managed by a government agency and primarily invested in Belgian government bonds. Others hope for a more market-based mechanism in which different players (insurers and pension funds) offer solutions. Other measures related to the second pillar are technical corrections with little impact.
A fundamental revolution in the pension arena is out of the question. The reforms are limited to cosmetic and technical interventions that will have minor effect. In-depth reforms that some countries have realised have neither been planned nor undertaken. The statutory pension age is not increased, the second pillar will not become mandatory, we continue to pay in lump sums instead of annuities and the three different pension systems (for public employees, private employees and the self-employed) remain distinct.
Further, fiscal support for pension savings remains an amalgam of unco-ordinated rules and people still have no access to a timely, accurate and co-ordinated pension account on which they can simulate the consequences of working longer, or stopping earlier.
The expectation is that, to solve the consequences of an ageing population combined with low economic growth, more reform will be necessary.
Health check: stable but vigilance needed
Pension funds manage about 33% of all second pillar assets, whilst 66% is managed by insurers. However, industry-wide schemes are becoming more important. The largest such schemes have been established as a pension fund; they represent the largest number of participants and are the fastest growing in assets under management.
Belgium does not allow the pure DC concept. DB is still commonly used in pension funds, although these are being closed. New plans are hybrid DB plans - DC plans as far as contributions and administration are concerned but DB for the benefits as the sponsor needs to guarantee a minimum yield of 3.25% on retirement. In these hybrid plans, the risk of the investment return is solely taken by the plan sponsor.
As people become more dependent on their supplementary pension, it is logical that the monitoring and analysis by the regulator, the FSMA, becomes more important. Additionally, the responsibility of the social partners, through the joint management of the pension funds, means that safety and continuity is high on the agenda. Close monitoring has been the order of the day for more than five years, and Belgium has modern and transparent control legislation compliant with European regulations.
Despite turbulent times and poor stock market performance, pension funds are in fairly good shape and funding ratios remain in the green zone according to the two Belgian standards that need to be met, the 105% long-term calculation and the 120% short-term calculation. Only a dozen funds are working under a recovery plan. Drastic measures such as lowering the pensions, are not on the agenda. Most recovery plans are limited to a gradual recovery, whether or not, supplemented by additional contributions.
One could rightly ask how this is possible. After all, Belgium is not an island immune to economic and financial storms.
What causes this fairly healthy situation?
Notwithstanding the various recent crises, the long term return continues to be relatively high (4% real return over 15 years) and sufficient to cover growing liabilities. (For 2011, the expected return will be approximately -4 to -5%).
As 99% of pensions are paid as a lump sum, ever-higher life expectancy and inflation have little influence on the funding ratio. These risks are transferred to the members.
Very high buffers were created in the golden 90s. The social partners have not used that ‘overfunding' to finance additional benefits or to introduce contribution holidays and it was put aside to cover future negative volatility.
The recently formed industry-wide pension schemes are young and will have a positive cash flow for years which supports long-term management.
Belgian funds already have a longstanding policy of extensive diversification. Because of the small scale of the Belgian stock market it is usual to invest globally. Most investment restrictions were abolished several years ago.
As far as regulation is concerned, a dynamic and realistic set of rules was put in place a few years ago. The ‘fully funded' principle was defined pragmatically. A pension fund cannot hide behind a strict quantitative set of rules. They should build a custom risk model based on a set of consistent and coherent parameters. This model, together with the ‘soft but convincing' approach of the supervisory authority has certainly improved the governance of the funds.
What are the threats?
But anything can be done better, so where do the dangers lurk?
Unfortunately, Belgian pensions regulation has technical shortcomings. The most important one is that the rules on funding are not adapted to the new hybrid DC plans. The guaranteed return is diametrically opposed to the financial approach of the funding calculation. Assets are marked to market, but the liabilities of such plans must always equal the premium paid plus 3.25%. This makes effective risk management (for example, through LDI concepts) difficult. Applying a mark to market valuation for both assets and liabilities would be a more coherent model.
Solvency II and the holistic balance sheet approach are the themes coming from Europe. Belgian pension funds have historically invested about 40% in equity and if Solvency II were introduced, this would become untenable. The equity allocation would become too expensive and have to be swapped into less risky assets which causes lower returns, but higher contributions.
Selling equity is one solution but how to invest the cash is more challenging. The current crisis makes the flight to government bonds even more risky and expensive. Investments in long-term German Bunds make a fund vulnerable to interest risk and investing in an indexed bond portfolio exposes you to a unknown political risk of debt rescheduling. Mission impossible?
The more complex rules will also make many smaller pension funds unviable.
So what are the answers?
A few trends seem to pop up:
• The LDI concept is receiving greater attention. Although in young, growing funds with a long positive cash flow for years to come, it is a solution that creates no added value, for some funds it leads to a more manageable risk model adapted to the level of governance of the fund. The other side of the coin, however, is that given the long duration of liabilities, they should invest in long and low yielding paper that makes the portfolio sensitive for interest rate risk. Combined with the valuation of the assets, mark-to-market rules and the calculation of the liabilities as contribution-plus 3.25%, the risk of theoretical underfunding remains.
• By investing more in non listed assets such as infrastructure and direct real estate, funds are trying to diversify outside the equity portfolio and trying also to avoid ‘visible volatility'. But the danger of this diversification is that the governance of the fund is not always in line with the risks. Do management and the pension boards have the necessary countervailing power? Maybe the volatility is not visible but the underlying risk has not gone. An organisational structure sufficient to meet these challenges is a necessity. In addition, the implementation is a lengthy process, certainly if a ‘local' dimension is added.
• In bond portfolios we see a shift to Belgian paper as a result of a ‘nationality' reflex combined with the relatively high yield on Belgian government debt.
There is still a long way to go if Belgium wants to solve its retirement problem. The first pillar needs greater reform but in addition to the further restructuring of the first pillar, the second pillar must also adapt to the economic situation. Lower expected returns, higher risks together with more complex regulations will have to go hand-in-hand with economies of scale and better governance.
Karel Stroobants is an independent adviser and trustee of the Levi Strauss pension fund in Belgium