Once again, European pension systems – notably those of the Netherlands and Denmark – have scored most highly in this year’s Mercer CFA Pension Index. These successes are no accident, and among the key ingredients is years of pragmatic and consensual policy making. 

While the Netherlands and Denmark rank in first position for adequacy and sustainability respectively, Finland scores highest for the integrity of its pension system. 

While the success of good pension systems is to a great extent built on consistency of policy, a periodic willingness to accept profound changes or even system breaks – such as in the new Dutch collective defined contribution (CDC) system that will be phased in over the next few years – is also a crucial ingredient to secure long-term sustainability, adequacy and integrity.

In most developed pension systems, there has been a move away from guarantees as these have become unaffordable: in Denmark, for instance, the move has been towards unit-linked defined contribution schemes, while the Netherlands has introduced conditionality into its previously defined benefit accrual and indexation system.

In the Netherlands these changes have led to a reduction in trust in the overall system, particularly among the old, many of whom feel they will get less out than they paid in.

In her foreword to this year’s report, Margaret Franklin, CEO of the CFA Institute, talks about a mismatch in perceptions about pension benefits that could point to a future issue of trust in pensions. 

Franklin refers to CFA Institute research, highlighting that while about half of defined benefit (DB) pension schemes worldwide expect to have to cut benefits, 70% of beneficiaries expect them to be paid in full. This suggests a fragile bond of trust between funds, sponsors and members. 

The looming trust deficit

Defined contribution (DC) funds also hold a fragile bond of trust with members that has been supported in many cases by good investment returns. This bond may yet fray if economic conditions worsen and account balances are impaired due to a combination of poor returns, bad market timing, or reduced contributions because of unemployment.

As DC schemes mature, they will have to evolve to secure members’ ongoing trust: simple, low cost investment strategies may be good for the investment phase but better understanding of working patterns in later life and retirement income needs, and appropriate pathways, are becoming essential. 

The annual Edelman Trust Barometer points to two contributing factors in the establishment and maintenance of public trust – competence (delivering on promises) and ethics (doing what is right and good for society). Unsurprisingly, neither governments, business, NGOs nor the media are held to be both competent and ethical in the research.

For many DB pension funds, doing the right thing is at least easier than meeting long-term, multi-generational retirement income promises that may have been unaffordable in the first place. Here, at least, well-thought-through ESG and impact-investment policies offer a way for pension funds to demonstrate their good financial citizenship. 

ESG certainly offers better member communication opportunities than reducing indexation or benefit accrual rates – assuming such ESG policies rest on firm legal, regulatory and internal governance foundations.

But doing the right thing for society may be little comfort if members have to take a benefit haircut. Even before COVID-19 shattered the economic outlook, continued low yields and a poor long-term return outlook were conspiring to crimp the ability of underfunded DB schemes to meet long-term benefit obligations. 

The pandemic not only adds an economic downturn to the mix, it also clouds the outlook with a high dose of uncertainty in which businesses in many sectors will fail. A number of employers may also be unable to make the contributions needed to repair pension deficits.

The continued financial repression since the 2008-09 financial crisis has pushed DB funds into riskier assets. This is often within liability-driven or cashflow-driven investments as funds seek to reduce liability risks; where such frameworks previously rested on government bond and interest rate swaps, schemes may now seek to match liabilities with corporate paper or long-term infrastructure related cashflows.

And as pension funds have increased risk tolerance in liability-matching buckets, in return seeking portfolios they have embraced high-yield bonds, leveraged loans, direct lending and other areas of private credit. From a financial system perspective overall, this greater risk-taking has been the desired effect of quantitative easing. But if poorly governed, these investment choices could lead to adverse returns that, in turn, undermine both funding levels and trust.

Yet for many pension funds, a key ingredient in long-term success and the maintenance of trust will lie in their ability to design broad and diverse investment strategies. Here there are two important elements – good, responsive regulation on the one hand, and the governance and ability of individual funds to adopt a more sophisticated policy on the other. The two go hand-in-hand, and good policy, including fostering consolidation of pension funds, should underpin trust.

As competition increases for the scarcer sources of yield and long-term return outside public markets, nimbleness, sophistication and scale will all be key ingredients for long-term success, and trust, for DB and DC schemes alike.

Liam Kennedy, Editor