EU pensions market beckons

The removal of obstacles to cross-border pension provision was a priority for the European Commission (EC) between 1999 and 2004. This is clear from the European Pension Fund Directive and the EC's action on taxes.

From the commission's point of view, two problems were centre stage. First, the ‘demographic time bomb' and second, the lack of an internal pensions market.

Most European Union (EU) member states are familiar with the so-called three-pillar pensions system. The first is usually based on the pay-as-you-go (PAYG) principle. The demographic time bomb means the ratio of over-65s versus citizens aged between 20 and 64 will almost have doubled, from 27% to about 53% in 2050.

The second pillar is usually capital-funded. Systems within this category are generally much more robust than PAYG systems, because workers are saving for old age. Moreover, the calculated contribution is based on the future liabilities of the pension fund.

Until now only three countries in Europe have had a well-developed second pillar: Ireland, the UK and the Netherlands. The pension provision in the other EU member states is mainly based on the first.

It would be ideal if the first pillar was based on capital funding as well. But that is easier said than done, because remodelling a PAYG system into a capital-funded system means a country needs to maintain two systems during a transitional period. In most cases, the means for such an expensive operation is not available.

Few countries will find the necessary surplus within their budget. In Europe I know of only one country that has - Norway. Due to the proceeds of its oil and gas, it has built up a pension fund the size of its gross national product.

The Netherlands could have done the same when its natural gas reserves were discovered. Unfortunately it did not, despite the plea of Jan Willem De Pous, the then chairman of the Social and Economic Council.

The demographic time bomb will force us to make difficult choices in the future.

Without meddling with the pension age, a large profit could be made by enhancing the labour participation of the over-50s. This would kill two birds with one stone. First, there would be fewer people for whom a pension needs to be paid and second, more people would pay pension contributions.

Besides that, economising on pension schemes is almost inevitable. This could, for example, be achieved by increasing the official retirement age, or at least offering people who want to keep on working the opportunity to do so. Personally, I have enjoyed working full-time until the age of 71 and I do not want to prevent anybody from doing likewise.

Economies could be made by switching from final salary to average salary schemes. It could also mean the defined benefit (DB) pension would be replaced by defined contribution (DC) schemes, which have a further reach than average salary schemes.

DC schemes place the risk of disappointing returns on investment fully with the employees. Workers receive as much pension as their contribution plus the returns on its investment. The employer no longer guarantees the benefit. Therefore, many employers - contrary to their workers - prefer the DC schemes.

I would like to grant everybody a final salary pension. But, if something simply isn't there, it is like looking for the pot of gold at the end of the rainbow.

The member states are increasingly looking over each others' shoulder to find out how the pension problems are being tackled, for they have a mutual interest in the solidity of each others' pension system. That is why the tenability of the national pension systems has featured prominently on the agenda of the Ecofin Council.

The EC is also actively investigating the transferability of pensions and has held a large round of consultations.

The finding was that employers in general had many reservations about the proposal. They fear increased costs. At present, five-year ‘vesting periods' - the time a worker need to participate in a pension scheme before he is entitled to a pension - apply in Germany. This is bad for the mobility of the German labour market and conflicts with cross-border labour mobility.

 

n social issues - such as tax matters - new European legislation can only be adopted unanimously. Every member state has the right of veto. But this is an area in which we should let the public interest prevail over the interest of a number of employers because the increased flexibility of the labour market concerns all of the EU.

The Netherlands shows what is possible: it has short ‘vesting periods' and, in general, the transferability of pensions capital from one fund to the other.

For too long flexibility has been offered, and too little justification has been demanded, on crucial matters.

I am convinced that Europe needs to hurry up and improve real and informative reporting, especially for private investors. The step of prescribing the International Accounting Standards (IAS) as of 1 January, 2005 was crucial for the recovery of the faith in corporate Europe.

Many panic stories have appeared about the effects of the standards on Dutch pension schemes. Accounting is, however, nothing else then retrospectively establishing the reality. The IAS is quite clear in this respect: existing risks and value changes will be made visible in the annual accounts.

We might need to get used to it but accepting that fluctuations in balance sheets and results become visible seems more attractive to me than the alternative: that this information is merely destined for a small group of insiders and analysts. Stability of the financial sector gains more from transparency than from secrecy.

From a European
perspective the second large problem, besides the demographic time bomb, is the lack of
an internal pensions market.

At present every national market for company pensions is functioning in itself. The challenge for the EC was to remove the national fences.

It has done this by introducing the pension fund directive, which sets minimum standards for supervision on business economics. The EC has also been active in removing fiscal obstacles, by publishing a pension announcement, followed by infringement procedures.

In my opinion, the acceptance of the pensions fund directive is a great success. It was difficult to reconcile the differing views and traditions of the member states, for example on investment rules. Some countries demanded tight quantitative standards, while others preferred the ‘prudent person' principle. Fortunately, the commission has been able to reach a compromise with the European Parliament and the Ecofin Council.

Based on the pension fund directive, pan-European pension schemes began operating as of 23 September 2005, the implementation date of the directive. Pan-European schemes mean that an employer with offices in more than one member state can concentrate his pension obligations in one provider, inclusive of all implicit cost savings.

Before such a pan-European pension funds can function, the fiscal obstacles need to be removed. These barriers are mainly concerned with the deductibility of tax: in most member states, pension contributions are deductible, but only if they are paid to national pension funds.

After analysing the European Court of Justice (ECJ) case law, the EC concluded that refusing deductibility is a breach of the EU Treaty. Just before it submitted the proposal for the pension fund directive, it published this legal analysis in an announcement. Moreover, it has approached the eight member states that refused cross-border deductibility. In the meantime, seven members have announced that they will adjust their tax legislation.

 

nother fiscal issue is the transferability of pension capital from a pension fund in one country to a scheme in another country.

The EC has taken a case against Belgium on this. Belgium has conceded: it will no longer tax pension transfers to schemes abroad, or cross-border transfers to a national scheme.

This tax-free cross-border transfer is important for pan-European pension funds. Once transfers have taken off, employers and employees will have an interest in centralising the established pension capital in such a pan-European scheme. As long as there are fiscal barriers, a transfer will be difficult.

What will be the future hold for pensions? First, the necessity to keep pension affordable will inevitably lead to economies. These could be achieved by raising the official retirement age, or by decreasing pensions by average salary and DC schemes.

Probably a wide combination of measures will be needed. The adjustments will be more painful in some member states than in others, because some members have hardly built up any pensions capital so far.

Second, what will happen to the first pan-European pension funds? The pan-European pensions market has a very large potential. Who will get a share of this market?

Ireland and Luxembourg are biding their time. They have profited handsomely from the UCITS Directive on the establishment of European investment funds: schemes that can offer their services abroad.

UCITS did not exist before this directive. Both member states have implemented the Directive in such a way that they are now covering a large part of the European UCITS market.

Although exact statistics are not available, the market share of Luxembourg and Ireland's cross-border UCITS is estimated at 90%.

Member states that make the operating of pan-European funds difficult by setting additional requirements will find it hard to attract such schemes, with all their economic activity and high-value employment, for example, asset managers, accountants, actuaries and services by banks and other financial service providers. After all, any pan-European scheme can freely choose from 25 jurisdictions.

The EC has worked hard on pension during the last five years. This is appropriate, because the subject regards every citizen.

Many important steps have been taken. Much has been done to establish an internal market for company pensions, by the pension fund directive and by a pro-active fiscal policy.

The next steps need to be made by the member states. Because it remains their national competence, they themselves need to secure the sustainability of their pension systems.

In some countries this will require painful adjustments. However, burying one's head in the sand is not an option. This might lead to a disruption of social structures. Member states have to implement the pension funds directive and largely change their tax rules. The result will be an internal market for company pensions.

I am seriously convinced that the increased efficiency of the market will contribute to the affordability of these pensions.

Frits Bolkestein was a European Commissioner between 1999 and 2004, responsible for internal market, taxation and customs union issues