Alain Lemoine makes a gloomy assessment of the wider impact on French pensions reform and funding of the decision to drawdown on FRR
Describing FRR's new investment strategy as ‘liability-driven' is using soft terminology to describe its termination.
The FRR announced its new agenda on 10 March 2011. As Philippe Aurain, CIO of the France's Fonds de reserve pour les retraites (FRR), told IPE: "We are talking about FRR 2.0, it's a totally different fund." It is, indeed, and its main difference is the shift from FRR's initial long-term horizon to a closer end point. Instead of building reserves and spending them until 2040, the new FRR will pay €2.1bn every year from 2011 to CADES (Caisse d'Amortissement de la Dette Sociale, a vehicle managing repayment of social security debt), with an additional €4bn payment in 2020, and a supplementary lump sum in 2024, depending on what's left in the FRR at that time. Then FRR 2.0 will be terminated.
What is the meaning of this shift in the wider context of French pensions reform and its funding?
First, any change in the FRR's mandate means good news for asset managers who accommodate new needs. Take Schroder for instance, which received new flows of €500m in January, to add to the mandate it already manages for the FRR in US investment grade credit as a result of a recent tender offer. Many other changes will come as horizon shortens and strategy is redefined, mostly selling long term equity investments to buy all kinds of bond related investments.
But the shift also triggers more interaction on the difficult path of funding demographic transitions in the French pay-as-you-go (PAYG) system in a financial crisis context. A little history helps.
Twelve years ago, in 1999, France realised it had delayed reform too long to properly prepare itself for the inevitable demographic shock to its PAYG system. An idea was formulated to build a cushion to help smooth the retirement problem that is expected to need the most funding between 2020 and 2040. FRR was created then with the goal to accumulate as much as €150bn by 2020, thanks to the extent of the resources that were promised, including money raised from government privatisations. That was the theory. Then the incoming government became reluctant to support FRR and refused to commit all the promised resources. Also, designing rules and governance for the fund, hiring teams, selecting consultants to manage tender offers and building-up administrative management took time, so the FRR only effectively launched in 2004. The promised resources never materialised, even with €37.5bn in assets as of early March 2011, the fund undershot its target size.
Of course, the financial crisis changed the equation. Like many sovereign funds with a long-term horizon, FRR had a pronounced equity preference, with a 60% target asset allocation to equities, and a 64.5% real exposure to equities by 2007 as things turned bad. The fund lost 25% in 2008, triggering criticism, obviously comforting the government in its cautious approach to committing resources to FRR on a drop-by-drop basis. It is difficult to point any specific disorder, but French Cour des comptes, the judicial court for public finances, used the term ‘failure', in its report issued last February, to describe the risks of the FRR 2.0 reform. To support this view, the Cour des comptes concluded that FRR's poor annual performance of 3.1% was not only caused by the crisis, but by a lack of strategic orientation and a weak commitment from the government to its choices.
So things were not getting better on the pension funding front and many optimistic hypotheses were derailed by the financial meltdown and subsequent economic crisis. Rising unemployment brought lower contributions and a growing pension deficit as the level of unemployment benefit prompted people to seek shelter in retirement as soon as possible. Despite the 2010 French pension reform and its unpopular measures, such as raising minimum retirement age, growing retirement deficits will need more funding sooner than expected. Reforms will have to be softened to avoid social unrest observed in countries most hit by the banking meltdown.
Public retirement spending in France has already reached 12.5% of GDP, compared to a 7% average for OECD countries, and this is not going to get better, despite forecasts for a demographic gap biting harder on other European countries. By 2050, the rate of public retirement spending is expected to top 14.2% of GDP in France, versus an OECD average of 11.2%.
There is a growing fear that deficits could snowball into uncontrollable debts that might become difficult to sell to investors, as banks experienced in 2008 before they were bailed out by the world's governments and central banks. There is no lender of last resort for pension debts like the ones banks activated to avoid bankruptcy.
CADES, which manages social debt resulting from the accumulated deficits of French social security, is a good example of this unfunded debt dilemma. Since its launch in 1996, it has inherited €135bn of debt, and some tax resources to help repay it. CADES has managed its liabilities pretty well, it has amortised more than €45bn. By 2010, there was ‘only' about €90bn remaining to be repaid. But in recognition of its liability management skills, CADES was charged by the National Assembly in November 2010 with a new burden of €68bn in social security debt to be managed from 2011 and an additional €62bn between 2012 and 2018, which arose from the balancing act of the last French pension reform. Even if their borrowing cost has decreased, thanks to lower interest rates, the average coupon paid on CADES bonds stands at around 3.5% at the end of 2010.
With pension assets yielding a mere 3.1% on the FRR side, and retirement debts costing 3.5% on the CADES side, the simple temptation to manage the equation is to deleverage. That's what FRR 2.0 means. Deleveraging forces are also at work in managing assets and liabilities in the French second pilar retirement system; at first sight, AGIRC-ARRCO actually benefits from the 2010 pension reform, as raising minimum retirement age reverses the big cost it incurred in 1981 when the retirement age was lowered from 65 to 60, bringing it back to 62 in 2018 helps a little.
ARRCO, which was expecting a growing deficit (up to €6bn a year by 2018), is now forecasting a €1bn surplus by then. But it will be a short time relief, as deficit, even with the 2010 reforms, is expected to reach again €7bn a year by 2030. As a result, AGIRC-ARRCO is already tapping its long term reserves to finance the growing demographic imbalance between its contributors and retireees. Last November, GIE AGIRC-ARRCO, the centralising body managing the bulk of its reserves, asked AGIRC retirement institutions to hand over €5bn that it had to drag from its own decentralised long term reserves.
This was bad news for many asset managers, whose accounts were closed. And more redemptions will come. As reforms and recent trends are accounted for, new forecasts predict long term reserves of AGIRC will dry-up by 2016, and ARRCO reserves by 2032. With no assets left to fund growing retirement liabilities, the French retirement balance sheet could then face a solvency dilemma raised during the banking crisis, bluntly summarised by Janet Yellen, vice chair of the board of governors of the US Federal Reserve: "Nothing on the left is left, and nothing on the right is right".