More freedom - sweeter profits
The European financial markets have gone through a radical transformation these past two decades. The dismantling of capital restrictions and the formation of Emu have produced a deeper, more transparent market, of a kind that many would have considered unfeasible 10 years ago. But those who follow the present discussions on European pension schemes may well feel they are back in the early 1980s.
In many countries, the case for liberalising investment regulations made by European Commissioner Frits Bolkestein has only resulted in them anxiously sticking to investment restrictions. The fear of liberalisation is especially evident in countries with little to invest. Sometimes it seems as if the countries that would particularly benefit from building up pension capital are the most reluctant to compromise. Politically, this reluctance may be understandable, but in the age of the euro and the 24-hour capital market it is untenable and at odds with the urgent need to strengthen capital funding in European pension schemes.
Demographic figures draw a clear picture. To start with, we see a decline in population in the EU countries by 2020 and we see a considerable increase in the percentage of people over 65 in comparison with the percentage between 20 and 64 and still employed. The implications of this have already been demonstrated by Merrill Lynch. If the European member states stick to their present policies, the result may either be that the level of old age pensions will be halved, or that the size of the contributions will be doubled, up to some 25% of individual incomes. This is of course excluding rising public health expenditure.
The possible consequences are not hard to guess: Increasing wage costs, faltering competitive strength, increasing unemployment, increasing social contributions, a growing national debt and higher inflation. Not all of these possible disasters will befall us, but it will be extremely difficult to avoid them all. So it is important that we act. Fortunately, this is becoming commonly acknowledged, as became clear during the European Summit in Stockholm. We can no longer ignore the financial implications of ageing for the pension system. What matters now is that we learn from each other, that we exchange experiences and good practices.
In the Netherlands we are concerned that, with no further measures, the ageing of Europe might threaten the stability of our own national pension system. Although I think that the international acclaim for the Dutch economic model is overstated – at present, our competitive position is declining steeply – our pension scheme is something to feel genuinely gratified about. We feel that what we have is a balanced system, made up of a good mix of collective and individual responsibilities, a sensible spread of risks and a relatively high probability of coverage for the future.
This system rests on three pillars. The first pillar, the public basic provision (AOW), is a pay-as-you-go system that provides 50% of pension claims. The second pillar, or private provisions, are financed by capital funding and provides 40% of pension claims while third pillar individual supplementary provisions cover the remaining 10%.
The second pillar is the core of the pension scheme. This strong pillar, with the immense accumulated capital in pension funds, offers great advantages. This becomes evident when we look at the coverage of the pension claims expressed as a percentage of GDP. In the UK it amounts to 86%. Germany and France have 12% and 6% respectively. Capital funding is also more favourable. In the Netherlands it amounts to 58% of GDP, in the UK 56%, in Germany 8% and in France 7%.
In the Netherlands and the UK future funding has basically been safeguarded by capital funding. In France, Germany and many other European countries, this is not yet the case. About 88% of the whole of European provisions consist of public pensions funded by the PAYG system. Capital funding pensions comprise 7% and private pensions amount to less than 1%. Therefore we need to take measures and to act swiftly. The transition from a PAYG system to capital funding will be hard to bear, because of the burden of double contributions during the transition. This burden will be lighter if it is spread over a longer period. Fortunately, a number of countries are taking action now. Germany, for instance, is working on a shift from a PAYG system to capital funding and Sweden has come up with a creative solution.
But even a gradual transition to capital funding is not enough. Consider the Dutch situation for a moment. However healthy the Dutch system may appear, the Netherlands risks a rapidly growing state debt if nothing is done. Expenditures on the state pension will increase by 4.3% of GDP between now and 2040 making the present government surplus of 0.9% vanish into thin air.
Fortunately, the increasing tax returns from older people can be used to cope partly with this deficit. We have made pension contributions tax- deductible for employed people, whereas the pension benefits are taxed as income. Despite this, we are taking measures to cope with the increasing public pension costs, primarily by reducing debt in a bid to cut future interest payments. Over the past five years, our national debt has fallen from 75.3% of GDP to 52%. There is a political consensus to pay off the entire debt within 25 years. This will make available nearly 4% of GDP, that would otherwise have been spent on interest payments.
Another route is by increasing the labour participation of elderly people. That is why we encourage elderly people to continue working. We also try to curb the use of early retirement provisions by adjusting the pension system. Ideally speaking, early retirement can only take place on a basis of capital funded plans, where in the end the costs are borne by the employee proper. For this we have in the meantime created a framework by replacing provisions for early retirement (VUT) by pre-pensions and flexible pensions. Early retirement is not exclusively a Dutch phenomenon. I do think, however, that much of this problem will be solved by market forces. As young employees become harder to find, the need for companies to retain older employees will grow.
These developments urge us to take action to safeguard the future pension provisions in Europe. In this respect, private pensions can make a significant contribution if they develop sufficiently into full-grown pillars within the European pension plans. Then, we will also be able to reap the full benefits from well-managed investments. The accumulated pension capital also helps alleviate the consequences of ageing which affect the private pension funds proper. In the Netherlands, additional pension benefits will increase by 8.1% of the GDP between now and 2040, whereas the rise of pension contributions will be limited to 6.8–7.2% of wages. In other words, pensions are primarily paid from returns made on investments.
So, investments are of considerable importance and that is precisely why we have chosen a system that offers full freedom of investment for achieving high returns, without putting pension obligations under pressure. ‘Responsible freedom of investment’ is the core of the Dutch supervisory system. Not quantitative restrictions, prescriptions on how and where to invest, but qualitative principles such as safety, returns and reliability are the leading principles. The assets of all Dutch pension funds put together amounts to about E500bn. In 2000, 64% of this was invested abroad and 20% was invested in domestic shares. In comparison, France invested 5% of its E95bn pension capital abroad and 10% in domestic shares. Italy makes no foreign investments at all.
So, why the freedom of investment? The fact that it is practically impossible in the Netherlands to invest all pension premiums domestically might have helped. But also because quantitative restrictions evidently lead to lower returns, higher contributions, higher labour costs and consequently, less employment. That is why we stopped putting quantitative investment restrictions to pension funds long ago and why we have chosen the prudent person principle.
Or in other words, supervision based on qualitative principles. The independent Pension Insurance Board monitors whether the pension funds comply with legal regulations- safe and reliable investments producing enough returns to meet the obligations. This is done by ensuring that pension funds spread their risks evenly and that they have sufficient assets to meet their financial obligations. There is one general rule that the bigger the surplus, the more risk-bearing the investments can be.
Where there is no such surplus, however, strict rules are applied to safeguard returns. The asset manager himself is supervised too. Are the administration and organisation of his business properly arranged? Does he have enough expertise at his disposal?
So, no straitjackets here, but a guarantee that premiums are invested sensibly. This is the responsibility of the pension funds, but in case of any disagreements about compliance with legal criteria the supervisory body has the last say. We feel comfortable with the results. The returns are good and so far, not one pension fund has collapsed.
Still, some countries wish to hold on to certain quantitative restrictions. What they want, for instance, is that domestic savings are invested domestically by domestic pension funds. These endeavours are particularly popular in countries that hardly have any pension premiums to invest at all. Their assets are so sparse that the idea of having it invested abroad is apparently unbearable. Understandable though this may be, it is remarkable too in an age in which the capital markets have been liberalised.
It is also at odds with the concept of a common European market with a common currency, the euro. And it is not in line with the strategic goal that the European Council formulated in Lisbon: to become the world’s most competitive and dynamic knowledge economy in this decade.
Quantitative investment restrictions mean fewer returns, higher contributions, higher labour costs and less employment. The damage will be worse still if such restrictions are incorporated in a European directive. Countries that now profit from their liberal pension investment systems, countries that act according to the prudent person principle, would then be forced to comply with such restrictions.
My point of view is clear – no compulsory quantitative restrictions in the directive. It is simply unthinkable that investment restrictions would be imposed on countries such as the Netherlands and the UK as a reward for their sensible savings behaviour. Precisely because this is unthinkable, I am confident that we can eventually end up with a good directive, a directive that offers ample space for making investments while respecting the qualitative standards. Why? Because it is in the interest of a sustainable pension system. This is something that tends to be insufficiently acknowledged, because in many countries the role of pension funds is pretty insignificant.
After Stockholm, the necessity to strengthen our pension schemes is firmly on the European agenda. The urgency of reforms will become more pressing each year as the ageing problem grows. This decade, the liberal wind that has been blowing through the capital markets in the 1980s and 1990s will freshen up the pension world as well. A balanced pension system with a strong second pillar, with strong pension funds, will help to solve a lot of issues. Therefore it is important that we build up this pillar without delay. And we will find that the more room we are given to invest, the sweeter the profits will be.
Hans Hoogervorst is the Netherlands secretary of state for social affairs and employment. This article is based on a speech he gave at the recent European Pensions 2001 Conference organised by the Royal Institute of International Affairs in London