The future of European pensions is defined contribution (DC). Even in countries with strong defined benefits (DB) traditions, the trend is to-wards DC for new provision, with the UK providing a clear example of this.
For the investment funds industry this might appear as a state approaching Nirvana, as a whole continent decides on moves that should result in massive flows of assets in its direction. But life is rarely as clear-cut as that and the DC scene is no exception.
Lurking in every fund manager’s consciousness is the US experience. Here, the rise of the 401k DC pension vehicle was followed by an unprecedented flow of assets into the mutual funds industry, which has never had it so good.
But Europe is not the US. There are 15 or 20 markets as compared with one in the US. When Europeans say they are going DC, what is happening in Italy is considerably different to what is occurring in, say, Sweden or Ireland. The 401k is a standardised vehicle, while those being established in Eur-ope most certainly are not. If there is a common feature of all European DC schemes, it is that some type of individual account is set up and the assets that will eventually provide the pension are allocated to this. But the variety of ways in which this can be done are breathtaking in their ingenuity. Sometimes, these accounts are on a unitised basis, but not necessarily. In other cases, the build-up of the assets is more akin to a with-profits insurance bonus or deposit administration contract.
So what are the prospects for the investment fund industry in the DC revolution that has been proclaimed and is under way?
The UK is usually closest to the US model, but it has its own DC history, hidden behind the term ‘money purchase’, which before the real growth of salary-related schemes was the main pension method. By numbers of schemes and pension plans for individuals and smaller employers, money purchase or DC arrangements are still predominant, but not in terms of pensions assets. These plans are usually arranged with insurance companies, though other providers such as fund groups have made some inroads into the personal pension plan market both for individuals and groups.
The recent change in the marketplace has been the switching by some of the former DB schemes to DC, but usually only for new employees. Few schemes have made the full switch from DB to DC for all members.
Ironically, the investment management groups keen to participate have found that life companies have particular advantages for running DC schemes, and a number have set up their own life companies, to feed into their exempt unitised funds. Mercury Life has been the most notable exponent of this course of action. Now a number of managers are holding back from taking this step, as they believe that with minimal legal changes they may be able to use the new tax-favoured LISAs for DC pension provision. But lobbying on this issue is not over. LISAs could invest directly into the exempt authorised unit trusts, available to pension funds.
Current estimates put assets in occupational DC schemes at around £15bn, with projections for this to grow to £50bn by 2008. This compares with over £600bn now in DB assets.
In Ireland, the DC scenario is much the same as in the UK, in that virtually no new DB schemes are being established and the way forward is through DC corporate and individual arrangements, usually through insurance contacts and so invest in internal unit-linked life insurance funds, rather than investment funds.
The Netherlands has a big base of assets to match its DB schemes. But every new plan is now on a DC basis. There is considerable switching of existing schemes, but often with a hybrid DC/DB approach. The insurance companies have their products in place and look like taking the lion’s share.
In France, when the revolution comes, it looks like being in the DC mode, but in Gallic dress. The insurance presence is likely to be strong if not supreme, though these DC assets may be then outsourced to investment fund groups. Currently, any supplementary pension plans being established by employers will be on a DC basis. It is possible to do this with COB approved funds, though some form of life insurance wrapper needs to be used. The high cost of the current pension regime in France deters employers from providing additional benefits in supplementary schemes.
The German predicament on the occupational pensions side grows worse. Not only is it impossible to set up true DC schemes on a tax efficient basis, but in fact, few new pension schemes at all are being organised by employers and the numbers covered by occupational schemes are in decline, while the social security pension system itself heads towards bankruptcy. The new government seems to be in the grip of the same paralysis as the previous one in failing to grasp the pensions nettle. Cash balance schemes, providing a lump sum on retirement, are akin to DC in that the benefit emerges as a lump sum. However, where this is funded, it is done as for DB schemes. This can involve the use of external investment funds – such as Spezialfonds which in turn can provide openings to external managers as sub advisers.
The third pillar AS (Altersvorsorge-Sondervermögen) funds are new officially approved vehicles devised by the fund industry as a way of heightening awareness of the need to make provision at a third pillar level. These are being offered to individuals by the KAGs, run by the banks and fund groups. They are certainly a DC unitised product, but – as so often in the European approach – they have their own investment programme set out, with a spread of investments over a range of assets to a stipulated model (see IPE April, page 40).
In Italy, the new regime of industry-sponsored ‘closed’ schemes for those in certain occupations, or the ‘open schemes’ for others run by banks, insurers and investment groups, have embraced the DC principle, with individual accounts building up for members, and with the benefits depending on the investment returns. But the closed schemes are likely to be conservative initially and take the route of managing their investments collectively in one pool on a segregated basis. For the ‘open’ funds, this is very akin to true DC, but only funds of approved groups are eligible. Fund groups have generally been developing a special range of unitised funds for this market, often on a risk-rated basis.
The way forward in Spain, where funding is becoming obligatory, is through the DC archway, with pension funds being provided by pension operators, run by fund groups or insurance. The outsourcing of these assets to third-party managers is likely to develop as their is a need for greater diversification, though perhaps not in the immediate future.
Since the Swiss require that pension funds provide a minimum return of 4% per annum, changing to a DC from a DB environment is not easy. But there are trends to DC, where mutual funds would largely be used. To expect a wall of assets to come from this source into investment would be optimistic, despite the Swiss predilection for funds.
The Danes have a long established DC environment for pensions, which are usually through big labour market arrangements, often operating through centralised administration organisations, running schemes for a number of bodies. The schemes are on a DC basis, but with assets run on a segregated account basis, with a common strategy for each fund, on which a guaranteed rate of return is earned. An account operates for each individual, whose contributions earn a with-profits type insurance bonus depending on the fund’s performance. Third pillar individual pension arrangements available from banks and insurance companies are often on a unitised or unit trust basis.
It is the Swedes, however, that have embraced the DC revolution most wholeheartedly, with part of the first pillar state scheme being allocated to investment funds meeting Ucits requirements. In addition, the white and blue collar workers’ schemes are also moving to DC with a wider choice of investment or insurance funds. The PPM mechanism is being set up to handle this enormous flow into investment funds of the individual’s choice under the state scheme. The growth of corporate pension funds through pension foundations is largely on a DB basis, but with the change to the union and management agreements on pensions, DC may become the mould in future.
Sweden apart, no European country looks likely to deliver significant outflows of DC funds to investment managers in the near future, since most of the systems in place have a local twist, slowing up the opportunities for outside groups. Nonetheless, the DC revolution is in happening and its long-term impact on investment funds is bound to be significant – but don’t hold your breath.

Topics