Most major European countries seem to be sitting on a so-called pensions time-bomb, with unfunded state pension commitments threatening vast increases in taxation.
The expected growth in the private sector has the marketing departments of UK investment managers and actuarial consultants salivating. But is every firm assured a rosy future? Are they assuming that the experience of Europe will follow that of the UK? Might they not learn from our mistakes rather than merely repeating them?
Europe might be home to the first market where indexation will be the norm rather than being treated as some odd, specialist approach to investment. Investment management grew out of a perceived ability to perform better than the market by picking a select portfolio of shares. The harsh reality is that around 50% of pension fund managers perform worse than the market as a whole: the advent of detailed performance monitoring statistics has made this all too apparent. Furthermore, cheap computing power means that an alternative is available: buy all the stocks in the relevant index, and simply track the market.
Because indexation arrived after traditional management, it has often been presented as something which needs to be justified to warrant a shift away from the so-called experts. But in fact, the rational place to start when considering which investment option to use ought to be indexation: it is comparatively cheap and it does the job in terms of providing an average performance. Indexation also removes certain risks: the risk that your manager will underperform, a factor which ought to be a crucial consideration for individuals who are members of defined contribution arrangements, and the risk that your star fund manager decides to leave.
So, will Europe adopt indexation as its primary form of investment for pension funds? This is a huge question. The UK pension fund market is of the order of £500bn, and around 10-15% of this is indexed in one form or another: the percentage in America is higher at between 20-25%. In the longer term, the major economies of Europe might each have pension fund markets of comparable size. Whether the indexed proportion is 10%, 20% or 50% makes a big difference to the fortunes of companies offering indexation, but equally to those managers offering active products who might find themselves squeezed out of the market. In addition, investment consultants will find that there is less work for them to do in a market dominated by such arrangements: as index managers hardly ever underperform, you rarely need to appoint an investment consultant to find a new manager.
We won’t have the answer for a few years yet, but remember the above when listening to the blandishments of those advocating either indexation or active management: they may well be arguing for far more than just the assets of your pension scheme.