Numerous articles have been written about the demographic need for pension reform as countries across Europe struggle to come to terms with their ageing populations. The responses of individual European countries have been varied, as each, to a greater or lesser extent, moves from state provision towards private funding. The total pension fund market in Europe is now estimated at $3.9trn (E4.46trn). However, a significant portion of this is not available to third-party providers, due to the prevalence of book reserve systems (eg Germany), in-house management (eg Netherlands and Switzerland) and insurance arrangements (in many continental markets).
Germany, France and Italy are the countries that potentially have the greatest unfunded pension liabilities. If they move in the direction of funding they will become the countries with the greatest potential asset management opportunity. Germany’s commitment to pension reform has been regarded with some scepticism, yet in the past 18 months there has been a genuine shift in legislation to create funded pensions, with the introduction of both Reister funds and new occupational schemes (Pensionsfonds). The latter require all employers that have employees covered by the state scheme to provide a company scheme open to salary contribution by employees.
In Italy, where the majority of pensions are provided through life insurance, after many years in the planning there has also been some headway towards funding, through legislation that encourages the take-up of private pensions (Fondi pensioni). Italian employees pay a mandatory 7.1% of their salary to a redundancy scheme (TFR) which is accounted for as book reserves. It is possible that the Italian government will make it mandatory to use this TFR as a savings vehicle that will represent the release of a significant number of assets. Italy also has the largest mutual fund growth in Europe.
France on the other hand remains seemingly unconvinced about the need to fund and retains its precarious dependence on the state. The largest area of investment growth in France is mutual funds, with the largest mutual fund market in Europe.
In countries like the UK and the Netherlands, where pension funding is more established, there is a shift of a different nature. The shift in these ‘mature’ pension markets is away from corporate defined benefit schemes towards defined contribution (DC) schemes (see figure 1).
Legislation in Italy, in 1993, has meant that all new pension schemes must be DC. Sweden’s state pension is funded through AP Fonden, a variety of buffer funds from which employees can choose from a number of fund managers. The two largest industry pension funds in Sweden have also switched to DC.
These are some of the solutions that have been created to deal with the looming unfunded pension crisis. But are they enough? There are two other options, the first is to raise the retirement age substantially. This may seem an unpalatable option today but could be a solution in future. The second is for individuals to pay more towards their retirement during their working life.
What has the growing move to pension funding meant in investment terms? In the Euro-zone countries there has been a major shift from domestic to Euro-zone investment (equities as well as bonds) especially in Germany and France. Domestic assets now represent less than 50% of European exposure. In almost every country, the allocation to equities has risen both by value and number of mandates – especially Germany. There has typically been a corresponding fall in the asset allocation to bonds (see
figure 2).
In the past few years growth of specialist mandates, that is, single asset class as opposed to multi-asset, has continued throughout Europe, but more so in the UK than in other countries. The proportion of multi-asset mandates has correspondingly reduced. The switch from the multi-asset approach to specialist will also create opportunities for high-quality foreign managers
in those countries that have traditionally invested with domestic players.
Equity returns over the past 20 years surpassed predictions at almost 20%, where valuation growth represented 8% of total growth, earnings growth 5.2% and a further 4.4% was generated from dividend yield. The projection for equity returns over the next 10 years is 7.5%, according to Deutsche Asset Management, with 4.5% expected to come from earnings growth and 3% from dividend yield – although debate surrounds the likely returns from valuation changes. If these projections are correct the steep decline in equity returns will create opportunities for managers that can generate alpha.
For the same reason, there will clearly be increasing demand for alternative investments. This view is supported by the interest being expressed among funded pensions (typically DB schemes) in investment in funds of hedge funds. There is also a strong marketing push among traditional hedge funds to attract these institutional investors.
Index-tracking management has also grown from 3.6% (in 1999) to 4.1% (in 2000) in continental Europe. Most notably, use of index tracking in Belgium, Ireland, Spain and Switzerland has grown most significantly (between 20% and 30% in the period). The trend towards indexation across Europe is likely to continue for the foreseeable future as it provides an efficient vehicle for access to equity investments.
In recent years there has also been significant growth in the corporate bond markets in Europe. In the UK, the growth in demand for fixed income products has been stimulated by a number of factors that include accounting changes requiring companies to show pension liabilities on their balance sheets and the greater demand for fixed income products that typifies a maturing pension environment.
What of the future? Whilst by definition predicting the future can only be an extrapolation of the present we postulate in figure 4 the pension funding positions of the major European countries in 2010. On this basis, the countries likely to have the greatest momentum in the shift to funded pensions are Germany and Sweden. As such, they therefore represent a clear asset management opportunity in the coming years. France, on the other hand, if current trends are a reflection of the future, will remain behind the curve. The extent to which there is a shift from state to private funding may also have an impact on the demand for particular investment products with those countries that move to private funding likely to generate a demand for even wider asset management opportunities.
The extent to which there is further movement from the state to private funding and the timeframe in which this happens will be key to the future of the European pension market. In any event the future generations of Europe are likely to have to work longer, and/or save harder for retirement than did their parents or grandparents.
Frances Smyth is a senior consultant with WM Mercer Manager Advisory in London