The first step towards a single EU pensions market finally became a reality in June when EU finance ministers approved a directive that will allow large firms to offer employees a single pan-European occupational pension fund. While still awaiting approval by the European Parliament, this is a promising move towards addressing the need for pension reform and harmonisation in the EU. Not only is this good news for the EU as a whole, but for Germany as well.
It is now common knowledge that Germany’s state pension systems are under intense and growing pressure. Extended life expectancy, falling birth rates and early retirement are making pay-as-you go systems unviable for future generations. The Organisation for Economic Co-operation and Development has cautioned that Germany’s pensions soon will become unaffordable to maintain, forecasting that 21m Germans will be over 65 by 2050, compared to only 13m today.
Germany, like many other EU countries, has been enacting its own retirement financing reforms to provide for future generations. The recent moves to improve second- and third-pillar pension plan capitalisation are a promising start. However, while each country must work towards reforming its own pension system, the need for a single, EU-wide market for pensions must also be considered when making these reforms. Germany took this into consideration when it created Pensionsfonds as an external pension vehicle intended to be compatible with the European Commission’s draft directive on supplementary pension arrangements across all member states.
This is not a new issue. European Commission officials have recognised for almost a decade that a single EU market would be incomplete without coordination and harmonisation of pension funds across borders. Since it published its first draft directive on the liberalisation of investment regulations in 1991, steady progress has been made towards that goal. In October 2000, the draft directive to create a single market in financial services in the area of employee benefit plans was a significant milestone. The most recent occupational pension schemes directive is an important first step towards a European passport for supplementary pension funds, which will eventually eliminate obstacles to cross-border membership and transferability of pension rights.
We have a longstanding and growing commitment to Germany and to its pension markets. In fact, we opened our first European office in Munich over three decades ago. While we recognise that each nation should consider its own demographic, social and cultural needs, we have been fully committed to supporting all three elements of today’s retirement finance systems: government benefits, employment-related pensions and individual retirement savings.
In 1999, we were the lead-co-sponsor of the ‘Rebuilding Pensions’ study with the European Commission and other financial services firms and directed by Pragma Consulting. The study collated the ‘best practices’ among European pension plans and financial service providers and created a series of recommendations that could help shape an EC directive on pension governance. The study outlined five broad prudential principles that investment managers should use as a guide: security, profitability, diversification, quality and liquidity. We were pleased to see many of the best practices outlined in thestudy included in the occupational pension schemes directive.
A significant element of the directive embeds the concept of the ‘prudent man’ principle, giving pension plans the ability to invest up to 70% of fund assets in equities, allowing asset managers to make investment decisions following prudent investment principles to meet the plans’ liabilities. This will be a significant change for many of the EU member states, including Germany, where occupational schemes like Pensions and Unterstützungskassen have been required to follow strict quantitative guidelines that allow only 30% of assets to be invested in equities. In contrast, the prudent man principle ties the investment decision to the evaluation of total portfolio obligations entered into by each fund, instead of tying them to a single bundle of quantitative rules.
The most important principle that should be adhered to is providing security for pensioners and workers. Actuaries play an important role in providing this security. We were pleased to note that the directive will require regular review of the application of the rules regarding the calculation of technical provisions for plans, such as interest rates and other assumptions influencing their levels. Another aspect of security is to maintain a clear separation between the company’s assets and those of the pension fund, as well as between management and the board of directors. The board should be the highest authority of the pension fund and be ultimately responsible and accountable to the members and beneficiaries, to the plan sponsor and to the supervisory authority. The board should be a true reflection of the stakeholders of the pension fund.

Another encouraging aspect of the directive is the call for transparency of pension structures and reserves. The text calls for full funding at all times in the event of cross-border activities; the approach is more flexible regarding domestic pension practices.
Equally important is the separation of pension assets from corporate assets. Currently, the majority of German employers use the book reserve method, where the employer makes the pension commitment to employees and accrues a liability on the balance sheet. However, more companies are moving their pension liabilities off-balance sheet to improve the structure of their balance sheet and meet International Accounting Standards.
The move away from book reserves to funded schemes will play an integral role in the continued growth of Germany’s capital markets. According to estimates by Morgan Stanley and Goldman Sachs, the funded pension market in Germany will be valued between e700bn and e1trn by 2010.
Finally, the directive is an important first step towards providing mobility for workers and flexibility for employers to move employees across Europe and their affiliated companies. There is clearly a need for change in this area. According to EC statistics, within a year of starting, only 16.4% of EU workers change jobs, compared to 30% in the US. It is often difficult for workers to transfer pensions within the same country, much less within the EU. German companies that want to attract and retain the best employees from across the continent are at a disadvantage if they want to compete at an international level. We are encouraged to see the Commission is taking further steps to remedy the problem, including its recent communication on ‘Portability and Transferability of Supplementary Pension Rights’ and its consultations with interested parties about steps that institutions can take to improve the situation.
The benefits of harmonisation of pension funds across borders cannot be denied. As the barriers to cross-border pensions are gradually removed, financial services providers will be rewarded through increased economies of scale, the ability to diversify risk, and the opportunity to provide innovative new products to service the growing market. International companies operating in Germany will have a distinct competitive advantage. For example, full-service investment houses will have the opportunity to serve as outsourcing resources, both in the provision and servicing of new products, including fund accounting, daily valuation and shareholder record keeping. Global providers bring a unique expertise to German investors in administering and managing complex investment strategies. In addition, they have the advantage of scale, and therefore can absorb the inherent risk in these more complex services as well as the ongoing cost of technology to support them. Spezialfonds providers that can cover the full array of asset classes also will be able to develop more finely tuned, sharply focused strategies to meet a variety of investment objectives.
Harmonisation will allow German employers to provide the same level of benefits at lower cost, ease administrative burdens and increase their ability to attract the best talent from across the EU. In turn, their workers will enjoy lower costs for financial services, a wider range of investment and savings products, better returns on their investments and greater flexibility and, in general, a more efficient three-pillar system.
Reforms to the second and third pillar systems will ease the German government’s burden on funding the first pillar scheme. The German economy as a whole will benefit as savings rates increase, capital markets grow, and more capital becomes available for businesses to develop and prosper.
While there are still issues to be addressed before we enjoy a truly pan-European pensions market, recent developments point to a promising future, not only for German citizens but also for the financial services firms that are poised to serve their changing needs.
Thomas Bergenroth is with State Street Bank Germany and Klaus Esswein is with State Street Global Advisors, both based in Munich