The European pension fund market is in crisis. The state run pension fund systems throughout Europe are struggling to cope, and demographic projections for the next 45 years mean the situation will only deteriorate. More and more individuals are turning to privately run pension fund schemes to support them in their old age, as the state system buckles under the weight of pensioners. The question arises: are companies and individuals doing enough to ensure a comfortable retirement? Pension funds are focusing on their long term liabilities in their investment style, and seeking asset classes to match. Real estate has proved to be a high yield asset class, coupled with offering investors an attractive risk/return profile, compared with the broader equities market. These characteristics fit well with the current liability driven investment approach of pension funds. But how do pension funds invest?

Demographics shift – past, present and future
Populations in many of the mature economies around the world are aging. Western societies are aging for two reasons. Death rates are declining – people are living longer because of healthier lifestyles and better healthcare systems. In addition, birth rates are declining. In Europe, on average, family sizes are decreasing. In summary, we are producing fewer children and living longer. Policy-makers and analysts are fully aware of the time bomb waiting to cripple our social security system.
1950: The female population (Figure 1) is highlighted in pink and the male population in blue. From an economic aspect, the graph is very healthy. We have a broad base of young people (the baby boomers) aged between 0-19 years, a healthy labour population aged between 20-64 years, which supports the narrow top layer of retirees aged 65+ years.
2005: 55 years on, in 2005, the demographic picture looks a lot different (Figure 2). The broad base of the young in 1950 now comprises the rump of the worker population in 2005. The overall demographic picture is far more rounded. The young base is now narrower than the worker base, which obviously means there will be fewer workers in the future. Better healthcare and increased life expectancy has resulted in a broader retiree band, increasing pressure on the worker band to support them.
2050: Figure 3 (see over) displays the Europe population estimates for 2050. Over the course of the 100 years analysed, the demographics of Europe have almost been turned up-side-down. The retirees outnumber the young, and the aging worker band looks top heavy. The population distribution is top heavy, and as a consequence this will put incredible pressure on the worker base. In fact, the worker base is set to shrink further, as the young band narrows from 19 years down.
According to UN figures (Table 1, see over), in 1950, the number of workers outnumbered retirees by seven to one. By 1975, this figure was five to one, it is currently (2005) four to one, with projections indicating it will be three to one by 2025, and two to one by 2050. This poses enormous problems. So far, different EU members favour a range of strategies to tackle the problems. These revolve around three options:
n Closing ‘pay as you go’ financing gaps by increasing pension contributions;
n Shifting to public pre-funding of pensions by running surpluses in the public pension system over the next two decades; and
n Shifting to private pre-funding of pensions.
Resolving these tensions in a forward looking way would require more focus on the third option; that is starting to build up a private pension component now so that it will eventually help to compensate for the unavoidable future cutbacks in public pension benefits without pitting younger and older against each other.

European private pension funds landscape
The recognition by countries across Europe that they can no longer finance current levels of state pensions has resulted in countries paring back benefits as mentioned earlier. Consequently, the pressure is on individuals and companies to take up the slack. Historically low interest rates, stock market declines and a growing number of retirees, has led to a pension underfunding crisis that is threatening the future of the defined benefit pension plan system in many parts of the world. There is a growing consensus that pension benefits of workers throughout Europe are at risk.
Table 2 (see over) displays the size of the private pension fund market in Europe. Total assets under management are around e4.3trn. The top 100 pension funds in Europe sit on assets valued at about e1.1 trn, or a quarter of the total. The top 20 pension funds amass roughly e750bn, with the largest pension fund in Europe, ABP of the Netherlands, just over the e150bn mark. Looking at assets under management allocated to property investments: be it direct holdings, non-listed funds and listed property, the average is 6.5%.
In terms of the assets under management in private pension funds in developed Europe, the UK is by far the largest market with just under e1.6trn under management. The Netherlands, second in the list, has about half this amount under management at e700bn. Switzerland hits third spot, with just under e400bn under management. Not surprisingly, countries such as Germany, France and Italy that have historically provided very generous state pension plans to its retirees, are not well represented on the list. Remarkably, Spain, one of the largest countries in Europe in terms of economic power and population, lies in12th place, behind the small Scandinavian countries and Ireland.
However, it is unfair to compare the countries in Europe by assets under management alone. If one compares assets under management against gross domestic product for each of the developed countries in Europe, the list looks different. The Netherlands assets under management cover almost 170% of the county’s GDP. Switzerland’s figure is close to 150%, while Denmark is around 110 per cent.
The UK is just under 100 per cent of GDP. Now the potential problems faced by Italy, Germany, France and Spain really become evident. Italy achieves just over 20 per cent of GDP, but Germany, France and Spain all fall a long way short of the 20 per cent mark. The combined population of the latter three countries is 180m.
What does this mean for each of the developed countries in Europe? If one divides assets under management by population, the list looks different again. Switzerland now heads the list with an average pension fund size e52,000 per head. Individuals in the Netherlands stand at e45,000 per capita, while the Danes hit e37,000. In the UK, the largest country for absolute assets under management, the figure is e26,000 per person. Incredibly, Italy, Germany, France and Spain all fall short of e10,000, by a long way. In fact, assets under management in France and Spain are under e2,000 per head. It is clear that with state pension fund system set to change considerably in Europe to tackle demographic shifts, the onus will be placed in the laps of individuals and companies.
However, looking at the current state of the private pension funds in Europe, even in the more wealthy countries, it is clear the system is under-funded. In the UK, the Pensions Commission said: “As private companies have limited access to generous pension plans, more than 12m people in Britain, one-fifth of the population, are not saving enough for retirement.”
Unlike most of continental Europe, the UK has traditionally relied on its people to augment modest state pensions by saving for their old age through private and company pension funds. In recent years, pension funds have lost tax breaks worth some e8bn a year, stock market declines have eroded portfolios and savings have given way to a huge surge in private debt, partly because of a booming housing market.

Shift to liability-driven management
Robert Hayes, head of strategic advice at Merrill Lynch Investment Management, believes there are three major themes in pension fund investment at the moment. Each of these aims to solve specific problems rather than provide sources of return. They revolve around a liability-driven approach:
n Use bond markets to match liabilities and reduce risk;
n Re-examine equity mandates, considering the move to longer term, less constrained mandates;
n Search for additional alpha, through hedge fund investments, or portable alpha strategies.
The move to a liability-driven approach means that pension fund advisers and investment managers need to take a holistic view of the pension fund to fully understand the problems. This requires changes to the nature of the relationship between the pension funds, consultants and investment managers. Key is the understanding of the pension fund’s liability requirements.

Added value of real estate investment
Where does real estate fit into this liability-driven approach? The high-yield focus of the property sector offers investors the necessary income stream, enabling the matching of ongoing claims. In addition, low correlations with the boarder equity and bond markets, provide diversification opportunities in a multi-asset portfolio. In summary the risk/return benefits of listed real estate are:
n Enhanced diversification;
n Reducing correlation with stocks;
n Superior risk-adjusted returns;
n Strong added-value and risk-reduction benefits of property stocks in a mixed-asset portfolio;
n Focus on dividends, particularly REIT-type structures;
n Higher REIT/LPT exposure generated greater portfolio wealth.
State pensions will cease as we currently know them. Europe recognises that dramatic pension reform is urgently required. Ultimately, the onus will shift onto the private pension fund market, but that has its problems also. Contributions need to increase to provide comfortable levels of retirement for the retirees of the future. The crisis has led fund managers to look towards a liability-driven approach to management.
Real estate investment fits a number of criteria in the liability-driven approach, and this seems evident from the results of recent surveys, in which institutional investors envisage an increase in allocations to real estate. If allocations to real estate increase, the potential inflows could be significant. If the average allocation in Europe shifted from 6.5% to 8%, an additional e65bn would flow into the sector.
Fraser Hughes is research director of EPRA