Denmark has one of the most developed contributory pension systems in the world. All but 5% of Denmark’s second pillar pensions are operated on a defined contribution basis.
Their reach has been widened by the growth of industrywide schemes set up in the mid 1990s as result of collective agreements between unions and employers organisations. Today between 80% and 85% of the working population are covered by a DC pension plan. Conversely, company sponsored pension funds have been shrinking in number, and now account for only 4% of the pension fund market
Employees typically contribute one third and employers two thirds, both of which are tax deductible. Initial contributions to industry-wide schemes have been small, starting at below 1% but planned to grow to above 9%.
Hasse Nilsson, of Alcifor Advisory Associates says the system has grown in strength: “Contributions have been rising over time, determined as a percentage of salaries as part of the regular collective bargaining, with a target of 10% to 15%. Most of the schemes today are above 10% but below 15%, so we are almost where we want to be.”
Most pension plans are financed through with-profit deferred annuity contracts. With profit deferred annuity contracts funds are requited to generate an investment return of 2.5% to 4.5% depending on the actuarial basis of the funding vehicle. For contracts for scheme before July 1994, the interest rate is 4.5%, though, since then, the rate has been considerably lowered.
The retirement benefits that a guaranteed fund Denmark’s DC system are calculated according to this interest rate, which is determined by the Danish Financial Supervisory Authority in line with the Third EU Life Directive.
This system of guaranteed returns is now under considerable strain, following double dip in global equities and the fall in domestic interest rates. Although contributions are not at risk, future yields from the pension funds are in doubt. Insurance companies and pension funds are now asking where future returns are to be found.
Jesper Kirstein, founder of the mutual fund rating company Kirstein Finansrådgivning, says the current crisis has highlighted the fact that guaranteed return system prevents companies from seeking higher returns. “Although the pension companies have spent a considerable amount of effort building up their reserves over the past 10 years, they are still, in many cases, deficient, so that they are unable to conduct the investment policies they would like.
“The companies have had to build up reserves as an investment buffer, and when times get rough they are forced to take investment decisions which are sub-optimal. They are not free to choose the optimal investment strategy.”
Kirstein suggests that the problem lies in the asymmetry of the system: “The trouble with the traditional guaranteed scheme is that you have a long-term investment horizon but you have short-term restrictions. The guaranteed return is like an option. The company sells an option to the insured and that option has a price. The price, inevitably, will be a lower long-term return.
“This is why insurance brokers are now trying to convince their clients – and for very good reasons – that it may be wiser to move to a more unguaranteed system. They can move from a high guaranteed rate of return of 4.5% to a low guaranteed rate of return of 1.5% which some of the companies supply. Or they can move to a system where they have no guaranteed return at all.”
This is no real loss, he suggests. “In the long run the guarantee has a rate of zero. You can make any assumptions you want about future returns, but if you have a long-term investment horizon the guarantee has no value.”
Jorgen Leschly, of the investment consulting company Willis in Copenhagen, believes that people have been seriously misled about what thy can expect from their pensions under the guaranteed returns system.
“When all these industrywide pension schemes were set up in the 1990s the idea was to make something comparable to the civil servants pension. But the civil service pension is 60% of the salary at the level where you retire. A 15% contribution and 4.5% return on your investment is never ever going to produce 60% of final salary.
“So people in Denmark have been fed a lie that their contributions are going to provide them with a nice retirement egg. And one of the biggest challenges we face is that we have had DC systems since the late 1970s, but people have not understood that they are being handed the short end of the stick. They have not been bothered because for a long time the markets were booming and the returns were great.”
Leschly argues that people are going to have to switch to unit-linked investment to get the necessary returns. Unit-linked is still a small though growing part of the pensions market, and interest has been concentrated in certain types of company. “It started out as something you saw all the new economy IT companies doing. They felt they would be unable to attract fast moving, fast thinking people if they had a traditional pension fund. So they incorporated a pure unit-linked strategy,” he says.
Larger companies have been less enthusiastic, and have typically bolted on a unit-linked option to a traditional guaranteed scheme. Employers are worried that their employees will invest unwisely, Leschly says. “Often we hear the argument from employers that they can understand that unit-linked will provide them with the option of having a greater return or more flexibility, but they are reluctant to hand responsibility to an employee for investing his own money for his own pension.”
Carsten Schmidt, manager at benefit consultants Aon Denmark in Copenhagen, says that unit-linked is now a standard component of a corporate pension scheme. “Of the plans we set up, either new or adjusted design, nearly all will have some element of investment choice.”
However, the guaranteed element remains the backbone of the pension system. “Quite often employers will say that their contribution of two thirds will have to go into guaranteed interest but that employees can choose for themselves whether to invest in unit-linked. Very few plans we set up are 100% unit linked.”
The collapse in the equity markets does not appear to have discouraged investors, he says, although some will have lost 40% of the value of their investments. “It’s pretty amazing that there’s been very little response, even in the scandal press, about how people have lost lots of money. We haven’t seen this kind of comment yet. So initially it seems the ordinary investor accepts that the market goes down as well as up.”
However, unit-linked is not the only alternative to a guaranteed return system Kirstein says pension fund companies have another option – to abandon guarantees entirely and actively manage the money themselves “There is no necessary, inevitable progression from an unguaranteed system to a unit-linked system. The companies themselves might be able to supply an unguaranteed system and manage the investment themselves.
“This is a very interesting development. Do the companies have the competence to manage money? Is it a core competence for an insurance company to manage money? In my view, not necessarily. “
Certainly, there has been a growing move to outsource investment management. Large insurers such as Danica and Tryg-Baltica, number two and three in terms of market share and contributions, have outsourced the management of their money, albeit to their subsidiaries. Codan, number five, has outsourced its money management entirely.
The move away from guaranteed interest could represent an opportunity for investment managers in a pensions market that has been hitherto dominated by insurance companies.