Retirement Plan Design and Investments: Trends in Europe, Insights for North America
Pension Section News – Number 64 | May 2007
Retirement Plan Design and Investments: Trends in Europe, Insights for North America
By Frank Goasguen, Global Head of Institutional Clients, ABN AMRO Asset Management
European pension funds face challenges similar to those facing North American plans, so developments in Europe may help U.S. and Canadian plan sponsors find their way to a reasonable resolution of their current problems.
As in North America, the pension systems in European countries consist of three pillars:
Relative reliance on each of these pillars varies from country to country across the continent. For example, in Switzerland the state system targets a pension of about 30 percent of final salary, while in Italy the state system targets an 80 percent replacement ratio. Combine the Italian state system’s high replacement ratio with a high proportion of older workers, and it is not surprising that Italy’s 1st pillar system is in urgent need of reform, as shown below:
Reforming the state-provided pillar in many European countries will result in more inflow into the 2nd and 3rd pillars.
Both defined benefit (DB) and defined contribution (DC) arrangements can be found in Europe. Utilization of these designs varies across countries due to different historical factors and social norms. In several of the Eastern European nations that recently joined the European Union, 100 percent of employment-related plans are DC. By contrast, “old Europe” largely favors DB plans.
In total, about € 3.3 trillion (about $4.3 trillion US) is invested in European employment pension funds. The largest asset pool is found in the United Kingdom, at € 1.3 trillion, where major companies tend to have large DB plans. Two relatively small countries, The Netherlands and Switzerland, have large DB assets (€ 489 billion and € 393 billion, respectively) due to their compulsory 2nd pillar pension schemes.
Individual Retirement Savings
Europeans have roughly € 830 billion invested in individual retirement savings. Of this, almost ¾ is found in the United Kingdom, benefiting from favorable tax treatment for personal retirement savings as well as a more equity-oriented culture. Personal savings for retirement are relatively low in Germany and The Netherlands due to strong employment-related systems and less equity-oriented societies, and are also low in Italy and France due to heavy reliance on state systems.
A recent McKinsey & Company Study (“The Asset Management Industry in 2010”) identifies two key trends in the European pension environment:
For DB plans, these trends imply either a move to become DC plans or a move to change how the DB plans themselves are managed in order to keep them viable. For DC plans these trends imply continued growth as well as an evolution towards investment products that meet member and sponsor goals rather than seeking to track market-based benchmarks.
The remainder of this article considers these trends in more detail.
Managing in the New DB Environment
As suggested above, those DB plans that are not contemplating conversion to DC are changing their investment paradigms to ensure their longer-term viability. Just as in North America, accounting rules and valuation regulations have caused DB plan sponsors to face much higher volatility in their pension expense and balance sheets. Similarly, low long bond yields and a historical reliance on market index tracking have exacerbated this problem. The pension funding crisis is not just a North American phenomenon!
DB pension plans bear risks as a result of interest rate movements. In recent years, European plans have been trying to manage this risk by investing in long duration bonds, cash flow matching portfolios, interest rate swap overlays and swaptions. However, these approaches do not address the issue of equity risk, and can have some serious consequences for the pension expense as well. Consequently some European pension plans are taking a more holistic approach using liability-driven investing (LDI). The challenge for the pension trustees and their investment manager(s) in operating an LDI approach is to construct a portfolio that combines two separate sub-portfolios:
The upside portfolio can be created by combining uncorrelated returns from both strategic market exposures (beta) and from active management (alpha). To maximize the upside potential, the opportunity sets can be increased in both the alpha and beta exposures.
It is important to note that LDI is not the same as asset/liability management (ALM) as the latter has been traditionally practiced in Europe and North America. While both ALM and LDI are about linking assets and liabilities, the outcome of an ALM study tends to be a fixed strategic asset allocation. By contrast, LDI provides an opportunity to manage the pension fund portfolio relative to the liabilities in a dynamic way, taking into account changes to the funded level and risk profile of the plan as frequently as daily (although usually monthly). Dynamic LDI–An Example
The idea behind a dynamic LDI approach is to increase the commitment to higher-yielding “risky” assets when the funded level is higher, while increasing the commitment to the hedging or “risk-free” portfolio when the funded level is lower. This concept is similar to the constant proportion portfolio insurance approach used in some guaranteed investment products. It is designed to protect the funded ratio in bad times, and to take advantage of good times to build up that ratio. An example of the impact of this dynamic LDI approach in practice is shown below:
The chart and table compares the probability of the funded ratio of the real-life DB plan in question under two alternate approaches: traditional funding and dynamic LDI. The horizontal axis shows bands of funded ratios (for instance, “105% to 112%”) and the vertical axis shows the probability the actual funded ratio will be in the band. Compared to traditional funding, the LDI approach has delivered the same expected funded ratio for the plan (111 percent in this case), but with much less volatility. In particular, it is much more likely the plan will remain fully funded using the dynamic LDI approach.
The ability of dynamic LDI to keep funded ratios within a relatively tight band even in bad markets is illustrated below.
Of course, to properly benefit from dynamic LDI the plan sponsor must ensure very close communication with and between the actuary and the LDI investment manager so that the manager can explicitly take account of the development of the plan’s liabilities on an ongoing basis. This close cooperation is visibly developing between some European investment managers and actuarial consultancies. In this fashion, European DB plans intend to maintain and improve their long-term viability.
Outcome-Oriented DC Solutions
The dynamic LDI approach for DB plans is an example of an outcome-oriented approach to DB investing. Instead of focusing on market indices, the focus is on achieving a specific real-world outcome for the DB plan. A similar trend towards an outcome orientation is evident in DC plans in Europe (and elsewhere), as well as in the individual investment area.
In the DC world, outcome-oriented investments include:
According to the McKinsey & Company study mentioned earlier, the fastest growing of these product segments over the last 10 years are the target-date lifecycle funds and the inflation indexed investments. ABN AMRO Asset Management has noted that combinations of outcome-oriented features are also proving popular, such as target-date lifecycle funds that include guarantee provisions.
As more and more of the assets of DC plans (and individual retirement savings) concentrate in the hands of members who are age 55 or more, income generation will assume an ever-greater importance.
In the new market environment that is emerging in Europe, and in North America as well, there will be a great demand for investment solutions that capture the future needs of DC members and individual investors. These include
As DC plans evolve to meet these needs, a trend is already becoming visible in some parts of the world that will likely occur in North America as well. Over time, plan providers (whether sponsors themselves or the service providers such as insurance companies) will move to define a carefully selected set of investment options and managers rather than a fund supermarket. This trend is already well advanced in Australia and is increasingly visible elsewhere.
European pension funds are grappling with similar issues to those facing American and Canadian plans. Proposed solutions include strengthening the DB model, and switching from DB to DC plans. The solution chosen in a specific country seems to depend at least in part on cultural factors. In either case a move towards outcome-oriented investment solutions will intensify.
Frank Goasguen is global head of institutional clients at ABN AMRO Asset Management.