Pension Funds Online

A look into the future of defined contribution in Europe: Results of an expert survey

Over the last two decades, global pension markets have seen a fundamental shift away from defined benefit (DB) to defined contribution (DC) plans. The trend began in the United States and spread on to many Latin American, Asian and eastern European countries and is having a tremendous impact on public policy, the retirement industry as a whole, and the retirement security of future retirees. Though it has been bucking the trend for quite some time, DC plans are also becoming increasingly popular in western Europe. In order to compensate for benefit cuts initiated by European pension reforms or to facilitate a more balanced system, many European countries have introduced funded DC plans.

Europe is a diverse continent, which is made readily apparent by its different types of pension systems. It should come then as no surprise that European DC plans are as varied as are its individual countries. Not only are DC plans taking different forms and developing at significantly different speeds, there are also broad differences in institutional design, regulation and investment strategies, which has  resulted in a multi-faceted European DC landscape. For example, while the shift towards DC is well advanced in countries such as the United Kingdom and Italy, the Netherlands and Germany are still overwhelmingly DB countries. Some countries offer individual investment choice and individual accounts, while others do not foresee individual choice, but provide minimum-return guarantees.

To explore the future development of DC in Europe in more detail and to get a better understanding of what the future might hold, Allianz Global Investors conducted a study in cooperation with the Centre for European Economic Research (ZEW).[1] In this study, leading pension experts from across Europe were asked to share their views on how they expect the retirement landscape in their individual markets to develop over the next five to 10 years. The assumption here was that by drawing on the profound insights and expertise of the participants surveyed, it would be possible to gain a solid and well-founded snapshot of what we are likely to see in the future.

Participants in this survey included pension experts from pension funds, academia, regulatory agencies, consultancies, international organizations, asset management firms, insurance companies and associations; all in all, the survey incorporated the unique perspectives of 216 respondents. The survey focused on the most important European pension markets of France, Germany, Italy, the Netherlands, Switzerland and the United Kingdom, and covered many areas important to the future of DC in Europe, including:

·           Future growth of DC plans

·           Drivers of the trend towards DC

·           Prospects of pan-European pensions

·           Impact of the financial and economic crisis

·           Socially responsible investments and pension funds.

Future growth of DC Plans
There is broad and overwhelming consensus among European pension experts (88% on average)[2] that occupational DC schemes will continue to grow. In France, the Netherlands and Switzerland, 90% or more believe there will an increase or even a very strong increase in DC pension schemes over the next five years; around 85% agree in Italy, Germany and the United Kingdom. It is widely held (81% of all experts) that there is an ongoing shift in occupational pensions from DB to DC. This seems to be particularly pronounced in Switzerland (93%) and the United Kingdom (97%). The exception here is France; significantly fewer French experts (46%) have noticed a shift towards DC plans in their country.

The trend towards DC is considered so powerful that respondents in almost every country are expecting DC plans to dominate their respective pension markets in the future. Most Swiss, British, Italian and French respondents (around or almost 90%) expect DC pension plans to dominate; in Germany, 58%. Consistent with their markedly DB-oriented pension structure, Dutch experts do not agree with the notion that DC plans will prevail and expect hybrid pensions to dominate their pension market.

Drivers of the trend towards DC plans

The main driving force behind the trend toward DC appears to be cost considerations. Of the experts surveyed, over 90% in the Netherlands, Switzerland and the United Kingdom, exactly 90% in Germany, and a strong majority in the remaining countries agreed that cost considerations were a crucial factor driving employers to choose DC plans over DB plans. Interestingly, cost calculability ranked much higher than cost reduction; only 50% of the experts surveyed (slightly less in the Netherlands and Switzerland) agreed that reducing costs was one of the advantages of DC schemes over DB schemes. In Italy, France and Germany, this percentage was 60%+. The picture was quite different in the United Kingdom, where over 90% agreed that cost reduction was one of the main advantages of DC, suggesting that British firms are using DC plans to pursue different goals than their continental European counterparts. Other major factors driving this shift included reducing investment risk exposure and underfunded DB plans.

Prospects of pan-European pensions
It has long been predicted that a pan-European pension market would emerge one day: however, its progress to date has been quite limited, making many pension specialists skeptical as to whether it will develop any further. In fact, the respondents were split into almost equal camps as to whether or not they believed such a market would be instituted within the next 10 years. Dutch and French respondents tended to be more optimistic than their British counterparts. As for the drivers behind a possible pan-European market, 72% of the experts surveyed responded that the demand for cross-border schemes would be driven largely by multinational companies; the perception that increasingly mobile workers would stimulate the development of European pensions received a significantly lower rating.

Even so, many of the experts surveyed believe that a pan-European market will only develop once social, labor and tax laws have been further reformed (76% overall). Whether or not the changes required will actually take place remains uncertain. While the optimists slightly outweighed the pessimists, many did not have a definite opinion one way of the other. A small minority responded that they believed the EU’s IORP Directive offers is sufficient for implementing pan-European plans. Particularly noteworthy is that an overwhelming majority of the experts surveyed (82%) expect any future pan-European retirement plan to be DC.

Impact of the financial and economic crisis
Our survey shows that the financial and economic crisis did not undermine the general trend toward DC – quite the contrary. Even so, requirements of effective DC plans are in flux. Most respondents, with the exception of France, do not believe the crisis will roll back reforms in favor of funded pensions. Still, most country experts believe the crisis will actually accelerate the shift towards DC plans: 64% on average (United Kingdom, 90%; Netherlands and Switzerland, over 75%). While the number of like-minded respondents was substantially lower in France, Germany and Italy, the number disagreeing was very low and a large number of respondents in these countries were undecided.

The crisis is likely to change the face of DC plans while at the same time increasing the importance of protection mechanisms, such as formal investment guarantees, shifting asset allocation to less risky assets, or investment approaches that have built-in risk-managing strategies (e.g. lifecycle, outcome-oriented or inflation-protected investment strategies). While changes to asset allocation and the introduction of investment guarantees are expected in several countries, the proposition that risk-management investment strategies will become more important was almost unanimously accepted; on average by three quarters. The greatest support came from Dutch experts (97%), followed by some 80% in the United Kingdom, Italy and Germany, and 75% in Switzerland. Though only about 50% of French experts agreed, only 7% disagreed.

Socially responsible investments and pension funds

Socially responsible investment (SRI) has become an increasingly popular investment approach for pension funds in recent years. Though there are unusually wide country-specific discrepancies, a majority of the analysts (60% on average) are convinced that pension funds will include SRI criteria increasingly in their investment decisions. Almost 90% of French respondents were optimistic about the future implementation of SRI approaches. And while Dutch (80%) and Italian (62%) experts shared their optimism, their German and Swiss counterparts (54% and 46%, respectively) were guardedly reserved. Feedback from the United Kingdom was vague – slightly less than a third expect the importance of SRI to increase in British pension funds. A majority also believes that SRI will be extended to other asset classes. Given the positive general outlook for SRI, surprisingly few respondents expect SRI to be driven by the expectation of higher returns or lower risk – two of the leading arguments in its favor. On average, only 17% believed that an expectation of higher returns was actually driving SRI.

Public opinion is considered to be the single most important factor driving SRI (78% on average). In France and the Netherlands, 94% and, respectively, 95% agreed; in Germany, Switzerland and Italy, more than 70% agreed. These results indicate that, even if SRI is not thought to lower investment risk, reputational risk seems to be a major issue for pension funds. Most of the experts surveyed (64%) believe trade unions are the second most important group of stakeholders supporting SRI, which is particularly true for France (86%) and Italy (77%). In comparison, governments and regulators are considered to be having much less of an impact on SRI.

Conclusion

The survey shows that despite the diversity in national retirement and defined contribution systems, there are some common cross-country trends:

1)         DC plans are expected to grow in all European countries considered in this study.

2)         Cost calculability is cited as being the prime reason for the shift from DB to DC.
3)         Experts are skeptical about the prospect of pan-European pensions.
4)         The financial and economic crisis is likely to accelerate the shift from DB to DC.
5)         Pension funds are expected to invest more and more according to SRI criteria with public opinion being the main driver.

The current financial crisis has raised the question of protection in DC plans and how to achieve it. This subject is now high on the agenda and is likely to remain there. The question as to how these protection mechanisms should be designed is likely to become one of the key goals driving financial innovation in the pensions and asset management industry.

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