1. German balance sheets are full of pension liability risks - how do other European economies deal with this and what is the state of their balance sheets in your experience?
Lassen Sie mich vorausschicken, dass, wenn man über die Rente und Deutschland spricht, man sich daran erinnern muss, dass von Bismarck die Rente erfunden hat. Die Menschen sind damals einfach nicht in Rente gegangen, sondern haben gearbeitet, bis sie gestorben sind! Das war, bevor Deutschland vor fast 150 Jahren als erstes Land weltweit eine Alterssicherung einführte. Die meisten unserer umlagefinanzierten staatlichen Rentensysteme in Europa (auch als „Säule 1“ bekannt) haben dieses Modell zum Vorbild.
Of course, various reforms since then have taken place in each country. Among the most important, Pillar 2 private (corporate) occupational pension funds. They were also born long time ago, in 1875 in the US, when American Express established the first private occupational pension plan in the United States, where employers and employees contribute to a pension fund. In US and UK, these type of pensions schemes are much more relevant than in most European countries so far.
Now pension systems in Europe and around the world exhibit great diversity in their structure and characteristics, with a wide range of features and norms. Comparisons are not always straightforward. In the European Union, reforms to the member states public pensions systems to put them on a more sustainable footing, have tended to encourage the implementation of occupational pensions (Pillar 2).
In Europe, the IORP II EU Directive (2016) also set a common prudential framework for occupational private pension plans, that has been transposed by each country just in recent years. However, private pension funds still vary in size and approach across each country in Europe.
Actually, what you find is that there are only a few countries in Europe with low levels of first-pillar pensions but with significant private pension savings (particularly in the occupational pension sector). The Netherlands is one of these exceptions, where around half of all pension income comes from second - and third - pillar pensions (with the first pillar acting only as a safety net to prevent poverty). This accounts for the high ratio of pension assets to GDP (over 200 %). Occupational pension funds in the Netherlands account for around two thirds of all such pensions in the euro area.
But the growing importance of occupational private plans of companies is very clear when you analyze the benefits and sustainability of pensions in the different European countries. Take for example the Mercer CFA Institute Global Pension Index as a reference. It ranks countries pension schemes. European (or closely related countries) top ranked countries: The Netherlands, Denmark, Finland, Iceland, Norway, or even Israel, all have in common their, basically, mandatory occupational pensions. Austria is perhaps the exception to this rule: occupational contributions are compulsory, but the system is ranked low, probably because of demographic factors and the fact that the system is too generous. On the other hand, countries with voluntary second-pillar systems, such as Italy, Spain, Greece or Poland, get worse rankings because of their low penetration. Sweden is a bit different: it has voluntary occupational pensions, but with broad coverage, which also ensures a very good pension system. The best systems (The Netherlands, Denmark, Finland, Sweden) are not really facing big balance sheet issues. Their ratio of assets to liabilities appears to be good or, in some cases, even in surplus. Robust investment funds (usually managed by decentralized financial institutions) with employee risk-sharing make them financially sound.
In Spain (and in small Andorra, the country I live in!), only large companies have occupational pension plans for their employees. This is less the case for SMEs. Penetration is still low, but system reforms are favoring their future growth for the same reasons we discussed previously. Typically, they are implemented through fund vehicles (risk sharing by the employee, with not defined benefits -DB-). Different investment risk profiles are offered to employees, that can choose according to their personal needs and age. The plans always have a control commission to ensure independence of the fund governance, and assets are seggregated. Usually, there is also an external independent advisor that is a member of the commission to strengthen the professional investment management capabilities and the protection of the interests of the beneficiaries.
At MoraBanc, for example, we have a voluntary defined contribution (DC) occupational pension plan. The employee has a choice of four different investment strategies with different return expectations and risk profiles (you can switch between them every year). The employer will match your contributions if you make a contribution to the plan from your salary (we also have five options for the level of the defined contribution). It is an insured pension, that grows tax-free while in the plan, and are taxable only when withdrawn from the plan. Funds are segregated off-balance sheet and the beneficiary bears the financial risk. The control commission is the governance body of the plan. This is a successful scheme of voluntary plans sponsored by the employer, that will probably be an important part of forthcoming reforms to the broad pension system in the country.
2. When do you think it's right to start addressing these?
I understand that higher interest rates have allowed occupational private DB plans to use a higher discount rate to value their pension liabilities. But, as you pointed out, many company schemes still have significant financial risks on their balance sheets. In the recent past, we saw how any surpluses dissipated based on financial market movements. This was the case just a year ago, in 2022 (remember for example UK pensions crisis). Also in periods with low interest rates like we faced only some years ago. Rate cuts by Central Banks over the next months, or the possibility of a potential recession, and the prevalent geopolitical situation, all pose significant risks to economic and financial stability and to the solvency of this kind of private plans.
This means that now might be a really good time to think about transferring risk from sponsoring companies to financial - more specialized - institutions like VEDRA. As we have seen: The most robust European schemes are managed by funds or specialized financial institutions.
3. What are your thoughts/considerations when investing pension assets in terms of asset allocation and bespoke investment decisions, given the long-term nature of these pension assets? What have been the most important points in your experience?
Strategic asset allocation in investments has to be always based on your specific financial objectives. In the case of pensions plans, the main investment goals are, of course, to ensure adequate and sustainable benefits to contributors, achieving an optimal trade-off of risk and return, with adequate liquidity to pay all pension benefits as and when due. From my point of view, an asset-liability management -ALM- approach is the most important aspect as a starting point when managing these funds. These risk management techniques must be used to manage funded plans, particularly DB plans, but also DC plans. It is not just about managing assets, as in an open-ended long-only mutual fund. This is a common misconception in the pension world. Rather, it is about optimizing risk and return while meeting specific liability constraints, both financial and actuarial. Another key factor is to have a good investment governance framework. The governing body (the control commission I mentioned), has to involve the employer or trustee board in making strategic decisions at the highest level and, where appropriate, delegating their implementation and execution to sub-committees (such as an investment committee for these investment decisions) or third parties such as independent advisers and asset managers. The adequate technical skills and investment expertise of this supervisory commission and its members is also very important. On the other hand, they should also be well aware of any potential conflicts of interest (such as agency issues) that they may have in relation to the investments of the scheme. In my experience, these will be crucial in preventing mistakes. In our system of different risk profiles, we also adjust the default asset allocation according to these different targets. Long-term expected returns and risk metrics should form the basis of strategic allocations across a diversified investment universe. For pension plans, this means that some asset classes, such as equities, have a more important role to play than what we are used to seeing in investments with a shorter time horizon.. You will want to take advantage of the lower variance of equities when investing for the long term.
In terms of tactical decisions, the challenge for active management is to allocate capital to equities or credit assets when the relative spread between the return on capital and the money rate of interest is increasing, and to move out of equities when expected returns on capital (because of high valuations or tight credit spreads) decline relative to the money rate of interest.
Other relevant investment options that are available when managing a pension plan should include: inflation-protected assets (inflation bonds, real assets, etc), and alternative investments (private markets, or also some liquid alternatives with low beta when you really get a diversification benefit from them).
4. In light of current interest rate/core inflation developments and other risks, what do you think should be the target?
Currently, one of the outstanding risks in the markets is the concentration of stock indices in some pricey technology stocks. Because of that, I would suggest an increased allocation to actively managed equity portfolios when compared to passive strategies. This is a way to benefit from upside in the market breath due to prevailing different valuations among sectors and geographies.
On the fixed income side, real interest rates are not very attractive, given the difference between long-term bond yields and the level of inflation. If Central Banks start to cut rates and the economy starts to improve, a steepening yield curve could make long duration bonds for pension liabilities more appealing. Inflation-linked bonds are an interesting alternative to hedge inflation risks, with good valuations at the moment.
5. Should private markets play a role in pension assets?
Over the past decade, companies have been increasingly using private capital markets to raise funds to finance growth in their businesses. This has happened in both equity and debt markets. This can be seen in the number of listed stocks, which has not really grown much, and in private debt, a funding market that is now as large as the high-yield (listed) bond market.
This means that private markets should be part of the investment strategies of pensions plans. Pensions can afford the illiquid nature of these asset classes, while benefiting from their diversification potential. Having said that, these are very specific investment opportunities that usually require a delegation to a well experienced asset manager with strong technical capabilities in this area.