But this time, due to longer life spans and falling birth rates, population will peak and then fall gradually. By 2050, the elderly (those aged 65 and over) will be 30% of the population, up from 17% today. The old-age dependency ration, or the ratio between the 15- to 64-year-olds and the over-65s, will increase substantially. In the future for every 100 people of working age there will be 52 elderly (up from 27). This will have huge social consequences. To prepare for increasing longevity and fewer births, western European countries have undertaken significant reforms to pension systems. Despite different starting points, in almost all countries the trend is towards funded pensions, according to a recently released report from Allianz Global Investors. Funded Pensions in Western Europe 2008 explores the unprecedented challenges policy-makers face as they try to diversify the retirement income of their citizens across a wider base, while maintaining affordable public pension systems for their aging populations.

AS DESCRIBED IN THE REPORT, pension and life insurance assets in western Europe were worth € 8.6 trillion ($11.6 trillion) in 2007. With a predicted annual growth of 5.3%, this vast asset pool is expected to reach € 16.9 trillion ($22.8 trillion) by 2020. Yet the aggregate growth figure masks a very diverse prognosis for individual markets. The report also notes that Europe is no exception to the global shift from defined benefit (DB) to defined contribution (DC) plans. Focusing on the former EU-15 countries plus Norway and Switzerland, the report examines how governments are facing this substantial demographic change. They have scrutinized the sustainability of their first-pillar pay-as-you-go pension promises – and found them wanting.

In response, governments have introduced a range of reforms including benefits cuts, an increase in the state pension age and the establishment of a state pension reserve fund. The report examines how the impact of these reforms and of different DC models may vary, depending on the country-specific demographic forecast and the balance between public and private funded pension systems.

WESTERN EUROPE'S PUBLIC PENSION policies are based primarily on two different models. First, the Bismarckian model (found in Austria, Belgium, France, Germany, Italy, Luxembourg, Portugal and Spain) historically has aimed to deliver a high replacement level of income on an earnings-related basis, with total benefits increasing significantly as recipients live longer. In contrast, the Beveridgean model (found in  the Netherlands, the UK and Ireland) has aimed to prevent poverty. It delivers a low level of retirement income, often in the form of flat-rate benefits. It is generally associated with a developed, funded private pensions market, which supplements the low benefits. Mixed models are found in the Scandinavian countries and Switzerland.

The report analyzes the current position in the 17 countries and presents the latest results of the Allianz Pension Reform Pressure Gauge. The Pressure Gauge assesses the future sustainability of pension systems and the potential effectiveness of reform. It is clear that countries associated with the Bismarck model are under the greatest pressure to reform. Overall, the analysis demonstrates the direct link between a high level of state pensions and an underdeveloped funded private pension system. For Sweden, the UK, Denmark, and the Netherlands, the Pressure Gauge indicates a more modest pressure to reform. In addition to less dramatic aging, these countries have a lower level of state pension and a well-developed private funded system.

European governments are striving to balance public and funded pillars of their retirement provision structure. Many are strengthening second-pillar and third-pillar pension plans (employment-based plans and individual plans respectively) to offset public pension reductions. For example, Norway and Austria introduced a mandatory second pillar, and Ireland is considering this option. The UK plans to introduce auto-enrollment with the launch of personal accounts in 2012, which is mandatory for employers, but still allows employees to opt out.

HOWEVER, MOST PRIVATE-SECTOR SYSTEMS are voluntary, and the impact of government intervention varies significantly. The Belgian system encourages occupational pension provision on a sector or industry-wide basis – also a successful strategy in the Netherlands. Likewise, France’s occupational plan PERCO has grown assets from €77 million ($105 million) to €1.4 billion ($1.91 billion) from 2004 to 2007. In the same period, private pension saving – the third pillar – has also increased. Participation in the German Riester pension rose from 4.2 to 10.7 million, while the Austrian Prämienbegünstigte Zukunftsvorsorge attracted almost a million members. The popularity of these new plans demonstrates the increasing willingness of workers to save on an individual basis.

To relieve pressure, nine of the 17 countries analyzed for the report established a public pension reserve fund to support the cost of future liabilities: Belgium, France, Ireland, Luxembourg, the Nether- lands, Norway, Portugal, Spain, and Sweden. To ensure effective deployment of funds, the date for drawdown of assets is generally predefined. In Spain assets can be used once the public system has been in deficit for three years. In Ireland, the funds can be used from 2025 onwards, while in France this date is 2020.

Reserve funds are financed in several ways. The Norwegian Government Pension Fund, the biggest of its kind in Europe, is financed by Norwegian oil and gas revenues. The Irish government invests 1% of GDP annually in their fund. France sources funding from privatization revenues and surpluses in certain social funds and taxes. Other countries draw assets from contribution surpluses in the social security system. Portugal even adds a proportion of employees’ social security contributions and unclaimed tax refunds.

THE INVESTMENT STRATEGY OF RESERVE FUNDS also varies considerably. The Dutch AOW Spaarfonds has assets of € 23 billion ($31.4 billion) but they are earmarked in the Dutch government’s books, and so no real assets are accumulated. The Belgian Aging Fund has real assets but can only invest in Belgian government bonds specifically issued for the purpose.

The French, Irish and Norwegian reserve funds pursue sophisticated, diversified investment strategies. The Irish reserve fund is well diversified geographically, restricted from investing in Irish government securities and allocates two-thirds of assets to equities, 13% to bonds and the rest to private equity, infrastructure, real estate, currencies and commodities. The Norwegian reserve fund cannot invest in Norway and, like its French counterpart, its equity share is around 60%.

Several of these public funds are adopting socially responsible investing principles, and are helping to establish SRI as a mainstream strategy. The Norwegian reserve fund is subject to ethical guidelines established by the Ministry of Finance and supervised by an ethics council, with assets managed by Norway’s central bank according to a policy of active ownership.

Likewise, the French Fonds de réserve pour les retraites pursues a policy of active ownership, requiring managers to vote along clear guidelines. The fund has several specialist SRI mandates that, instead of excluding specific companies, apply a “best-in-class” approach. In 2006, the fund initiated a process aiming at assessing the entire portfolio on extra-financial criteria and encourages managers of its other equity mandates to make extra-financial indicators part of the selection process and to share data.

ALTHOUGH THE TREND TOWARDS DEFINED contribution arrangements is well established, the design of DC in western European countries varies significantly, largely as a result of regulation. In its purest form, DC plan members make the investment choice and use the accrued fund (contributions plus investment growth, minus charges) to generate a pension, for example in the form of an annuity. This is the main design for the UK’s personal pension, and is also the model used in Italy’s open pension and France’s PERCO. In Germany, however, the capital value of contributions must be guaranteed, making pure DC plans impossible, while Swiss DC plans are subject to a minimum interest rate. In both cases there is no investment choice.

WHILE IT IS HIGHLY LIKELY THAT THE SHIFT towards defined contribution plans will continue in Europe, it is not yet clear which form will dominate. However, with the growing inadequacy of the public pension systems, private funded plans will represent an increasingly important element of total retirement income. The report argues that it is crucial that the potential for efficient asset allocation is not restricted by regulation in the form of quantitative investment limits. Finally, the report suggests that DC may represent a practical solution to the thorny issue of cross-border pension plans. Implementing cross-border DC plans is still a challenge, due to the variations in national regulation and taxation systems. Nevertheless, compared with DB plans, DC is simpler, more flexible, and more portable, and might well lead to a workable model for pan-European pensions.

Published by PROJECT M in June 2009

(Illustration: Tina Berning)