In February 2012, the European Commission issued a white paper addressing the rapid aging of the population of the Eurozone, and the implications this has for the area’s pension systems. The paper presumes familiarity with the idea that there are “three pillars” to a sound pension system: a state-subsidized flat subsistence pension, earnings related pensions, and voluntary retirement savings.
There was a fair amount of material in the EC report on the need to keep the old geezers working longer than they might have expected (although it wasn’t phrased exactly that way).
Aside from that, key points included the following imperatives:
- A more effective protection of workers’ occupational pension rights when an employer becomes insolvent;
- Improved consumer information and perhaps a certification scheme for so-called third-pillar retirement products;
- A code of good practice for the second pillar, occupational pension schemes, addressing risk-sharing and mitigation, shock absorption, and related issues;
- Resumption of work on a pension portability Directive.
It all sounds reasonable enough, but none of it speaks to the issue of the practices of pension managers. Are they getting the optimal use out of their portfolios? If not, shouldn’t that side of the equation be squarely addressed?
Challenge and Response
EDHEC-Risk shares its own views in a new paper, one with the catchy title, “Response to the European Commission White Paper ‘An Agenda for Adequate, Safe and Sustainable Pensions’” (Response to EC).
This paper takes the attitude of Rahm Emanuel: it is a pity to let a good crisis go to waste. The demographic challenges in the Eurozone and the debate it has set off should surely call forth bigger Big Picture thinking than this. There are three points in particular EDHEC wants to see in what would presumably be a re-written white paper: discussion of how to coordinate pension reform among the different nations constituting the Eurozone; proposal of a specific prudential framework for pensions, and; movement toward the generalization of asset-liability management practices.
The “asset-liability practices” stuff is what has caught our attention here at AllAboutAlpha, because this is, finally, where alpha enters the picture. It would seem obvious that if Europeans are worried that their pensions aren’t making enough money for the promised pay-outs, one of the (few) rational solutions is to change the way in which pension managers make use of their portfolio, their assets, using them to take a more aggressive (alpha seeking) stance.
This is not the first time EDHEC-Risk has made this point. Not even the first time this year. In March, with the support of AXA Investment Managers, it published “Shifting toward Hybrid Pension systems: A European Perspective.” This made the case that pension funds “do not fully use their ability to diversify across asset types such as illiquid assets,” and thus they get locked into less than the optimal investment strategies.
The term “hybrid pension systems” refers to systems that don’t fit within the usual “defined benefits” or “defined contributions” dichotomy, and it was the position of the March paper, just as it is the position of the newer EDHEC paper, that such hybridization – exemplified in the cash-balance plans available in the U.S. – is part of the solution to the problems created by demography.
Not just demography, either, but changes in life style are at work. As Response to EC reminds us, “[A] typical career was once spent in a single company, whereas it is now more often segmented between several companies and countries, and frequently punctuated by periods of unemployment.”
For a variety of reasons, then, there is a risk on the one hand that DB pensions will not be able to sustain the benefits they have promised. There is also a danger that DC plans, which by definition have made no such promises, will not produce return matching retiree’s needs, and that the mismatch will require public intervention.
Thus, Response to EC concludes that a hybrid framework, which would have greater flexibility than either, if devised so as to express contributions and entitlements “in an intelligible way for the contributors, might be a good starting point, which might facilitate convergence across Europe.”