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Pensions - the knockout punch
Someone slugged the old guy on the door from behind, and made off with the purse……..
Cuts, cuts, cuts….this week’s UK budget delivered a combination of punches that put pensions on the ropes. There were also uppercuts in the form of a levy on foreign companies used to purchase UK residential properties worth more than £2m, and body punches with the introduction of general-anti-avoidance rules scheduled to take effect in 2013. However, for the British expat standing in the neutral corner, developments further afield are of greater importance to their retirement planning.
In recent years, the value of pension funds and savings of investors have taken a dive as major economies try to reduce their debt against the backdrop of a low growth environment.The UK Chancellor in his budget speech tried to reassure the people that their pensions would be safeguarded. As we all know, nothing is safe in this environment. And yet, the answer to the pension conundrum cannot be found by sheltering in term-deposit accounts; there is indeed a cost to both individuals and society when we sit on cash in the bank. The solution to the current problem lies in a commitment to long term investment by individuals, institutions and governments alike. Moreover, the way forward for expats is to budget for their own pensions by taking advantage of opportunities as they present themselves in the market.
Terms of engagement
- Below the belt hits – the prospect of low interest rates of between 0.5 – 1% on deposit accounts until 2014
- The sucker punch – an inflation rate of 2.7% across the EU block is eating into any return on savings
- In a clinch – the ongoing defensive policy of quantitative easing or ‘printing of money’ by the EU, UK and US central banks has resulted in depreciating currency values
- Pulling punches – corporate earnings are generally in a healthy state, with companies waiting for the right time to pounce
- Saved by the bell – stock markets have rung up returns of circa 10% since the start of the year (see chart below)
MSCI World Index - Source: Yahoo Finance
Taking the gloves off
When we look at the scorecard of our pension funds to date, it becomes apparent that there are no quick fixes or overnight returns to be had. Financial advisors help investors structure pension plans that fit their personal risk profile and view of the world; what works for one person may not be ideal for another. To this end it is important to have a diversified portfolio in order to reduce risk. Ultimately however the aim is to find ways to generate better returns than those available for cash deposits or government bonds; to achieve this investors must be prepared to go the distance with their retirement plans!
When you gaze too long into the abyss, the abyss will gaze back.…
Until now it has been taken for granted that a euro is a euro, wherever it is held in the Eurozone. However many individuals, companies and banks are beginning to question this assumption. The change of heart has become ever more visible in Greece where:
- There appears to be a steady leak of money from Greek cash deposits
- Companies such as Vodafone are reportedly limiting the amount of operating cash they hold in Greece overnight
- There are stories circulating of restaurants that refuse to take credit cards, insisting on cash only payment
Whilst politicians treat austerity as an academic exercise across Europe, the results on the ground are somewhat different. With wages and pensions stagnating, it looks increasingly unlikely that confidence in the market will return any time soon. Although Greece has commited to reform measures imposed upon it by the EU, any agreement is likely to be reversed in April 2012 when a new general election is scheduled to take place. The odds are still 50 / 50 that Greece will leave the Euro.
Will the medicine kill the patient?
This new bailout could have the adverse effect of throwing the country into a tailspin of both recession and debt. The bailout is for all intents and purposes a default; it may not be disorderly, but it is a form of default all the same. Greece may eventually decide that the only alternative to more austerity is to exit the Euro. Should this happen it is likely that the government will reinstate the drachma as the national currency, with the markets forcing a devaluation of up to 50%, therein wiping out the wealth of the ‘middle classes’. Such a drastic fall in value of the currency may make exports look attractive and boost growth prospects over the short term; it could also result in the imposition of exchange controls on the country’s banks in order to prevent mass cash withdrawals.
The impact on pensions and savings
The burden of the new deal will be carried by the Greeks themselves and the private sector, including pension funds that were forced to invest in Greek bonds and have now suffered a 70% writedown on their investment. The key issue for investors is the ability of the Euro to get back to ‘business as usual’ should Greece leave the single currency. But what if the contagion were to spread beyond the euro-zone firewall provided by funding from the ECB and IMF? Portugal, Italy and Spain would come under intense pressure from investors wary about the risk of another victim. This could lead to a run on the Euro and have damaging consequences for pensions and savings. The fate of the single currency now seems like a game of chance.
Just ask yourself …do I feel lucky?!
To be or not to be; that is the question…….
As the Euro weakens, the impact on wealth management for expats on the continent is becoming a point of increasing concern. Whilst the threads that bind the single currency together begin to unravel, it is clear that investors have a lot to lose in the event of an uncontrolled break-up of the Eurozone. The pain will be felt particularly by expatriates in terms of their pension fund holdings.
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The Euro is as coveted a prize to the European mainland as the Higgs boson has been to particle physics. The discovery of the latter may unlock the door to our understanding of the universe, whereas the creation of the former was heralded as one of the greatest economic and political advancements of the last century.
A lot of energy has been expended over the years in order to avoid a clash of interests among European Member States. Despite this effort, it now appears that certain governments have managed their deficits as if they have been living in a parallel universe, ignoring even the most basic of agreements. The absence of governance in applying rules has set Member States on a collision course which may ultimately end in a ‘big bang’ for the single currency.
Whilst the results of the Higgs experiment have so far proven inconclusive, the probability of a Euro collapse occurring is almost down to a ‘toss of a coin’ with a 50% likelihood of a break-up. Europe’s politicians have finally grasped the gravity of the situation and are now attempting to solve the Eurozone crisis through fiscal union. However, this new development does not disguise the fact that the monetary union is fundamentally flawed and is thus unlikely to convince the markets.
Devaluation and wealth management
In order to revive growth in the weaker peripheral countries, the European Central Bank (ECB) lowered interest rates on 8 December from 1.25% to 1%. It is envisaged that the ECB is prepared to reduce rates even further over the coming months if necessary to stave off recession. Such actions will also have the net effect of weakening the value of the Euro significantly and will result in the erosion of discretionary spending power related to pensions.
The Euro is currently trading just below $1.30 (see chart below), with some analysts predicting that it could trade within the $1.10 – 20 range by the end of the first quarter of 2012.
Chart: EUR / USD
Should the financial crisis continue, market uncertainty is likely to drive the value of the Euro down further, perhaps even leading to the break- up of the Eurozone.
It is difficult to speculate on all possible future paths that the Euro crisis may take; indeed the situation can yet be retrieved if proper structures are put in place and adhered to. However, in the event of default by Greece, Spain or Portugal, a move to reinstate previous national currencies would likely trigger a run on domestic banks. This may also coincide with a much smaller core of European Member States clubbing together in order to retain a strong Euro.
In any case, wealth management advisors are taking the prospect of a Euro break-up more seriously. Investors may witness the value of their holdings rise, fall or become subject to prolonged legal uncertainty, depending on how any break-up would occur. Exchange rate adjustments would have an impact on the wealth of expatriates, with pension portfolios that hold net assets in foreign currencies gaining from devaluation, and vice versa.
There is always a certain element of ‘dice- rolling’ when conducting an experiment. Scientists at Cern in Switzerland predict that within one year we will know whether the Higgs particle exists; the fate of the Euro will become known much sooner.
Watch this space!!
Consider a currency that begins with the letter E……
For over a year now it seems like the Euro has fallen down the rabbit-hole. Politicians in Brussels appear to move from one surreal chain of events to another. One minute everything is upside down, and the next we are all back on our feet again. Last month all eyes were diverted to the plight of the US Dollar; however the troubles for the Euro were always destined to return.
Whose dream is it anyway?
To fully understand the problems faced, it is necessary to examine the compendium of the Eurozone, which outlines the various events that have taken place since its inception.
The euro was to be the great modernist project; the party of all parties. Through adopting a one-size-fits-all monetary and economic policy, trade would be boosted and cross border commerce simplified. The European economy would be more secure if exchange rates and interest rates where controlled from the centre by the ECB. There would also be reform in pension policy that would encourage the mobility of labour across Europe, making it easier for expats to continue contributing to private pensions as they moved from county to country.
Someone has stolen Brussels tarts
In order to ensure that the Euro cake was sliced fairly, the Maastricht criteria was designed as a series of qualifying tests to admit Member States to the table. It now appears that these tests were neither comprehensive nor stringent enough in their application. A number of knaves amidst the Member States chose to circumvent the rules and were less than transparent about the size of their budgetary problems. Some others were enticed by potions with ‘drink me’ labels emblazoned on them, only for their debt to grow to unsustainable levels.
There have been more than one or two teaspoonfuls of wishful thinking along the way. Attempting to bring Nordic, Germanic, Latin, Celtic and Slavic cultures under one roof is a significant challenge; asking them to abide by strict rules and walk along straight lines was perhaps expecting too much. Indeed, what previously seemed like an opportunity to trade freely now looks like an invitation to the Mad Hatters tea party.
Is it better to be feared than loved?
The Euro appears to have lost its ‘muchness’; alas the European dream with its promise of fraternity and solidarity now seems to be fading. There is no doubt that the architects of the single currency had the best of intentions at the outset. However, eating the cake made certain Member States bigger than their boots; as a result the value of the Euro is now over-inflated.
The two ‘fat boys’ of Europe find it difficult to talk in unison about the real issues surrounding the currency. Like Tweedledum and Tweedledee they make disparate noises about the Euro being defended at all costs, even if it means having countries such as Greece, Ireland, Spain, and Portugal living at ‘wits end’. Meanwhile, directives emanating from Brussels are brandished like ‘the sword that knows what it wants’…..all you have to do is hold on to it!
And yet the problems of the Euro cannot be solved simply by applying evaporating cream. The call of “off with their heads” from certain quarters is not the answer. The Euro is not a figment of our imagination; but who decides where the dream goes from here? Who makes the path?
Here is a list of ‘6 possible things’ for the European Heads of State to consider before their next summit breakfast:
- If you cut a balloon loose, can you control where it will land?
- Will credit rating agencies ignore a Greek default in whatever disguise?
- Can the ECB print more money without turning the Euro into wallpaper?
- Will pension funds persevere and continue to purchase sovereign debt?
- Can the ‘white queen’ of the IMF be the champion and save the day?
- Will there still be a place called Euroland in 10 years time?
And there you have it……..OK, I will just get my hat!!
Before you build your edifice, be sure of the ground beneath your feet.
The geographical distribution of assets such as equities, bonds and property has taken a more global path in recent years as pension funds seek to spread their risk. As a result, the currency exposure of assets under management has become an increasingly important factor in the investment equation.
Expatriate Pension fund currency risk and return
The impact of currency fluctuation on pension plans can pose a risk for meeting investor objectives. Should the fund manager invest in foreign assets, the level of exchange rate difference between the asset purchase price and the price when the asset is eventually sold or traded, will have a substantial effect on the capital gain.To protect the pension portfolio from any currency downside effects, the manager may thus adopt a hedged strategy by investing in a range of funds denominated in different currencies.
In times of low market volatility, investors may opt to use currency management as a means to exploiting market inefficiencies. Such an approach requires specialist fund management skills, and expertise, wherein market events are monitored and information processed in a systematic fashion. Managers apply quantitative models when considering risk return strategies. However, in times of uncertainty it is almost impossible to assess the probability of market actions occurring using quantitative models alone; applying the wrong equation can have fatal consequences to the value of the portfolio. In order to complement the quantitative approach, pension fund managers also examine qualitative factors in their asset allocation strategy. These include:
- the business nature of the assets held
- the management style in terms of either a passive or active approach
- the turnover rate of the various assets held in the fund along with the average holding period
- the application of risk control measures
Adopting a hedging strategy can become a costly exercise if the risk that is being hedged does not materialize, or reverts against the position taken. Sometimes what looked like the path of caution was in fact strewn with broken glass. Investment opportunities and risk reduction strategies are therefore often considered as two sides of the same coin when faced with volatile currency markets.
Currency devaluation
The financial crisis has forced pension fund managers to regularly rebalance their foreign currency exposures in order to avoid falling short of targeted returns. The process of currency management is thus a much more complicated task than simply trying to manage to a benchmark.
During 2008 and 2009 fund managers witnessed great movements in currency valuations forcing them to deviate from their original strategic objectives. Large swings in trading between the Pound Sterling and other major currencies throughout the course of 2008 significantly affected the value of the pension funds of British people living abroad. Expatriates with pension portfolios based in Sterling experienced a marked drop in the value of their assets set against other major currencies as a result of ‘quantitative easing’ policies adopted by the UK government and the subsequent devaluation of the Pound.
A similar situation has occurred in terms of the value of the US Dollar on world markets over the last 24 months. Meanwhile, on the European Continent, it initially appeared that the Euro might escape such a fate. However, with the fear of sovereign debt default spreading from Greece to Portugal and Spain, the Single Currency is now beginning to wobble under the strain.
No need to panic
Pensions are long- term investments; decision-making should therefore not be based on one year’s results. Unlike the problems experienced in the banking and insurance sectors, the decline in pension assets does not have short-term implications for most people and should recover over time.
However, risk relating to currency exposure still represents a degree of noise that should be ironed out of the portfolio. It is prudent therefore from a medium term perspective to hedge the foreign equity and bond exposure of client holdings in pension funds against currency fluctuation.
There is talk of a new world odour; unfortunately it smells just like the last one.
As the bulk of people in the Western World get older, the economic stability and social structure of society will become more dependent upon pension systems. Such systems provide long-term capital for industry and contribute to economic growth and job creation. The development of private pension provision can also play an important part in addressing the issue of rising national debt as it reduces reliance of the population on state pension benefits.
Calculate the future value of your retirement fund
The success or failure of such a theory depends on whether individual workers have a sufficient level of pension savings that would allow them to replace their final year of salary when they retire. Across EU countries, Sweden and the Netherlands come closest to achieving this, with workers enjoying a level of pension income of circa 90% of individual earnings at the moment of take-up of retirement. The UK and Ireland do not fare as well with pension replacement coverage at 45% and 40% respectively; meanwhile France has currently a coverage ratio of circa 17% of individual earnings upon retirement.
Coverage by mandatory and workplace pensions
Source: EC and EFRP 2011
As the economic environment changes, so too does the pressure on EU Member State governments to address any imbalance in their finances. The situation has not been helped by the recent EU Stability and Growth Pact (11 March 2011) which outlined policy commitments to foster competitiveness, raise employment, and reinforce financial stability. The new agreement by European ‘heads of State’ has encouraged governments to focus on a deficit ceiling of 3% of GDP and a gross debt limit of 60% of GDP. This approach however is likely to trigger adjustments in national pension systems and have a negative impact on pension savings, resulting in the burden of ageing being shifted onto future generations.
The promotion of sustainable pension systems has always been an important part of a nation’s broader economic strategy. Unfortunately the ongoing financial crisis has left many countries struggling to jump-start their economies; it appears that national pension policies are in the government crosshairs once again. The State coffers may profit from any short-term pension reforms, but are likely to pay dearly for it afterwards. Already in Europe there are signs of countries retreating on their pension commitments:
- In both Hungary and Poland the governments have opted to transfer what were mandatory privately funded pension assets back into the state system in a bid to tackle its deficit.
- In Ireland, the pension reserve fund assets were used to recapitalize the failing banks. An additional annual levy of 0.6% is now to be charged on domestic pension funds, the proceeds of which are to be used to stimulate the employment market and fund construction projects.
- In the UK the private pension sector has been hit by a reduction in tax relief on contributions. It has also moved the link of public sector pensions from the Retail Price Index benchmark to that of the Consumer Price Index therein reducing expected pension payments by up to 25% over a lifetime.
- In France the government increased the retirement age for drawing state pensions from 60 to 62 and raised the age of entitlement to a full pension from 65 to 67.
An age of revolution
In this new age of revolution the internet is the weapon of choice of the masses and information the bullets that load the gun. This means that the structure and management of pension systems need to be more transparent than ever. As a result of ever-changing rules, only the well-informed tend to have an understanding of where they stand; there are thus a lot of worried people along the pension food chain. No one has the power to see through the Matrix of government reform processes…. it is however expected that any such reform is connected to the people it represents.
Every now and again you stumble across one in this business…… a diamond that wants to stay coal!
In medieval times alchemists applied their knowledge and wizardry in the quest to transform base metals into gold. Modern day pension fund managers find themselves in a similar predicament in their attempt to deliver what often seems to be the impossible in terms of the provision of sustainable retirement income for scheme members. There is no mercurial way to run a pension fund; no magic dust that can be sprinkled on the fund to make it perform better; there is however choice as to where assets are allocated.
Portfolio Diversification
The diversification of a portfolio can be achieved by investing in a range of classes that have a negative correlation with each other, such as equities, bonds, and property. The lower the correlation between asset classes in the pension portfolio, the more the assets will complement each other and therein lead to a reduction in the portfolio risk.
While Europe holds its breath in anticipation of an inflationary cycle, managers are considering investment in commodity funds as a long-term hedge against rising prices. The continuous increase in the world population coupled with the scarcity of natural resources has brought commodities back into demand as a favored asset class. The Dow Jones Commodity Index below illustrates the recent rally in this market sector.
Dow Jones Commodity Index – Source Bloomberg
Investment strategy
Trade in commodities such as copper and silver is triggered by changes in the spot price. The spot price is the price quoted for the purchase or sale of a particular commodity at a specified time. In order to avoid the risks associated with price fluctuations, buyers will use a futures contract wherein an agreement is made to purchase a set amount of a commodity at a predetermined price and date. On the other hand side of the coin, sellers will try to lock-in a price for their products. The active commodity trader will sell future contracts as they near their expiry date and buy new ones with a spot price further from expiry. Any gain or loss in this position is related to the spread between the sell price and the new spot price.
Commodities are not a single asset class; to this end managers invest across a range of sectors including energy, base metals, precious metals, and soft commodities such as coffee, cocoa and sugar. Some fund managers prefer investment in equity-based natural resources, whereas others opt for commodity-related companies such as plastic producers. Investment in a blend of physical commodities and related equities can thus offer investors the best of both worlds and help diversify the risk.
Some pension funds prefer to adopt a ‘buy-and-hold’ position when selecting assets for long term returns. A passive exposure to commodities delivered successful results from 2002 until late 2007, when it was possible to capture a broad upswing in the market. However, the sustained growth in the sector came to an abrupt halt towards the end of 2008 resulting in a flight to safety in the financial markets.
Alternatively, the active manager would argue that the volatility of commodity makes them less attractive as ‘buy-and-hold’ investments. They maintain that the cyclical nature of commodities results in them being a momentum trade and that any passive diversification benefits represent a significant opportunity loss.
Through the use of derivative instruments, managers may employ investment strategies that involve short as well as long positions, allowing them to produce positive returns in uncertain markets. Ultimately, the aim is to provide a high rate of return, while also managing market and operational risks to protect capital from the volatility inherent in the asset class
Management expertise
The level of management expertise is of great importance in the quest for profitability. It is vital that the commodity manager has considerable experience and understanding of the fundamental drivers of the commodities in which they trade. In addition, managers need a solid grounding in trading instruments and techniques in order to develop their own investment style and philosophy. Some managers like to focus more on the area of supply and demand, whereas others will be more concerned with market flows or technical analysis.
When analyzing commodity producers, managers will consider the debt/equity ratios on company balance sheets. The more leveraged companies tend to perform better in a rising commodity market due to the fact that their margins will rise; however this position is not sustainable in a market downturn. Another factor to consider is whether companies are low or high-cost producers, as this will impact their earnings. Low-cost producers tend to be less affected by commodity price fluctuations and thus have an advantage over higher-cost producers on the downside.
In order to asses which companies are most suitable for investment, managers use the net present value analysis (NPV) to project future cash flows. Key assumptions such as commodity prices, exchange rates, production targets, and operating costs are built into the equation so as to test company valuations under various market conditions.
Surge in global demand
The emerging markets continue to be a driving force with 55% of most commodities being consumed by these countries. China in particular has a significant requirement for the supply of raw materials in order to fuel its explosive growth. Australia with its abundance of metals, coal and food has been the immediate beneficiary. However, recent flooding has presented Australia with a huge challenge in terms of the extraction of both copper and coal, and thus restricted supply. When the water finally recedes, it will take a long time to repair the damage to existing mines. Such events inevitably help sustain the upward pressure on commodity prices.
The asset allocation strategy of a fund depends on the manager’s objectives, risk appetite and time horizons. Given the global squeeze on essential resources, the opportunity to reduce portfolio risk through the purchase of commodities will appeal to the alchemist in all pension fund managers.
Compromise usually comes one teaspoon at a time. One day you find yourself down the road and you don’t remember where you made a left turn.
So now we know what is in store for the Irish public ……..or do we? For the last few weeks the Irish Finance Minister has looked like a guy running around in a frying pan. It would now seem that all has been settled and the Irish people can relax in the knowledge that the rescue package has been passed by the government and approved by the EU and IMF. On closer inspection however, not all is as it may appear.
Irish banks have developed a reputation of being like the Bermuda Triangle in that money keeps disappearing when it goes in there. In the first instance the banks were guilty of using property as a piggybank; unfortunately it now looks like the government may be about to do something similar with the national pension reserve.
The National Pension Reserve Fund
The National Pension Reserve Fund (NPRF) of Ireland was set up in April 2001 with a specific mandate to fund the costs of future social welfare and public service pensions. With the proportion of Irish workers to pensioners projected to fall from five-to-one to two-to-one by the middle of the century, the creation of such a fund had been a significant undertaking for the government. The date of the first pension drawdown from the fund is scheduled for 2025.
The fund was launched officially with approximately €6 billion from the proceeds of the flotation of the state owned telecoms company Eircom, along with a commitment from the government to add at least 1 per cent of gross national product to its coffers each year. The 2010 third quarter results of the NPRF show that there is currently €24.5bn of assets held in the fund, which have subsequently been divided into two parts. The first part of the fund called the ‘discretionary portfolio’ is worth €17.9bn and is invested in a range of equities, bonds and alternative assets: http://www.nprf.ie/Performance/performance3Qtr10.htm
The second part of the fund totaling €6.6bn has been invested in a ‘directed portfolio’ comprised of preference shares and ordinary shares in the Bank of Ireland and Allied Irish Banks (AIB). This action was facilitated through the passing of emergency legislation during 2009 by the Irish Government and is invested in the banks at the behest of the Minister for Finance. These investments will remain part of the pension reserve, with any income generating from them being accrued to the fund.
The National Recovery Plan
The ongoing financial crisis and present high yields on Irish bonds have curtailed the State’s ability to borrow and forced it ‘cap in hand’ to the EU and IMF for support. The argument put forward by the government is that this external aid is needed to pay for key public services for Irish citizens and to provide a functioning banking system that will support economic activity.
A package in the region of €85bn is to be assembled with a view to helping the country structure its finances. Of this, €35bn will be used to support the banking system, with €10bn earmarked for the immediate recapitalization of AIB in order to bring the bank up to regulatory capital levels, and €25bn to be made available on a contingency basis.
In a prime example of how to ‘borrow from Peter to pay Paul’ the Irish Government has agreed to make a contribution to the €85bn facility with an injection of some €17.5bn from the NPRF. As a result, the extent of the external assistance required will be reduced to €67.5bn.
The €17.5bn funding has been secured by the government through the introduction of a new piece of legislation called the ‘Credit Institutions (Stabilization) Bill’, which also permits the restructuring of AIB as a non-listed financial institution using cash from the pension reserve
Investment Policy of the NPRF
A pension fund has to be adaptable and flexible so that it can react to conditions on the ground. In the light of the current economic and political climate, the task for the NPRF is to position the reserve fund assets in such a way that it serves the interests of all stakeholders.
In addition to its obligations to Irish banks under the ‘Credit Institutions Bill’, the NPRF is being allowed to invest in domestic sovereign debt. Up until now the majority of Irish bonds have been held by overseas investors, which therein results in an outflow of money from the State in the form of annual coupon payments. This new investment policy would assist the Irish Exchequer in bringing these assets back home and investing them in the local economy.
A sovereign bond, linked to the consumer price index, is to be created in 2011 for both pension schemes and insurers. To this end the government proposed the launch of a four-year ‘solidarity’ bond which pays an annual fixed rate of 1% with added bonuses of up to 50%, provided pension funds are invested for a longer time. The bond has a similar structure to the ten-year bond, paying a coupon each year and a bonus for investors who hold it to maturity.
The government has also decided to take the opportunity to shore up the country’s poor infrastructure by directing the NPRF to invest in this particular asset class. Investment in infrastructure is an attractive proposition for pension funds as it provides a good hedge for inflation, and can generate stable and long term income. It may also be used to promote projects that spur job creation, and invest in renewable energies such as the development of water and waste management systems.
The downside
The shift in investment policy enabling the pension reserve to invest in Irish debt runs the risk of the NRPF becoming the sole buyer of the country’s bonds in the foreseeable future should private pension schemes not be enticed to participate. Irish schemes may decide to shun such a move for fear of the risk of Ireland defaulting on its sovereign debt.
An additional point of concern is that the existing €24.5bn of funds accumulated in the NPRF is in itself not sufficient to cover the estimated pension liabilities in both the public sector and the state pension; recent estimates suggest that the current requirement for a fully funded pension is €116bn. The assets held in the NPRF were the only pre-funding that existed to cover pension liabilities. Under the latest reform and recapitalization of AIB this figure may be reduced significantly; the pension drawdown date of 2025 beckons!
Sooner or later the crisis-haunted financial merry-go-round will come to a halt. There are however only a limited number or rides available on the carousel. When the music stops…..it may be the pensioners who are left standing.
The camera lens opened and shut in his mind as he saw himself driving a convertible down an ocean highway. Along the bay shoreline a wind surfer toyed with the breeze; he pulled into a marina café that unfolded onto the sands …
The road to retirement is indeed paved with good intentions; however a number of potholes may present themselves along the way, in the form of stock-market volatility, fluctuating interest rates and inflation. It is important therefore to connect the dots in order not to be thrown off course in your planning.
The life-cycle hypothesis
With many people living for up to 30 years in retirement, the onus is shifting to the individual to take responsibility for their pension planning. The situation can be analyzed in terms of savings and consumption over the life-cycle.
The concept of the life-cycle hypothesis was first developed in 1963 by Franco Modigliani (see chart below). The life-cycle hypothesis assumes that individuals consume a constant percentage of the present value of their life income; the level of consumption is dictated by preferences, tastes and income. Modigliani argued that the average propensity to consume is higher in young and old households, where members are either borrowing against future income or running down life-savings. In contrast, middle-aged people tend to have higher incomes with lower propensities to consume and higher propensities to save. The development of both occupational and private pension schemes targeting the middle-age section of society has been a welcome savings model to help provide an adequate income level after retirement.
Life-cycle hypothesis
Source: Modigliani (1963)
The pension life-cycle process
Pension advisors conduct both a client profile and a risk profile of the investor in order to have a careful evaluation of retirement income needs and ascertain the type of investment approach to be adopted. At this stage the individual is informed of the risks associated with each investment choice. Information is also collected on the desired level of pension income upon retirement, and the level of contributions to the scheme. Thereafter a strategy is designed for each individual in line with their goals and objectives; this in effect is the role of management.
The aim is to have the correct balance in terms of risk and return as the individual progresses through life; this balance can be adapted as circumstances change. Whether the individual is a member of a company pension scheme or invests with the help of a financial adviser, there is a need for a structure that limits risk when approaching retirement. Although there is no set timeline for the rebalancing process, research has found that the most rewarding life-cycle strategies are those that maintain a constant exposure to equities during most of the pension fund accumulation period, whilst gradually moving into fixed income based investments in the last decade before retirement.
Use of pension modelling
Models are used to simplify complex issues and explore the likelihood of different scenarios occurring. When using pension modelling, there is no ‘one-size-fits-all’ investment strategy, but moreover a range of outcomes for each approach taken. These outcomes will differ as conditions in the marketplace change.
Through the aid of technology and the development of suitable default options, pension fund managers will seek to design life-cycle savings models that deliver optimal investment strategies geared to retirement. Pension models that calculate the projected return on investments allow individuals to estimate the value of their savings over the period. However, having faith in fancifully high returns often results in many people saving too little and being forced to recalculate their retirement plans at a later date.
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The journey to the promised land of retirement has many twists and turns. Upon arrival the reality of the situation may differ from the earlier vision of how it would be. Perhaps it is best to be a little more cautious in terms of expectations. Indeed, the house with a sea view may have to wait!
When the ‘winds of change’ are blowing – most batten down the hatches to protect themselves. Some hoist the sails and take advantage of the change.
The existing French national pension system was set up in a bygone era when circumstances were different. Change is afoot, the kind of change that requires a firm hand on the tiller. Problems can occur however when policy making is influenced by external forces, such as the ‘markets’ or the mood of the electorate, which are not easy to control. If the chosen course is not navigated correctly, the ruling party may find itself on a collision course.
The French government has recognized the need to protect the national pension system from its demographic imbalances so as to ensure that it remains financially sustainable. The pension reform bill, newly passed by France’s National Assembly and likely to be approved by the Senate, is a major step in addressing the shortfall in the nation’s mandatory, state-run pension system.
In order to keep a sinking ship buoyant it is necessary to bail out the water that is weighing it down. France’s growing budget deficit currently stands at 7.5 per cent of GDP, significantly above the 3 per cent target set by the EU. The new policy is designed to reduce the country’s pension costs and bring public borrowing down. It is forecast that measures undertaken by the reform would rein in the deficit to the tune of €70 billion by 2018 and bring the pension system back onto an even keel.
The Conseil d’Orientation des Retraites (COR), projected a series of consequences should retirement reforms not be addressed, as highlighted in the diagram below:
France has one of the world’s highest life expectancy rates with the most recent statistics revealing a lifespan of 77.8 for men and 84.5 for women. The problems associated with an ageing population are compounded when a country also has a falling birth rate. As a result, the dependency ratio of those aged 65 and over as a proportion to those aged 20-64 is expected to rise from the present figure of 25% to 50% by 2050. This means that as time goes by the onus will be on a dwindling number of working age people to support those in retirement. These demographic trends are putting tremendous pressure on the French pension system,
In order to put the PAYG pension system on a sounder financial footing it was necessary to consider the reform options and their likely consequences. The three choices open to policy makers were as follows:
- To lower retirees’ pensions;
- To increase compulsory contributions;
- To raise the retirement age.
The French government decided that the best way to respond to the demographic imbalances was to raise the retirement age and therein the number of years of contributions to the state-run system needed to receive a full pension. The new government policy increases the standard retirement age to 62 years from its current 60 and will raise the age of entitlement to a full pension to 67. This change will be phased in from now until 2018 with a four month increase in the legal retirement age per year. The reforms will require both men and women to have paid social security contributions for a minimum of 41.5 years, instead of the current 40, in order to qualify for a full pension. The objective is thus to have the contribution term increase in line with the rise in life expectancy, so that the ratio of ‘period of pension payment’ to the ‘working period’ remains constant.
Far away fields are not necessarily green
It is up to each individual country to decide which system is most suitable for its people, and how the system should be structured to cope with the changing demographic background and economic situation. There is always a trade off when reforming current systems between the prevention of pensioner poverty, and the ability of a state to honor the promises they make.
National retirement-income systems are complex with pension benefits depending on a wide range of factors. Differences in retirement ages, required years of service, benefit calculation methods and adjustment of paid-out pensions make it very difficult to compare pension systems. There are however a number of useful metrics that facilitate cross-country comparisons.
The replacement rate, which measures pension entitlements as a share of individual lifetime average earnings, amounts to50% in France. This is below the OECD rate which equates to 70% of earnings after tax. However, the French spend an average of 24.5 years in retirement, compared to 19.8 for other OECD countries as highlighted below:
France currently spends 12.4% of national income on public pension provision compared to the OECD average of 7.2%. This accounts for 23% of government expenditure in comparison to the OECD average of 16%. This obligation to provide retirement benefits over an extended retirement period has made the pension promise too expensive to maintain.
In 2007, Germany opted to gradually increase its standard retirement age to 67 from 65 in order to deal with the impact of an ageing population on its pension system. The Netherlands and Denmark have followed suit setting their retirement age at 67 by 2025, whereas Spain and Italy have recently increased their retirement age to 65. Meanwhile, the United Kingdom has pledged to raise its retirement age to 68 by 2046. The newly passed reforms will thus bring France more into line with other European countries.
All hands on deck
To accommodate the shift in demographics, there is a need for a real change in attitude from all stakeholders. In the first instance, it is important for the government to address the issue of employment of the over fifties. The employment rate in France for the 55-64 age bracket is just 38.9% compared to the European average of 46%. In reality, French people stop working on average at 58 which effectively deprives the retirement system from their potential contributions. The anomaly however is that they do not actually retire at that age; they are usually made redundant. As such, a significant proportion of French people claiming their pension for the first time are effectively unemployed.
It is important that both private and public employers adapt the work environment in order to facilitate the integration of older workers, invest in training, and make changes in production processes so as to have more ergonomic production lines.
Another solution is to do away with incentives that subsidize early withdrawal from working life whilst at the same time aligning the mandatory pension contribution periods for workers in the public sector with those in the private sector. Such a move could prove to be a contentious issue. The social security pension for private sector workers in France is calculated on the average of their ‘best’ 25 years of salaries. In comparison, public workers retirement is calculated on their ‘last six months’ of salary, which is a much more favorable proposition.
The government’s new retirement policy is designed to reduce benefit dependency. For their part, workers need to understand that early retirement is not a right, and that, unless they can afford otherwise, they must get used to working over a longer term. Public pensions for workers entering the labor market today will be significantly lower than those offered to their parents and grandparents. Voluntary, private provision for old age will also be needed to maintain future living standards.
Turning-circle manoeuvres
Pension reform has to be credible both economically and politically; markets need to be convinced by the nuts and bolts of the government’s economic policy. France currently shares the same high credit rating as Germany in terms of government borrowings, which reflects confidence in Sarkozy’s action on pushing through reforms and trimming the budget deficit.
But the issues at stake for the French government are not just solely about numbers; they are also about strategy and how to deal with a much wider political problem that the pension reform has posed. Deficit levels and how to service them are important; there are also other factors that come into the equation such as employment levels and how much pain the public can endure before they bite back. The reform measures will have a negative impact on public spending power; President Sarkozy may not just be ‘cutting his own cloth’, but that of consumer demand as well. In order to bring the people along with it, the government has therefore to convince the masses that they have a shared vision of a better road ahead.
With indicators suggesting that economic growth this year will struggle to reach 2%, the OECD is showing signs of nerves. Although pensions are indeed liabilities of the future, the timing of pension reform cannot be conditional on how the economy fares. When setting policy there are a broad range of elements in the mix, including workers, employers, unions, the bond markets, the IMF and voters. Policy making is often a balancing act wherein the platform underfoot is always moving while the balls are being juggled in the air.
Government decisions on pension policy are a reflection on the ideology of the party in power. Of course no particular ideology has all the answers; reform will always lead to heated debate and can result in street protests that may force the hand of government. It is therefore important to have a strong government in office. Fortunately, Mr. Sarkozy’s ruling UMP party has a majority in the French Assembly. To an extent they are taking a gamble in forcing through such a significant piece of legislation in the run-up to the 2012 presidential election. However, the government views structural reform as being essential to France’s longer-term economic prospects and fiscal solvency.
Given the various challenges that lie ahead, it may not all be plain sailing for the government; any ‘headwinds’ need to be met with a degree of nimbleness on the part of the policy makers. However, by undertaking this task now, the anticipated political hurricane may be downgraded to a tropical storm in time for the election.