Institutional Investment - May 16, 2012

Shifting Towards Hybrid Pension Systems: A European Perspective

This study highlights the need to reform retirement systems and pension funds, as well as the need to adopt professional management structures and to considerably improve the product offering of defined-contribution (DC) funds.

Among the key prescriptions of the study:

  • In DC plans, primarily in the US and the UK, employees bear all the financial risk and no guarantees are offered by the sponsor or by prudential regulation. However, the lack of guarantees and transparency could lead to a problem of trust – it is thus important that some guarantees are offered in DC funds and that their costs are clearly explained in order to avoid creating a biased risk/return illusion. These changes would help to avoid future disappointment amongst employees, who would reduce their participation in such retirement systems and potentially question their perception of their overall remuneration.

  • Participants are first and foremost exposed to inflation risk and longevity risk, and DC funds need to adopt an asset-liability management strategy in the manner that defined-benefit (DB) funds do. Today, DC funds are under-diversified and they need to stop solely investing in equities and government bonds, thus observing the first principle of modern portfolio theory. Such a diversification of asset classes should allow them to invest in illiquid assets in order to benefit from their risk premium over the long term. The long-term choice also means that it is necessary to adopt professional risk management practices, because when the investment horizon, liabilities and eventual guarantees are taken into account, such (dynamic) risk management strategies need to be put in place.

  • Regulators can also contribute to the adoption of professional management practices for pension funds. In their review of DC systems, regulators understood the dangers associated with transferring uncontrolled risks to fund participants and today, the first generations of Target Date Funds are rightly being called into question. The EU directive on pensions (the IORP directive) facilitates the adoption of professional financial management practices and economies of scale. In the UK, the new Pensions Act requires auto-enrolment of employees in pension plans, and introduces the government’s National Employment Savings Trust (NEST) – a professionally managed structure with controlled costs which will serve as a default option. This should raise awareness in the industry on pension fund management.

  • The most significant developments to institutional pension systems in the short-term will likely be seen in DC funds. It is important to create DC funds that address the need for retirement savings and can then serve as default investment options in existing plans. In the UK, companies are now required to provide their employees with a retirement savings plan and many will need to have ready-made pension plans to hand. We should expect to see some consolidation of DB and hybrid funds in the market as economies of scale are possible, particularly where the industry is highly fragmented.

This research was produced as part of the AXA Investment Managers research chair at EDHEC-Risk Institute on "Regulation and Institutional Investment."

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