Unlike insurance, no EU legal framework exists yet for pension funds. A proposal for a Directive is under preparation so that pension funds also benefit from the Internal Market principles of free movement of capital and free provision of services. At the same time, the Directive will establish rigorous prudential standards ensuring that pension fund members and beneficiaries are properly protected.
By operating freely in capital markets, pension funds can optimise their investment policy and help accelerate EU capital market integration. Increases in pension fund investment returns will benefit employers (decrease in pension contributions) or employees (increase in pension benefits). This can be achieved without compromising pension security. In the context of the ageing population, this can help Member States preserve the long-term financial sustainability of existing pension systems and provide risk capital to promote jobs and growth
Professor E Philip Davis, Brunel University, West London
In presenting the following remarks, I should state at the outset that I am strongly in agreement both with the aims of the Directive and the specific drafting that has been put forward. Hence, the bulk of my remarks aim to provide further material which underpins the current proposal, also addressing some of the contentious issues highlighted in Mr Karas’ working document. That said, I have some suggestions for improvement of the Directive itself. The presentation draws largely on recent work I have undertaken on “Portfolio regulations of life insurance companies and pension funds” for the OECD Insurance Committee (downloadable from http://www.pensions-institute.org/wp/wp0101.pdf) and a critical review article on UK pension regulation (http://www.pensions-institute.org/wp/wp0009.pdf).
1 Portfolio management of pension funds
Whereas some specific issues arise for defined benefit and defined contribution funds, the most crucial aspect of pension fund investment are quite general. The portfolio distribution and the corresponding return and risk on the assets must seek to match or preferably exceed the growth of average labour earnings. This will maximise the replacement ratio (pension as a proportion of final earnings) obtainable by purchase of an annuity at retirement financed via a defined contribution fund and reduce the cost to a company of providing a given pension in a defined benefit plan. This link of liabilities to labour earnings points to a crucial difference with insurance companies, in that pension funds face the risk of increasing nominal liabilities (for example, due to wage increases), as well as the risk of holding assets, and hence need to trade volatility with return. In effect, their liabilities are typically denominated in real terms and are not fixed in nominal terms. Hence, they must also focus on real assets which offer some form of inflation protection. This implies a particular focus on equities and property as well as foreign assets.
An additional factor which will influence the portfolio distributions of an individual pension fund is maturity - the ratio of active to retired members. The duration of liabilities (that is, the average time to discounted pension payment requirements) is much longer for an immature fund having few pensions in payment than for a mature fund where sizeable repayments are required. A fund which is closing down (or “winding up”) will have even shorter duration liabilities. Given the varying duration of liabilities it is rational for immature funds having "real" liabilities as defined above to invest mainly in equities (whose cash flows have a long duration), for mature funds to invest in a mix of equities and bonds, and funds which are winding-up mainly in bonds (whose cash flows have a short duration). Flexibility in the duration of assets, which may require major shifts in portfolios, is hence essential over time.
These points are implicit in the Directive and well catered for by the specific proposals in Article 18, such as the rules limiting any restriction on equities and foreign assets and the specification that defined benefit regulation should “allow for the nature and duration of the expected future retirement benefits”. But these underlying points – including contrasts with insurance which mean that identical regulation is not appropriate- could be stressed further in the presentation of the Directive.
2 Further justification of a prudent person approach
The case for a prudent person approach is well set out in the Commission paper entitled “Rebuilding pensions, security, efficiency, affordability - recommendations for a code of best practice for Second Pillar Pension Funds”. The specific case may be worth expanding, not least because it stems directly from the above features of the investment approach. Apart from the control of self investment, the degree to which quantitative regulations actually contribute to benefit security is open to doubt. This relates to the above-mentioned link of liabilities to average earnings growth, necessitating investment in “real assets”. Moreover, appropriate diversification of assets can eliminate any idiosyncratic risk from holding an individual security or type of asset, thus minimising the increase in risk. Again, if national cycles and markets are imperfectly correlated, international investment will reduce otherwise undiversifiable or "systematic" risk. In the case of restrictions which explicitly or implicitly oblige pension funds to invest in government bonds, which must themselves be repaid from taxation, there may be no benefit to capital formation and the "funded" plans may at a macroeconomic level be virtually equivalent to pay-as-you-go. Meanwhile, changes in duration depending on the maturity of a fund require marked shifts in portfolios that may be hindered by quantitative restrictions.
Even for defined contribution funds, it is hard to argue a sound case for such rules, given the superior alternative of prudent person rules. There seems little evidence that defined contribution investors need "protecting from themselves" i.e. prevented from taking high risks. Indeed, in practice, experience suggests that investors in individual defined contribution funds at least historically tend to be too cautious to develop adequate funds at retirement, while companies running defined contribution funds may invest excessively cautiously to avoid lawsuits. Portfolio limits would, however, appear to be particularly inappropriate for defined benefit pensions, given the additional "buffer" of the company guarantee for the beneficiaries and risk sharing between older and younger workers, and if benefits must be indexed. Clearly, in such cases, portfolio regulations may affect the cost to companies of providing pensions, if it constrains managers in their choice of risk and return, forcing them to hold low yielding assets, and possibly increasing their risks and costs by limiting their possibilities of diversification and asset/liability matching.
These points underpin the choice of prudent person approach in Article 18.
3 Definition of a prudent person approach
It is noted in Mr Karas’ paper that the prudent person approach requires further attention in terms of definition to make it workable in an EU context. The following may be helpful both in defining the approach and distinguishing it from quantitative restrictions:
The prudent person rule is focused on the behaviour of the person concerned. The process of making the investment is the key test of prudence. More specifically, the test is of the behaviour of the asset manager, the institutional investor and the process of decision making. It needs to be assessed whether, for example, there has been a thorough consideration of the issues, there is not blind reliance on experts and it is essential to have undertaken a form of “due diligence” investigation in forming the strategic asset allocation and prior to any change or variation to it. The institution should also have a coherent and explicit statement of investment principles.
There is typically an implicit or explicit presumption that diversification of investments with close attention to liabilities is a key indicator of prudence. The prudent person rule, in effect, allows the free market to operate throughout the investment process while ensuing, along with solvency regulations, that there is both adequacy of assets and appropriate levels of risk for the liabilities. The onus is on internal controls and governance structures in which the authorities may have confidence. Correspondingly, a wide degree of transparency is needed for the institutions (including in particular identification of lines of responsibility for decisions and of detailed practices of asset management).
In contrast, the logic of the quantitative restriction approach is that prudence is equal to safety, where security of assets is measured instrument by instrument according to a fixed standard. The focus is placed on the investment itself. The overall risk of a pension portfolio must not go beyond a certain level. This leads to a quantitative view of prudence which is focused on the idea that the investment itself can be tested as to whether or not the decision was prudent at the time. The model effectively tests the investment category, the asset class and the outcome of the investment. On the other hand, explicit allowance is by definition not made for potentially offsetting correlations between types of financial instrument as well as liability composition. It thereby overrides the free choice of investments.
Points such as these may be used to develop the definition of the prudent person rule if deemed necessary.
4 Portfolio returns and risks
I am in agreement with the need for a prudent person approach. The Commission note that equity investment is focused where there is a prudent person approach, and quote a figure of 10% for average returns in prudent person regimes over 1984-98 and only 6% for quantitative restriction regimes. I have some further supportive evidence on these points.
Table 1: Pension funds’ portfolio composition 1998
Sources: National flow of funds balance sheets, Mercer W (1999), "European pension fund managers guide 1999", William M Mercer, London. In Japan the switch was made to prudent person rules in 1998.
Table 1 presents data for end-1998, derived from various sources, of the pension fund sectors of ten countries. Taking the countries together on average, portfolios with prudent person rules have fewer bonds, more equities and foreign assets than those with quantitative restrictions. Such a contrast would be much greater if the countries which have recently switched to a prudent person approach for pension funds (such as Japan) were excluded, as they are slowly adjusting to the new regime.
As regards estimates of returns (Table 2), the sectors with prudent person rules had higher returns over 1980-95 than those with restrictions. The average difference between prudent person and restrictions is of the order of 200 basis points. As regards risk, the data suggest that the volatility of real returns for countries with asset restrictions was actually higher in this period than with prudent person rules, underlining the fact that the latter may be counter productive. The 1970-95 data suggests that the difference between prudent person and restrictions is rather less, albeit still substantial, over a longer period - around 80-100 basis points. These outturns show that superior returns by prudent person sectors are not just a quirk of the selected data period.
Table 2: Estimated returns on pension funds’ portfolios (1980-95)
Source, Davis and Steil (2001) “Institutional Investors”, MIT Press and own calculations.
Besides looking at absolute real returns, it is also relevant to compare realised returns with benchmarks (Table 3). Are pension funds optimising given the opportunities, which may differ markedly between countries? Two benchmarks are proposed, first the returns on a portfolio with 50-50 domestic equities and bonds, and second a global portfolio of 50-50 international bonds and equities. These proxy the type of return that could be obtained if quantitative restrictions did not bind. We also look at the returns on pension funds relative to average earnings, given an excess of returns over average earnings growth is essential to the viability of pension funds. The returns on the benchmarks indicate marked cross-country differences over 1980-95, despite the ongoing global integration of capital markets. In many cases a global portfolio offers a better risk/return trade-off than a domestic one.
Table 3: Pension fund and life insurance real returns and benchmarks (1980-95)
Source, Davis and Steil (ibid), own calculations.
Table 4: Comparing pension fund and life insurance real returns with benchmarks
Source, Davis and Steil (ibid), own calculations.
Looking at the comparison of the portfolio returns with the benchmarks (Table 4), it is evident that sectors did not always profit fully from the available opportunities. On the other hand, risks on the institutional sectors’ portfolios are generally lower than for the benchmarks, reflecting wider diversification. Comparing regulatory approaches, the difference in the shortfall between prudent person and quantitative restrictions is no less than 280 basis points, and 220 for the global portfolio. The excess over average earnings, while it is adequate on average during this bull market for both sectors, is nevertheless 2 percentage points higher for prudent person sectors. Given liabilities are not greatly dissimilar across countries for pension sectors, this indicates that portfolio restrictions raise costs unduly and are damaging to employee retirement security.
These data strengthen the case for a prudent person approach by showing that the conclusion of higher returns applies to a variety of countries (including non-EU ones) and data periods. Comparison with achievable benchmarks strengthens the conclusion.
5 Some suggestions regarding the text of the directive
Comparison with what I consider to be best practice in the fields concerned shows that the proposed Directive is very much in line. I nevertheless have a couple of suggestions for attention:
Article 11: in 3(d) it could be added that members of defined contribution funds need projections of retirement benefits based on benchmark rates of return set by the authorities, as well as details of the impact of management costs in reducing rates of return.
Article 14: in 2(b) one could add “where appropriate”.
Article 14: Whereas it is highlighted that defined benefit plan assets should be kept in line with liabilities, there is no mention of the counterpart for defined contribution funds, which is that the company needs to be obliged to maintain the contributions which it has agreed to make.
Article 16: I am strongly in favour of the flexibility, subject to firm supervisory oversight, permitted for domestic funds. I correspondingly oppose the strict treatment of cross border activity in paragraph 3, which could render such funds unattractive (because of the need for costly hedging or low yielding assets).
Article 17: Further clarificatory words could be useful to show that the article does not apply to sponsoring companies bearing risks of defined benefit plans
Article 18 In paragraph 5 I consider the option to retain quantitative restrictions undesirable.
The seventh paragraph I find ambiguous, with the meaning of “individual” being unclear. Does it mean an individual scheme or an individual country? If the latter, it is undesirable and would in my view risk undermining the Directive. It also is unnecessary as the need for taking the liabilities into account is already covered by the paragraph 3(a).
Finally, I see the Directive as setting standards for the core issues in pension regulation, namely separation from the sponsor, portfolio regulation, funding rules, the scope of supervision and information disclosure. There are a number of other areas of pension regulation that will rightly remain subject to national determination, such as rules in relation to annuities and on worker participation in fund boards. But it should be recognised that restrictive regulations on vesting and portability (where in some countries vesting has been 10 or more years) can be barriers to labour mobility and as such may warrant closer attention by the European Union institutions at a later stage.
 Address: Brunel University, Uxbridge, Middlesex UB3 4PH, United Kingdom (e-mail ‘firstname.lastname@example.org’, website: ‘www.geocities.com/e_philip_davis’). The author is also a Visiting Fellow at the National Institute of Economic and Social Research, an Associate Member of the Financial Markets Group at LSE, Associate Fellow of the Royal Institute of International Affairs and Research Fellow of the Pensions Institute at Birkbeck College, London.