Increasing pension gap: turning society’s challenges into strategic opportunities for asset managers
It is no secret that the sustainability of our pension systems is one of today’s defining social and financial issues - one which, as is becoming increasingly clear, will require considerable cross-industry collaboration and co-operation to resolve.
In this article, we aim to provide a factual overview of the challenges linked to the financial sustainability of these systems and the transformations under way in the pension market in terms of market size and expected growth. In addition, we also want to elaborate on the implications of such changes for asset managers, highlighting the key ingredients that would help them transforming this challenge into a business opportunity. In this context, Luxembourg - being in a leading position in sustainable finance and alternatives - will be particularly well equipped to cope with increasing investment volumes, new digital solutions and distribution to new client segments.
EU pension systems – principles and limitations
While the sustainability of pension systems is far from a recent issue, a recent acceleration of demographic shifts in Europe have been rendering it all the more pressing - bringing the spotlight onto the issue like never before. In particular, the region’s increasing life expectancy is leading to significantly higher retirement needs, catalysing the region’s ever-widening pension gap.
Exacerbated by the region’s ever-widening pension gap, the European pension system crisis will inevitably lead to an increasing share of pension fund and retail investor assets being directed towards capital markets.
Pension systems in Europe are based on three pillars: encompassing either public, state-funded plans (pillar I), non-public solutions which can be occupational-based and require contributions from employers and/or employees (pillar II) and private, i.e., individual solutions (pillar III). The European pension systems are largely heterogeneous in terms of size, characteristics, and development: Some EU Member States have a first pillar that provides pensioners a guarantee against poverty while others offer a replacement rate reaching as high as 80% of final salaries (Luxembourg, the Netherlands for instance).
The extend the second pillar pension schemes also varies greatly across the EU, being highly developed and accounting for the majority of pension assets in states such as Ireland (56.7%) and Germany (54%), while having significant room for further penetration in other markets such as Finland (7%) or Italy (10%). The role and development of the third pillar is very similar to that of the second pillar, accounting for the lion’s share of pension assets in countries such as Poland (66.3%) and the Czech Republic (63.6%), while other countries such as Italy (13.8%) and France (10.5%) are behind the curve in terms of third pillar development.
There is an additional source of heterogeneity between the EU countries, namely the defined benefit (DB)/defined contribution (DC) split. While there has been a shift from DB to DC plans , DB schemes still represent 85% of total pension schemes in Europe, with Germany, Belgium, the Netherlands consisting mostly of DB pension schemes, and on the other hand, Spain, Italy, Austria relying on DC schemes. Another heterogenous characteristic of the euro area pension fund sector is the large variance in the number of reporting institutions per country - with some nations boasting a large number of pension funds, and others having very few.
Despite their heterogeneity, Europe’s pension systems are findings themselves subject to the very same challenges – challenges that are calling their current order of operations into question. The first and most pressing challenge relates to the ageing global population. With the population segment of those aged 65 and above set to double from 10% to 20% by 2050, significant development and innovation is needed across the Europe’s pension systems to ensure that they remain not only efficient, but sufficient to ensure the prosperity of their fast-expanding retirement-age populations.
Catalysed by low fertility rates and increasing life expectancy, surging old-age dependency ratios have led to a sharp rise in pension spending and deficits throughout the 2010s – a trend that, should it remain unaddressed, is set to exacerbate for years to come. As a result, according to a recent study by the IMF, additional efforts are needed to ensure the long-term sustainability of pension systems. The number of countries in the IMF sample whose pension spending accounts for over 10 percent of their respective GDP increased from 9 out of 27 in 2000 to 18 out of 28 in 2050, highlighting the unsustainability of European nations’ pension systems. Indeed, researchers have estimated that by 2050 the eight largest state-run retirement systems in the world will have a pension gap of around 400 trillion dollars.
Although the strategic decisions as to the positioning of asset- and wealth managers in the context of the “pension gap” are not made in Luxembourg, the marketplace will be of the utmost importance for the industry to implement these decisions.
Previous pension system reforms, such as increasing retirement age or reducing replacement rates, have served to somewhat improve financial stability. That being said, these measures have also had the unintended consequence of widening intergenerational divides, further threatening support for pension systems in the long-term. Attempts to improve sustainability have disproportionately disadvantaged younger generations, however, in turn potentially disincentivising them from participating in pension systems in the future and further complicating the situation. Lastly, the COVID-19 pandemic has created more public debt, which will render the need for pension system reforms all the more pressing.
At the bottom of it all, one increasingly obvious truth remains: People who want to live comfortably in retirement will need to rely increasingly – if not almost exclusively – on private provision. And this is increasingly recognised – particularly by today’s young generation.
While pension systems across the EU are largely heterogeneous in terms of their structure and characteristics, they all face a common challenge: an ever-increasing old-age dependency ratio resulting from rising life expectancy and falling birth rates.
Transformation underway – the rise of private provision
In light of this, the rising prominence and use of personal pension products across the European Union is unsurprising. This increased reliance on the third pillar has been driven by countries promoting private savings in order to ensure a high standard of living at old age. Private pension providers also play a large role, as mounting public debt levels exacerbate EU countries’ budgetary pressures. The increase of the third pillar is likely to continue into the coming decades, as governments around Europe increasingly seek to narrow the widening gap between the state-provided pensions and their citizens’ retirement income needs. Indeed, the European Commission forecasts that public pension spending is set to increase significantly from 11.6% of GDP in 2019 to 12.7% in 2045.
Even more important is the increasing flux of “average” – i.e., not financially inclined – people towards the stock market. Retail funds, particularly ETFs and most prominently in the form of savings plans continue to see record inflows – particularly in Germany. Germany’s BVI, for instance, finds that the number of people investing in fund-based savings plans has increased “particularly strongly”, showing that “many savers have lost their chronic hesitancy when it comes to investing in securities”. The National Opinion Research Centre (NORC) at the University of Chicago carried out a survey on the rise of retail investors in 2020 and found that 38% of respondents who had never owned an investment account before, opened a non-retirement investment account in 2020. The research also found that generally, new investors were younger (under 45), and possessed smaller holdings than their predecessors.
The pension market in Europe
So, what does this mean for the overall pension market in Europe? And what does it mean for the asset management industry?
First of all, pension assets are significant – alone accounting for approximately 20% of households’ net financial wealth in the euro area. This trend is accentuated in countries with a high number of occupational pensions. Second, the size of pension funds in the euro area has increased over the past two decades, both in absolute terms and as a percentage of GDP. Indeed, pension fund assets have more than doubled since 2008, with the total figure standing at approximately EUR 3 trillion as of 2019. In terms of euro area GDP, this constitutes an almost two-fold rise from 13% in 2008 to 25% in 2019.
As seen in the graph below, investment fund shares predominate the Euro area’s pension funds landscape and account for almost half of assets as of Q1 2021. This figure highlights the sheer magnitude of the role played by investment fund managers, a role which is set to increase as a result of the abovementioned factors and challenges.
In addition, it is estimated that European households hold USD 48.4 trillion of financial assets, of which USD 14.9 trillion are held in currency and deposits. As illustrated below, the amount allocated to cash and deposits has remained stable, at about 30%. Cash and deposits are a viable option when inflation remains low. However, in the current context of inflationary pressures and no change in interest rates in the EU area, individuals may decrease their allocation to cash and deposits in order to maintain their purchasing power, which will likely be transferred to insurance and pension assets, among others due to the aforementioned factors.
Asset management today already captures by far the largest share of the non-public retirement pie. That being said, there remains significant potential particularly in Western Europe) for further penetration, as a result of the steady decrease in pension income compared to work income in the last year prior to retirement. This trend is particularly prominent in Germany, where this is already exceptionally low – coupled with low personal assets penetration rates (i.e. total of retirement assets under management over total personal financial assets).
Notably, the increasing price-sensitivity of both investor segments has resulted in a historical flow of investor assets into low-cost, passively managed products. This has led to increased (price) competition and a decrease in performance-based that has in turn contributed to heightened margin pressure across all geographies and product categories. This is, however, clearly expected to be compensated by higher sales as a result of an increasing number of people turning to private options for retirement savings.
Implications for asset managers
All this suggests that an ever-increasing share of financial assets (and pension assets in particular) is poised to be directed towards the asset and wealth management industry in the coming years. The key strategic question for issuers and asset managers now is how they can tap into expanding value pools and capture the largest possible share of this potential additional market. How can they provide offerings to a large number of very diverse investors across quite fragmented markets in Europe in a way that incentivises people to make these savings? How can they capitalise on this opportunity in an increasingly challenging competitive environment with an ever-increasing number of non-traditional players entering the market with innovative products and value propositions?
We believe that 4 key trends should be highly considered in the current political context:
Through its already leading role in sustainable finance and Alternatives, Luxembourg is particularly well positioned to benefit from the developments resulting from the AWM industry’s answer to the widening pension gap.
Implications for Luxembourg
In conclusion it is very evident that, as the dynamics of the European pension market change, there is a vast potential for asset managers to develop and offer specific retirement products, or to offer traditional products specifically with a retirement rationale. This is a perfect example of how one of society’s greatest challenges is at the same time one of the greatest opportunities for the asset management industry.
Although the related key strategic decisions are usually not taken in Luxembourg, it is important to notice that Luxembourg is exceptionally well equipped to cope with these developments – not only because it already has the required infrastructure, skill and resources needed to manage increased inflows but particularly because the asset management industry in Luxembourg can leverage location advantages also for the development of entirely new topics and solutions. Particularly Luxembourg’s position as front-runner both in the fields of sustainable finance and alternatives is of course a major asset of our local marketplace.
Notes
[1] OECD - PENSION MARKETS IN FOCUS 2021 https://www.oecd.org/daf/fin/private-pensions/Pension-Markets-in-Focus-2021.pdf
[2] ECB - New pension fund statistics https://www.ecb.europa.eu/pub/economic-bulletin/articles/2020/html/ecb.ebart202007_03~5ead7cb1dc.en.html
[3] IMF - Pension Reforms in Europe: How Far Have We Come and Gone? https://www.imf.org/en/Publications/Departmental-Papers-Policy-Papers/Issues/2021/09/10/Pension-Reforms-in-Europe-464651
[4] Stanford - Financing Longevity: Addressing the Challenges of an Ageing World - 2019 https://fsi.stanford.edu/news/financing-longevity-addressing-challenges-aging-world
[5] IGNITES Europe - German retail fund flows beat record set in 2000 https://www.igniteseurope.com/c/3497174/445284/german_retail_fund_flows_beat_record?referrer_module=emailForwarded&module_order=0
[6] Thinking Ahead Institute – Global Pension Asset Survey 2022 https://www.thinkingaheadinstitute.org/research-papers/global-pension-assets-study-2022/
