The EU pension dilemma: Pan-European Personal Pension to the rescue?

Pension is known in the western world as income at age and what pays the bills, when one retires from his/her job life, what was put aside during work life. But not many actually understand how much is needed to be prepared for age or may be in false hope that state pension will be enough for a living. The EU recently progressed a Pan-European Personal Pension Product (PEPP) for market adoption as part of the Capital Markets Union (CMU) agenda. Will “PEPPer” spice up the European pension market or have we missed the problem's root cause after all? Can it build momentum for a multi-trillion push in investment asset growth fuelled by European consumer capital? 

We hardly think long term, especially when it's about money

Medicine is getting better, we live longer, and need to spend longer and need capital at age beyond job income to do so. Population ageing in the developed countries has intensified pressure on public pension systems. Besides from inheriting capital from family sides, one needs to put money for later. And when time comes and it's not enough we are compensating by working longer, or are in need of spending less - but some will she fortunate enough to have had enrolled on a pension plan that pays back in age when time comes.

It seems clear that society will not be able to guarantee quality of life in retirement unless one saves on their own behalf including private (i.e. corporate) pensions leading governments to adopt increasingly active policies designed to involve citizens in financial measures for retirement. How much one needs when being retired is where expert opinions differ very much. Some guidelines vary from 60 – 80% of average pre-retirement income (each month) to maintain a previously experienced lifestyle assuming medical cost are covered by insurance and so on. 

Most people don’t possess proper knowledge to make required savings and investment decisions, especially taking all relevant factors, such as income, professional career, or health, which, moreover, interact with each other into their planning approach. Employees are forced to acquire a whole new set of skills and must become their own financial planners, stock pickers, and economic forecasters. Especially as the economy is shifting more towards freelance and contract work - all of jobs which without benefits or pension attached.

PICTURE: Pension Psychology

Many people experience anxiety and develop negative attitudes toward contemplating the latter stages of life and planning, ultimately avoiding this activity when being young as retirement is far away and an abstract concept indeed. Old age pensions constitute an essential part of a retiree’s income and for many people, adequate pension provision makes the difference between a comfortable old age and poverty. Some touchpoint of understanding may be through own parents in their retired lives but when it comes to self awareness and preparing for things to come (in 20,30 or 40) one tends to ignore this fact and pushes it into a later future. But sadly there is no last minute fix when to be applied later other than winning the lottery - or trading bitcoin.

How will tackle the individual dilemma on capacity, willingness and opportunity to plan for retirement? Capacity being cognitive factors and skills required to plan and save for retirement, distinguishing one person from the next. Among others, one's knowledge, skills, fluid, and crystallized intelligence, and psychological biases would likely influence the ability to plan and save. Willingness represents the motivational forces and the attitudinal and emotional factors that determine the likelihood that a given individual will begin planning and will sustain savings activity over time - for a long time. And opportunity being simply in a position to put money aside, through an means of an income. 

Building our pension time bomb 

European Union households are amongst the highest savers in the world, but the bulk of those savings are held in bank accounts with short maturities (in deposits, not investments). As of December 2019 this amounted to approx. $14 trn (Source: ceicdata.com). These assets don’t gain lots of interests, if any at all - in more cases today, negative interests are being applied by banks for larger amounts held pushing deposits away and leaving people little choice but to withdraw cash and start stuffing their mattress(es) - Pablo Escobar style. Capital wants to grow through interest without risk. And with interest rates gone south, there is plenty of capital everywhere, looking out for yield, but little opportunity - which will keep interest rates low for a long period or maybe forever. We need to move forward towards acceptable yield / risk concepts to move into capital markets for preserving and growing capital (and pension) to meet the challenges posed by population ageing and current low interest rates without thinking they will rise again anytime soon - or at all.  

U.K. now has a $4 trillion retirement savings shortfall, which is projected to rise 4% a year and reach $33 trillion by 2050. This in a country whose total GDP is $3 trillion. That means the shortfall is already bigger than the entire economy, and even if inflation is modest, the situation is going to get worse - with or without Brexit.  Other European nations have like France, Belgium, Germany, Austria and Spain all have pay-as-you-go (PAYG) schemes, which means they have nothing saved in the public coffers for future pension obligations, and the money has to come out of the general budget each year. The crisis for these countries is quite predictable, because the number of retirees is growing even as the number of workers paying into the national coffers is falling.

With growing population and ageing of society the world’s biggest economies (US, Japan, Europe , Canada, Australia, China and India) are sitting on a $70+ trillion pensions “time bomb” that may grow beyond $400 trillion in 2050 (WEF analysis) due to the changing age pyramid and lack of personal pension awareness and contribution. Another revealing fact which is known and still yet unresolved in work life is gender pay equality gap which is no different when it comes to pension. This is specifically troubling given women are statistically in favour of becoming older than men. Across Europe, the majority of pension assets are still held in (largely legacy) Defined Benefit (DB) arrangements, as an integral component of company-sponsored compensation schemes, but in decline these days as they have become present-day corporate burdens, inherited from a past generation of employees and managers that, in severe cases, can jeopardise the very solvency of their sponsoring firms. , The future growth will thereby be steered towards the establishment of Defined Contribution (DC) pension plans for ongoing workplace pension provision. So far so good. We know now that in most countries, one cannot “plan” to leave his personal financial well being at age solely to count on the state pension pillar - unless you may be a citizen of countries like Switzerland, Iceland, Denmark, Netherlands, Finland or Sweden, etc.

In search for a pension scheme for all

To begin with, it’s always favourable to explore, understand and synthesize experiences and developments of those countries that may have embarked on a pension solving journey and thereby to possibly learn and adopt from. A look at the global pension asset map shows Europe as fragmented, not as union when it comes to pensions. Funded pensions will need to play an increasingly important role in delivering adequate retirement income security in future, and thereby investment of pension assets will increasingly drive future securities markets.

The world's largest pension asset, clearly the US, operates a DC-based pension model called 401k, with limited employee contributions depending on age - $19,000 per year for workers under age 50 and $25,000 for those 50 and up. If the employer also contributes, the total employee/employer contribution for workers under 50 is capped at $56,000, or 100% of employee compensation, whichever is lower. For those 50 and over, the limit is $62,000. As of 2019, 401k plans held an estimated $5.9 trn in assets and represented more than 19% of the total $30 trn US retirement assets (DB and DC-based employer-sponsored retirement plans for private- and public-sector employers). That’s by far lead the largest pension base globally, but represents only 14% of companies, which had 401k plans for their employees in 2012 - and these are mostly large companies. As of today this still leaves more than 1/3 of Americans with just $1,000 (or less) saved for retirement.

Source: OECD (Distribution of pension vs. country GDP, as of 2019)

Sweden operates a state pension fund called AP7 with different blends investing into Equity and Fixed Income. The Swedish state pension consist of income pension and premium pension. All citizens are entitled to both. AP7 Såfa is specifically designed to act as this complement to the income pension. AP7 Såfa aims for savers who do not wish to be active in fund market, complementing state income pension with an improved risk diversification and potential higher investment returns, where risk allocation is driven by pension savers’ age. Full throttle on equity unless one gets closer to retirement when gradually shifting towards fixed income happens. 

Where does this leave us in Europe? 

As part of the Capital Markets Union (CMU) (de-)regulation efforts, the development of the Pan-European Personal Pension Product (PEPP) was conceived, which aims to provide portable pension products across member states with a long-term retirement nature to increase its attractiveness to young people and mobile workers, to help to further facilitate the right of Union citizens to live and work across the Union.  Existing and new providers (insurers, pension funds, investment firms, banks and asset managers) authorised under EU regimes will be able to design PEPPs, which would provide for retail investors, an additional choice for complementary retirement savings and more mobile workers can benefit from improved portability. As for now, PEPP could help to grow the pensions market in the EU from the current estimate of €0.7 trillion to €2.1 trillion by 2030. But even without PEPP, it may still grow to an estimated  €1.4 trillion (from new investments in national personal pensions and growth of assets) over the same period. However, this positive impact of the PEPP was yet predicated on required tax advantages, similar to those available for national personal pensions - yet pending. 

So far, PEPP has received positive feedback in the market from many bodies such as Insurance Europe (representing Europe’s insurance and reinsurance companies), PensionsEurope (the representative of European pension funds), EFAMA (the European Fund and Asset Management Association), Better Finance, AFME (the Association for Financial Markets in Europe) and others. Ireland has recently announced it may adopt PEPP as eligible product for the forthcoming Irish auto-enrolment project, which could see every employee automatically enrolled into a pension scheme by 2021. 

Sizing our pension opportunity

Is PEPP the endgame we have all envisaged and provide a reliable pension opportunity to approx. 231 million employed citizens across Europe? State-defined income-related pensions (Pillar 1) will continue to be country sovereignty for all the right reasons. The Pillar 2 industry is domestically driven, in some countries more successful than in others depending on corporates in their need to provide attractive, competitive benefits to their employee base.  is But why not adopt a pan-European version of Sweden's AP7 as a mutualized service, with low operational cost, transparent and easy to sign up to and use, supported with the right tax incentives to invest into one's individual retirement future? Do we need 5, 50, 500 different providers or just 3-5? Let’s assume for now that the Swedish AP7 model works for Sweden. A solution will need to work for all EU citizens with varying disposable incomes ranging from €5.239 in Romania to €28.820 in Luxembourg - helping to build a pension for the continuous eroding European middle class as well as for low wage jobs.

We have $14trn in term deposits in Europe, in desperate need to transform to a sustainable, growing asset - which could be partly directed into pension if incentified. Furthermore let’s assume some a simplified calculation model ... using a potential of 231m pension customers, measuring an aggressive 50% customer participation level, and providing a monthly DC pay-in average of 50 EUR (low) or 150 EUR (high) over 25 years can lead to a AuM inflow of €1,7 trn to €5,2 trn - fully linear, leaving aside asset value growth and inflation.

In order to be a successful pension product and service, it is important to be to an absolute maximum scaleable, transparent and cost efficient, as well as simple. PEPP could build a base for Europe’s future capital market and enable EU savings to be put to better use and transformed into long term investment vehicles. PEPP needs to work without needing a financial advisor; provide clear and transparent investor protection rules; and low-cost point of sale addressing all and not only small savers. The financial services industry needs to be part of this endeavour for sure but so does corporates, politics and society need to be to drive needs for behavioural change and awareness and stimulus and tax-related incentivisation and last but not least a compelling, easy to understand pension proposition towards the consumer base. 

Such a challenge can provide many merits on European level when jointly agreed and provided with clear guidance, not leaving it fully up to the markets to figure out rules and execution - like we have seen with other initiatives that ended up in running short of their vision. The European Commission could make sure, that a certain investment ratio is being directed towards the European economy as well as ensure to apply ESG guidelines - in accordance to drive self sustainability and future growth narrative for European capital markets adjacent to the US, UK and Asia. Europe has the means, capital and ambition to build a pension environment for its citizen it requires in future. But it needs to be built now to deliver in future and generations to come. First examples of banks understanding the broader pension opportunity (e.g. ZKB with frankly.ch launching July 2020) may show the way for others to follow or to build and deliver a true solution serving the pension needs for the masses -  not just a few. 

Some useful sources to dig into mention in this blog are as follows:

• https://ec.europa.eu/commission/presscorner/detail/en/MEMO_19_1993
• https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32019R1238
• http://www.oecd.org/daf/fin/private-pensions/Pension-Markets-in-Focus-2019.pdf
• https://www.ap7.se