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“Germany’s pensions system has been around for more than 100 years and has seen off two world wars and hyperinflation. But pension funds are worried that this could kill off the entire system.”
That was the devastating analysis by PensionsEurope’s Secretary General Matti Leppälä speaking at the UK’s National Association of Pension Funds conference in Manchester earlier this year. He was talking about one of the European pension regulator’s latest initiatives, ORSA—the Own Risk and Solvency Assessment—a process designed to assess the overall solvency needs of specific risk profiles of insurance companies.
After much lobbying from the UK, the Netherlands, and Germany, the Solvency II-style funding requirements were formally postponed for pension funds. But the governance and risk-reporting elements were preserved—and it’s this that the proposed ORSA would fall under.
“ORSA could be translated into the pensions environment as an assessment conducted by the IORP [Institutions for Occupational Retirement Provision] of the risks faced by the undertaking and reconciliation of those risks with the available security mechanisms (including capital but also sponsor support),” the European Insurance and Occupational Pensions Authority (EIOPA) stated.
The ORSA does not in itself create a capital requirement but will pose difficulties for companies with weaker solvency and significant defined benefit (DB) liabilities—and there is a genuine fear that the proposals will lead to a “back door” form of solvency provisions. “The ORSA must not be used to introduce the solvency framework,” says Leppälä. “This risk-based solvency capital framework would put such a need for more capital on the balance sheets that it would be impossible for the sponsor companies to come up with that capital. That means the DB pension funds, as they exist today, would not be able to survive.”
Georg Thurnes, a partner at consultants Aon Hewitt in Germany, agrees that the German pension fund industry is “very concerned” about the issue.
Due to the complicated nature of Germany’s pension system (more on that later), some funds that are subsidiaries of one of the country’s many insurance companies will already fall under the first phase of Solvency II because they are integrated into the group reporting rules.
And even independent pension funds will very soon have to implement everything related to Pillars 2 and 3 of Solvency II, including the ORSA reporting requirements.
“It is our expectation that, at some point in the future [the independent pension funds] will also have to comply with the Pillar 1 approach, in terms of valuation of the balance sheet and solvency capital requirement,” warns Lutz Morjan, senior director of client solutions at ING Investment Management International. “There’s still some hope that won’t happen, but it’s not the opinion of our house. It may have been delayed by [European Commissioner Michel] Barnier for good reasons, but it is just a delay and EIOPA won’t give up on having this implemented.”
Unlike in other countries, corporate pensions are very much voluntary in Germany. Sponsors decide to offer a pension for their employees either from a social responsibility perspective or just to be attractive in the labour market.
The concern is, if the extra reporting requirements lead to increased costs and complexity—and a potential Solvency II-style capital requirement is hinted at—sponsors will find that frustrating, says Morjan. “We are very resilient, and we will make it work. What I’m concerned about is that the social security system will be decreased over the next decade, so that the government can pay less in public pensions. That means we have to find other sources of pension, so that millions of people aren’t left poor when they become old. If we make [the requirements] too complex and too costly, [the system] might not die, but you won’t see any expansion of the occupational schemes, which will be a big challenge for the German society.”
It is not just the ORSA proposal that threatens to burden German corporate pension funds, however. Alf Gohdes, chief actuary at Towers Watson in Germany, headed up the German Institute of Actuaries working group charged with transforming the commission’s instructions for the quantitative impact study, conducted at the end of last year. He notes this is just a small part of the overall picture.
“The ORSA is an isolated point being picked up from a whole bunch of factors relevant under the Pillar 2 and 3 studies carried out around the middle of this year,” he says. “It doesn’t make sense without connecting it with the others. You can’t build a car while just thinking about the quality of the tyres.”
As an example, Solvency II-type regulations could well put further restrictions on equity investments—a challenging issue for a country that historically invests very little in the asset class already.
The financial transaction tax is also causing headaches across Germany, as is the wider issue of European Market Infrastructure Regulation (EMIR) and central clearing. And that’s before you get on to domestic regulatory concerns.
Before we continue, it’s worth laying out exactly who we’re talking about when we say “German pension investors”. Most are insurance-regulated, hence the problems with Solvency II and other regulations above. But one is not.
The first group is the nonregulated “direct pension promise”, or “direct commitment” pension fund, which sits on the corporate sponsor balance sheet. It is the most free-form pension type in terms of regulation and investment strategy and requires only that all money entering the plan be guaranteed nominally by the employer until the retirement date.
Next you have the “pension fund”, an insurance-regulated product set up by individual employers, employer associations, or insurance companies. Again, the sponsoring employer remains secondarily liable and must step in if the pension fund fails to meet the pension liabilities—but it has a better tax profile.
Third are “pensionskassen”, another insurance-regulated version that has more limits on what it can invest in. These are usually set up for one specific employer or for a certain industry.
Finally, there are support funds, set up as subsidiaries of the sponsoring employer as a registered association. These are typically set up for groups of employers or as an industrywide pension fund. Here, the employer remains the primary debtor of the liabilities and only uses the support fund as a paying agent.
There is also a pension lifeboat vehicle similar to the UK’s Pension Protection Fund, called the Pensions-Sicherungs-Verein (PSV), funded by fees from direct commitment, support fund, and “pension fund” vehicles.
Employers using “pension fund” vehicles pay 80% less PSV premiums than the others, which has seen a number of employers switch to this vehicle in recent years, according to Sabine Mahnert, senior investment consultant at Towers Watson in Germany.
Each of these different types of pension has a different investment profile, but all struggle with the current low-yield, low-rate environment. Across the board, German investors are heavily invested in bonds—a large proportion of which are corporate bond issues.
“About 15 years ago, a typical equity/bond split would have been 30/70,” says Mahnert. “That has gone down now to 20/80 in the corporate pension space. With insurers, the equity allocation has reduced further: 5/95 or even less.”
While the recent rally in equity markets has prompted some tactical shifts towards the asset class, that’s as far as the stocks story goes in Germany. “The biggest challenge for German institutional investors is to achieve their long-term return target of around 4% given the current yield levels and market outlook,” says Frank Witt, PIMCO’s head of institutional client service in Germany. “At the moment, 10-year yields stand at 1.7% for German Bunds… in recent years, investors have realized that traditional approaches may not be sufficient to meet their long term objectives.”
The “direct pension promise” funds are taking advantage of their lack of regulation and allocating more risk into their funds. Funding levels of these sorts of vehicles are around 60%, according to ING’s Morjan, but they are willing to allocate more to equities, alternatives, and real estate. Up to 30% is typically invested in stocks, although Klaus Mössle, head of Fidelity’s institutional business in Germany, says he had clients with up to 60% in equities.
For the insurance-regulated pension funds, it’s more about diversification throughout their fixed-income portfolios and chasing different risk premia.
For example, while
the majority have divested from banks, other financial assets are attractive.
And, while many ran away from asset-backed securities—particularly
mortgage-based ones
—they’re very happy to invest in senior loans.
There’s a lot of interest in infrastructure debt, but not much money has been allocated to it yet, according to Towers Watsons’ Mahnert. Equity investments in infrastructure are less popular, as German investors prefer stable, fixed-income-type returns. Those investors seeking equity infrastructure will consider direct investments or, if not, investments that allow them a great deal of transparency and involvement at the target investment level. Emerging market and high-yield debt are also popular, with interest growing in senior secured loans.
Strategy-wise, German investors are adapting their risk management processes following the financial crisis and now recognise that investing needs to start with an asset-liability framework, Mahnert continues. Many direct pension promise funds have embraced liability-driven investing (LDI), although implementation has been hampered by the low interest rate environment.
Implementation of LDI in the insurance-regulated pension funds has been even more limited. “Insurance-regulated investors are looking at LDI approaches but more for the future than the present,” says ING’s Morjan. “They can use forwards and derivatives, but it’s a highly regulated sector so the exposures are limited in terms of how much you can put into your books.”
Carl-Heinrich Kehr, principal at Mercer, says he has a couple of clients working through the LDI process at the moment. Others would not adopt an explicit LDI approach in the same way as the UK funds would, he explains, because insurance-regulated investors don’t have market prices reflected in the balance sheet.
Interestingly, with all the focus on de-risking, there’s little appetite for pension-risk transfers. Given the nature of Solvency II, insurer-related solutions are deemed just too expensive (and as noted earlier, some of the deficits on these funds are sizeable).
“Buyouts and buy-ins usually occur only when there are substantial changes in an organisation,” says Mercer’s Kehr. “Investors who do want to consider a different platform for their pensioners compared with their active members are more likely to do so for tax efficiency reasons than for buyouts.”
Longevity risk products are also not yet broadly accepted. “The reason mentioned most often is that market participants believe there is no independently assured mortality data available for making this type of bet fair,” explains Aon Hewitt’s Thurnes.
Employers who are keen to remove the liabilities from their balance sheet can do so using an informal trust arrangement, he adds. “Companies started doing it 20 years ago; many more have done them in the past 10 years. Most large companies in the DAX index do it, for example.”
What we are seeing the start of, however, is an emerging defined contribution (DC) class. DC in its traditional format doesn’t exist in Germany—the legislation isn’t there to support it—but savings plans that look similar to a 401(k) are becoming more popular.
Employers often set them up to allow for additional contributions, and they usually follow a lifecycle approach, meaning the investment strategies are similar to those on DB plans.
“The trend from DB to DC was already there, but it has become more urgent, as it has in the Netherlands. The guarantees being handed out have become too expensive,” says Fidelity’s Mössle. “We’d call it an emerging DC market in Germany. The assets are between €40 billion and €50 billion, depending on how you define DC.”
These cash balance plans are unlikely to develop into DC plans as the UK or Denmark would recognise them, though, according to ING’s Morjan, that’s politically motivated, as “politicians are trying to make pensions as safe as possible for the employee”.
This sector might warrant a closer look soon, however, as defined benefits might well be regulated out of existence.