AEIP 1 Memorandum Benefits of mandatory collective occupational pension schemes

January 2011 AEIP 1 Memorandum Benefits of mandatory collective occupational pension schemes Preliminary Summary Mandatory collective pension schemes possess substantial advantages over other methods of occupational pension provision, and should be safeguarded especially during periods of economic crisis because, as this document will explain, they have already proven to have transparent governance and the ability to provide a higher pension whilst guaranteeing solidarity. Mandatory collective pension schemes are set up by collective labour agreements concluded by Social Partners, which are the representatives of the employers and the employees, at industry-wide or inter-sectorial level. These schemes are jointly managed by the Social Partners themselves (often called Paritarian Management), who act on behalf of and in the interest of their members having no profit aims. In addition, the participation to these schemes is generally compulsory for all the employers and workers covered by the aforementioned collective agreement. Moreover, when the national legislation provides for extension procedures of the agreement (erga omnes effect of the collective agreement 2 ) this compulsory rule will often be extended to those employers and workers, who are not affiliate in the signatory Social Partners. The compulsoriness of these schemes makes sure that on the one hand, every worker will have a pension income in his/her old age despite their current concerns on this issue; on the other hand, these schemes imply that the employers will contribute to build pension income in favour of their employees. In short, this compulsory element is a solution representing an extraordinary tool for poverty prevention when understanding that poverty is defined as a cost for the State 3 and for the taxpayers. 1 With support of CWPS (EI), NCCMP (USA), VB (NL), SOKA-BAU (DE) 2 This happens when the national labor legislation provides for that: sometimes the extension of the legal effects of the agreement to all the sector is automatic after fulfilling some specific requirements; some other times, the said extension is made by a Government s act (usually a Ministerial Decree). 3 It is important to bear this in mind especially at times of public budget and sovereign debt crises instead of focusing on possible short-term gains that would actually place obstacles in the way of the long-term objectives. This recommendation goes hand-in-hand with the reformed Stability and Growth Pact, which takes into account not only debt levels, but also implicit liabilities, notably costs related to ageing populations, and in particular projected pension and health care expenditures. 1

In addition, the compulsoriness of these schemes further strengthens and accentuates the traditional advantages of the collectively run schemes, such as their lower execution costs, their higher returns on the invested portfolio, their higher stability towards the financial fluctuations and even the possibility to provide solidarity for their members. As a matter of fact, any form of compulsory participation (i.e. statutory mandatory participation via employer, via employee, or quasi-mandatory participation via collective contracts) that exist in the Netherlands, Denmark, Sweden, Australia, Iceland, Switzerland and others 4 helped these countries score well against the others. In other works they reach the highest level of participation in non-statutory pension schemes, their pension deposits are overall very high and the pension capital is managed by experts. Moreover, the aforementioned countries are also known as having ones of the best pension systems in the world and are better-equipped for the upcoming demographic challenge than others. Empirical research and experience show that in countries without this automatism, even larger groups of employees build up much lower pensions than in those with compulsory participation. In short, mandatory collective schemes are cheaper and provide higher pension income through their higher returns on investment, uphold the idea paritarian (joint) management by their participants and have the potential to provide solidarity. Moreover, they are fully in line with the provisions of Treaty of the European Union 5 and the EU objectives expounded in the Green Paper by the European Commission, titled Towards adequate, sustainable and safe European pension systems. The following paragraphs will expound more on technical detail of the advantages of such mandatory collective schemes. Execution costs Pension savings should be aggregated in such a way as to guarantee adequate returns by reducing all sources of management expenses both administrative and investment. Moreover, aiming at achieving adequate returns is not only common sense, but, as stated above, also an important element of the EU goals 6. The cost we pay for pensions matters as much as the investment returns we get, but it is often overlooked. The cumulative effect of the execution costs, as little as they may seem, have a strong impact on the final pension benefits. These relatively high costs are applied by most individual private schemes as a result of unutilised economies of scale. The 4 For a complete list and data see OECD documents Pensions at a Glance, Public Policies across OECD Countries, 2005, Retirement- Income Systems in OECD Countries, 2009 5 Article 3, paragraph 3 of the TEU 6 In particular, the Laeken objectives adopted by the European Council in December 2001, and of the Common objectives for pensions agreed upon in 2006. Moreover, that is one of the main messages of the aforementioned Green Paper by the European Commission. 2

consequential costs of individual private schemes are usually about five times higher than those of collective arrangements 7. The box below demonstrates the difference in final pension between someone who pays an annual fee and someone who does not. Box 1: Costs matter 8 Imagine a wise young person, who decides, at the age of 25, that he [/she] will save for a pension, so that he [/she] can retire at 65 and enjoy a pension for the next 20 years. He [/she] sets aside 1000eur each year, and raise that sum to cover inflation, which is 3%. He [/she] receives a 6% return on their money. This means that, by the age of 65 if they have no fees to pay, they will have a pension pot of 248,170eur. This in turn will create an inflation-protected pension of 16,080eur for the next 20 years. Now imagine that this person has to pay a fee of 1.5% per annum on their savings [which is typical for a DC plan]. How much will that reduce the pension that will be earned? The answer is that it will be reduced to 9,900eur. In other words, someone who pays no fees gets a 60% higher pension than someone who pays 1.5%, because 16,080eur is about 60% more than 9,900eur Of course some fees will need to be paid in order to administer the pension. However, [by comparison], a large DB pension plan would have charged less than 0.5% for this service [and would produce the greatest benefit to the participant]. Many are shocked to discover fees may be several times higher than the initial investment. In the example above, individuals who put aside 1000eur per year over 40 years end up paying about 66,000eur of fees without interest, which makes it a total of 292,377eur with interest. The chart that follows shows that a mere 1% increase in costs (which is a common difference between individual and collective pension schemes) leads to 27% decrease in the final pension 9. 7 Costs and benefits of collective pension systems (Chapter 4 by J.A. Bikker and J.de Dreu) Springer. 2007. 8 Source: Pitt-Watson, D., Tomorrow s Investor: Building the consensus for a People s Pension in Britain, RSA Projects, December 2010 9 Various studies usually conclude a difference of 25-30%. 3

Figure 1 - Erosion of pension benefits due to annual operating costs 10 The administrative and investment costs are both reduced mainly thanks to economies of scale. In addition, the non-profit character of the collective pension schemes plays an important role. There are no shareholders to satisfy and no profits to distribute, which means more money for the pensioners. Their interests are the sole interests of these pension schemes. Investment returns Investment returns are equally important as plan costs in order to achieve a safe and adequate pension. Economies of scale not only dampen management and marketing costs, but also boost investment returns. In particular, on the one hand large collective and mandatory funds can have access to complex investment strategies that individuals would not be able to use; while on the other hand, they can invest in very-long-term assets, and their long-term investment strategies that are just those that get the best returns. Individuals are not financial experts and lack the skills to save and invest rationally. It is evident through the research in the field of behavioural finance that procrastination, self-control problems, and limited financial knowledge lead to insufficient pension savings and low returns. Even individual investors with some financial knowledge make systematic errors and often do not know what is best for them. 11 Every percentage point that is lost annually due to this 10 Source: Bikker, J.A., J. De Dreu, Operating costs of pension funds: the impact of scale, governance and plan design, Journal of Pension Economics and Finance, 2007 simulates the impact of operating costs on annual pension payments, assuming annual wage growth of 3%, annual inflation of 2% and a nominal investment return of 7%, as well as an uninterrupted contribution payments over 40 years and a pension payout period of 20 years. 11 Munnell, A. H. and Sundén, A. Coming Up Short: The Challenge of 401(k) Plans Washington, 2004. 4

irrational behaviour creates 25-30% decrease in pension benefits, in the very same way as described above concerning costs and investment returns. The mandatory participation plays an important role in achieving better investment returns through long-term investments as the members withdrawals are very limited, and therefore the scheme can rely on high amounts of capital to be invested in complex asset strategies (i.e. real estate, some hedge funds ) without having to worry about random short-term fluctuations. (This applies mainly to DB plans, which have a fairly constant investment horizon, while DC plan participants have an investment horizon that shrinks as they age). This advantage is particularly important during financial crisis: as collective mandatory pension schemes are not supposed to pay out their commitments before the retirement age of their participants, they can wait for years until they recover the temporary losses deriving from a financial turmoil. They can therefore prevent people from panic reactions of withdrawing their assets or even quitting their pension scheme by provoking further losses to the pension funds, which are obliged to rapidly seek liquidity by selling their equities in order to pay out the accrued capital to the leaving members. Finally, the paritarian management is advantageous since the participants are also the owners, which results in fewer conflicts of interest. Moreover, the management is granted to their representatives who are responsible of taking the most balanced and wise decisions. Risk sharing and solidarity Collective pension systems draw their main strength from solidarity at two levels: across and within generations. The first level of solidarity within generations consists in pooling together participants with different levels of risks who pay the same contributions. In addition to that, solidarity plays a fundamental role for those members who cannot pay their contributions to the scheme during some periods of their working lives. It is well known that the non-contributory periods significantly reduce the final pension amount, especially in the DC schemes. Mandatory collective schemes usually provide coverage for these periods by paying the contributions on behalf of their sick, pregnant or (temporally) unemployed members: this means that the other members will pay for the ones in need through the collective pool, providing solidarity and contributing to a more adequate pension income for everyone. Another form of solidarity is to protect the elderly against economic shocks that would result in sudden losses of their pension capital just before they retire. To make this possible, all the members can temporarily accept under-funding or pay higher contributions in order to protect the elderly. As a counterpart, the fund could use the financial capital of the older generations (considering that the younger members do not have any or very low financial capital) to invest in risk-bearing capital that brings higher returns. To put it simply, it works as if the young generations were investing the pension capital of the elderly at their own risk and 5

provide them a safe and indexed pension. Therefore, this generational solidarity mechanism can fill the gaps in the financial markets by allowing the young to share the financial risks of the elderly, and the elderly to share the wage risk of the young. Finally, it should not be forgotten that even the European Court of Justice 12 considered the mandatory collective schemes managed by one pension institution as consistent with the EU Competition law insofar as their characteristics were necessary to provide solidarity. More in particular, these schemes providing solidarity were considered as carrying out a mission of general economic interest according to the article 86(2) of the Treaty of the European Union (TEU). Solidarity has therefore been put above competition law and has become one of the most important European values. Without mandatory participation solidarity cannot be guaranteed. Conclusion Nowadays numerous countries are facing an uneasy demographic challenge and are compelled to reform their pension systems. Policy makers who are striving to offer the future generations sustainable and adequate pensions should not forget what experience has shown us: people who are not obliged to participate in a pension scheme, tend to save too little, invest their savings poorly, and cash out whenever they have the chance. Due to the demographic prospects many countries will be incapable of providing an adequate and sustainable pension solely through the statutory systems and their provision will have to be completed by 2 nd and 3 rd pillar pensions. This completion should not be an option, but a precise duty of Member States. Ignoring the benefits of mandatory collective occupational pension schemes or destroying the basis on which they are built, such as their compulsoriness, the role of the social partners or the collective bargaining agreement systems, would just bring more social costs in the long run. These would derive from the poverty of the elderly, and would imply higher costs for social protection, health care systems, as well as linked increasing expenditures for the state and higher taxation in the long term. Bibliography Almeida B. and Fornia William B., A Better Bang for the Buck: The Economic Efficiencies of Defined Benefit Pension Plans, National Institute on Retirement Security, 2008of Defined Benefit Pension Plans, National Institute on Retirement Security, 2008. Bikker, J.A., J. De Dreu, Operating costs of pension funds: the impact of scale, governance and plan design, Journal of Pension Economics and Finance, 2007. 12 In particular, we quote here the so called Albany case (C-67/96 - Albany International BV v Stichting Bedrijfspensioenfonds Textielindustrie) 6

European Commissions Green Paper: Towards adequate, sustainable and safe European pension systems Munnell, A. H. and Sundén, A. Coming Up Short: The Challenge of 401(k) Plans. Washington, 2004. OECD Pensions at a Glance, Public Policies across OECD Countries, 2005, OECD Pensions at a Glance, Retirement-Income Systems in OECD Countries, 2009 Pitt-Watson, D., Tomorrow s Investor: Building the consensus for a People s Pension in Britain, RSA Projects, December 2010 Steenbeek, Onno W and Lecq, S. G. Fieke van der (Eds.), Costs and Benefits of Collective Pension Systems, Springer, 2007 For more information please contact: Miroslav Florián AEIP - Financial Affairs Advisor Jessica Buckley AEIP Public Affairs Advisor Email: Miroslav.Florian@aeip.net Email: Jessica.Buckley@aeip.net Tel: +32 2 233 54 22 Tel: +32 2 233 54 23 Francesco Briganti AEIP Director of the Brussels Office Email: Francesco.Briganti@aeip.net Tel: +32 2 233 54 21 AEIP Disclaimer AEIP represents the European Paritarian in Brussels since 1997. The Association gathers 26 leading large and medium-sized Social Protection Management Organizations which equally represent the employees and the employers through a joint governance scheme; plus 39 other affiliates coming from 22 countries AEIP represents its members values and interests at both the European and International level. In particular, AEIP - through its working groups - deal with EU coordinated pension schemes, pension funds, healthcare schemes, unemployment schemes, provident schemes, health and safety plans and paid holiday schemes. The final goal of AEIP is to achieve pan-european paritarian schemes of social protection. The values of AEIP are threefold: paritarian management, solidarity and transparency. 7