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02 June 2014

Why taking more risks is the only way out of Europe’s demographic crisis 

KBL Richelieu CIO David Desolneux explains how European pension funds require a new investment strategy to create value in the context of an ageing population

It’s time to move from wealth preservation to value creation

In demographic terms, we are in the midst of a revolution.

Many governments appear to be only now recognizing this fact – and realising that as a consequence, their generally conservative retirement strategies are profoundly flawed.

Take the case of Japan, where the median age is 44. With one of the world’s highest life-expectancy rates and lowest fertility rates, the population is simultaneously graying and shrinking. This is already putting enormous strain on the national economy, and that pressure will only increase over time.

Unsurprisingly, given the size of the country’s retirement-age population, the Japanese Government Pension Investment Fund (GPIF) is the world’s biggest pension fund, managing more than €900 billion in assets.  

That may sound like a great deal of money – but the GPIF has a fairly poor track record of return on investment, and one that is entirely inadequate to meet the country’s long-term needs. Indeed, until 2013, fund managers focused on capital preservation, generating an unsustainable internal rate of return barely above 1.5%.

The fact that the GPIF continues to pay out more than it receives in contributions is making an already precarious position worse with each passing day.

Facing the kind of demographic crisis that Europe will likely experience 20 years from now, Japan is in the midst of a radical reorientation of its national savings strategy. It may soon become the first country in the world to abandon the idea of national wealth preservation in favor of value creation.

Until the middle of last year, two-thirds of GPIF assets were invested in Japanese government bonds. While this may help fund state debt, it will lead to a long-term capital shortfall, as the population continues to rapidly age and contract.

More recently, the weighting of government bonds in the pension fund portfolio has been reduced from 62% to 55%, favoring increased corporate investments. The fund held 17% of its assets in local shares last quarter, 15% in foreign equities and 11% in overseas bonds.

GPIF managers appear to be heeding the advice billionaire investor George Soros provided to Prime Minister Shinzo Abe at the January Davos meeting: Accelerate the reorientation of public-sector pension fund strategy towards riskier products.

Now compare Japan to France, another rapidly aging nation whose pension system is under strain. Currently, just 11% of French state pension fund assets are invested in equities.

For the past few decades, in an inflationary environment, French state pension fund managers focused on preserving capital. As government bonds were paying relatively high interest rates, these investments performed reasonably well.

Those days are finished.

Today in France and more widely in Europe, inflation has disappeared, along with high returns. French government bond yields – standing at 2.1% over 10 years as of April 1 – are no longer sufficient to support long-term obligations.

Like in Japan, these low yields simply cannot meet the systemic requirements of an aging population. That’s why French individuals are increasingly investing in private pension schemes, along the lines of American Individual Retirement Accounts, which provide tax advantages for retirement savings.

Today, generating a sustained return from traditional, low-risk investment vehicles has become nearly impossible. The only option – for many individuals and for entire pension plans – is now to focus on value creation, typically through the corporate sector.

Nevertheless, European individuals generally don’t view equities as a preferred means to long-term savings. Compared to their peers in the US and UK, relatively few Europeans have significant equity exposure – partly because they haven’t seen the need to fund their own retirement, something they have long believed the state would manage for them.

Looking at the seven largest pension fund markets (the US, UK, Australia, the Netherlands, Japan, Canada and Switzerland), the average equity exposure is today 47%. Of these countries, only Japan, Canada and Switzerland continue to favor a more conservative approach; nevertheless, their average equity exposure is 30%.

The managers of these funds – with the notable exception of the GPIF – have recognized over the past several years the need to create value to ensure long-term viability. Given that, in many countries, total savings generated by pension funds now exceed GDP, this strategy appears to be paying off.

Only time can tell if this broad movement – from wealth preservation to value creation – will ultimately prove successful. In the meantime, the global demographic clock will keep ticking.

David Desolneux is chief investment officer at Paris-headquartered KBL Richelieu, a member of KBL European Private Bankers.

- Pensions Insight