September 2010


US_Spurs_140A type of product that has seen healthy inflows of money during the financial crisis is the American target-date pension fund. Could Europe benefit from this model? Angele Spiteri Paris asks if Europe, with its dire pensions problem, could benefit from the target-date model as an alternative to lifestyle funds. The European Commission warned us again this summer of the worrying pensions problem towering just over the horizon. While state pensions creak more loudly under the weight of more pensioners that have to be supported by fewer workers’ taxes, private pension funds – which are meant to take up the slack – still suffer from a lack of participation.

Although not without its own pension problems, the US may have found a part of the solution that Europe could do well to follow.

Target-date funds revolutionised pension provision in the US, bringing simplified investment to the masses and encouraging employees to save for retirement by virtually doing nothing.

They are also good for fund managers’ inflows. Research by Morningstar found that contributions to target-date funds in the US in the year that heralded the financial crisis – 2008 – dipped, but only fairly modestly, and quickly recovered in 2009.

Todd Ruppert, CEO of T. Rowe Price Global Investment Services, an American manager that offers target-date funds to the US market, says that in the US, the percentage of plan sponsors using target-date funds as their default options rose from 30% in December 2007 to 55% as at December 2009.

“Despite the uncertainty in the markets – or in fact because of it – assets in target-date funds have continued to increase,” says Ruppert.

Default options in the UK and Europe centre mainly on balanced and lifestyle funds. With the latter, members are told how their risk profile changes through time, with the equity-bond mix changing to reflect it. For many, this is about as exciting as the small print on a credit card application.

With target-date funds, they are told their retirement date and that, pretty much, is it.

Lack of participation in European occupational pension schemes has always been a major hurdle, so a default investment option that addresses scheme members’ needs and requires little, if any, member participation could be part of the answer to this problem.

Setting the example
Target-date funds in the US have proved to be hugely popular and although they are not a panacea for the pensions problem, they have helped stir the pensions market from its slumber.

In the Morningstar research paper, analysts say these products have been a “smashing success”. The data provider estimates net new inflows into target-date mutual funds stood at $58bn (€45.9bn) in 2007, dipping moderately during the steep 2008 bear market to $43bn, and notching around $45bn in 2009. In each of those years, every single category of target-date funds enjoyed positive inflows, from retirement income funds on the short end, to target-date 2050+ funds on the long end.

A survey of the US defined contribution (DC) market by consultancy Towers Watson found that target-date funds were the most prevalent default investment option. Nearly three-fourths of survey respondents (72%) used target-date funds as the default option, followed by 13% who use balanced or
lifestyle funds.

The survey also found that 78% of those using target-date funds as their default option selected funds not affiliated with their record-keeper.

So it looks like the target-date default option could be significant for increasing pension scheme participation in Europe. Default options are good because if most of the time people do not think a great deal about their pension coverage, then once entered into a scheme by their employer they are unlikely to go to the trouble of opting out.

The target-date option is good because it seems to answer savers’ needs more adequately.

No explosion
On paper, this US import seems to provide at least part of the answer to the UK and European pensions conundrum.

But if they are so appropriate for these markets, why haven’t US money managers like T. Rowe Price, Fidelity and Vanguard made more of them here? And what of the European policy makers – are they interested?

Experts say there are a number of reasons for this, ranging from regulation to investor profiles and market size.

Ruppert says: “Target-date funds are appropriate to help solve Europe’s pension issues but you need to have regulation that is sensible. In Europe, there is no consistent legislation and unless this is drawn up to foster and embrace the use of target-date funds then they’re never going to be as popular as they are in the US.”

But one thing is certain: Europe is in dire need of a pensions silver bullet, or even just a brass one.

In a June green paper entitled Towards adequate, sustainable and safe European pension systems, the European Commission noted that in 2008 there were four people of working age for every EU citizen aged 65 years or over. By 2060, that ratio will drop to two to one.

“The recent financial and economic crisis has aggravated and amplified the impact of these demographic trends,” the paper says. “Setbacks in economic growth, public budgets, financial stability and employment have made it more urgent to adjust retirement practices and the way people build up entitlements to pensions. The crisis has revealed that more must be done to improve the efficiency and safety of pension schemes.”

Potentially, a European version of target-date funds could very well help people build up their private pension fund relatively painlessly.

Brian Kite, DC specialist at Mercer Investment Consulting, says: “While none of these solutions is perfect, when you’ve got a big number of previously un-pensioned employees, with varying degrees of financial literacy, then target-date funds are probably a much easier concept to explain than even lifestyle funds.”

Daniel Enskat, senior managing director of Strategic Insight Global, a consultancy, says: “European 401(k)-type products were a key discussion at Fund Forum International in Monaco this year. It seems as though the industry in Europe is finally at an inflection point. Over the last few years there’s been a lot of talk around this and now we’re beginning to see variations of US target-date funds grow to a meaningful size.”

David Hutchins, UK head of DC research and investment design at AllianceBernstein, is similarly optimistic. He says: “Target-date funds will end up being the dominant vehicle in Europe, although not at first. People will make lots of mistakes before getting to that point.”

AllianceBernstein is one of the few large American investment houses that has begun to roll out target-date funds in Europe. Many others have, as yet, laid low.

In a recent piece of research by Amin Rajan from Create, one of the investment management respondents said: “Europe should learn from the US which has made a lot of mistakes in the DC space over the past 25 years.”

Kite, of Mercer, gives an example: “There was a huge range of equity exposure in the US funds. Some still had 60% equity exposure at retirement, which obviously makes them very susceptible to a market turndown. Our research showed that the managers were assuming that everybody behaved rationally, when behavioural economics suggests that people rarely do so.”

Kite adds: “So having a high equity exposure at retirement was fine if everybody behaved sensibly. But you saw many people borrowing on their 401(k) plans before they even got to retirement and when they did get to retirement, they started drawing down the money out of it faster than expected. So they essentially had too aggressive an investment strategy for what they were actually doing.

“One of the key lessons there is that fund managers need to make assumptions about what people will actually do rather than what they ought to do.”

The fact remains that the US experience of these pension solutions will prove valuable for Europe.

Tom Douie, vice president at American Century Investments, says: “Over the next 18 months to two years we will see an increased demand for target-date products and the likelihood is that US providers will look to service some of that demand.”

But although the general sentiment towards these US imports is positive, not much action has been taken to create and market European target-date funds following the US model.

No marketing push
Interestingly, none of the three largest providers of target-date funds from the US – Fidelity, T. Rowe Price and Vanguard ­– have been visibly aggressive in pushing their capability in Europe.

Fidelity does offer some target-date funds on its platform in the UK and has had success in Germany, while Vanguard is in the process of creating such products. Ruppert, at T. Rowe Price, says his firm is currently in discussions regarding the possibility of marketing target-date funds in Europe.

So although there is some movement, on the whole, the marketing thrust behind these solutions by the big providers has seemed somewhat weak. And this begs the question why.

Experts cited a number of reasons for the situation.

In Europe, insurance companies and low-cost product providers have a strong hold on the pensions market and therefore anything marginally more expensive, as target-date funds may be, would suffer in comparison.

Douie, of American Century, says: “In continental Europe, investment product distribution is dominated by insurance companies and banks, which does lead to a certain inertia. But all it takes to turn that around is for one or two insurance companies to favour target-date funds.”

Enskat, at Strategic Insight, gives another potential reason for US providers’ reticence. He says: “If you’re a big 401(k) provider in the US, you have a strong distribution capability there which you might not have in Europe.”

The size of the European pensions market was also mentioned as a possible deterrent. Hutchins, at AllianceBernstein, says: “If you look at the current size of the market, it doesn’t look exciting to US managers coming from the mature environment in the States. Also, some of them may not have the infrastructure to deliver target-date funds in Europe.”

Kite says: “It’s a big ask for them to jump into a market that is in its infancy with very few pension plans using target-date funds, considering that there are already players in the European market who could launch such products.”

However, Christof Quiring, head of pension solutions at Fidelity in Germany, said: “A big marketing push does not say anything about the importance of a product group. We had a great success in the German market in 2009 and thus the market is of great importance for us. For corporate pension plans we have received €289m in 2009 in target funds. The market in Germany is, of course, not as big as in the US, but measured against the net inflows, Fidelity International is the market leader in Germany.”

But although they may not have done so to a great degree, this does not mean that US managers will not be targeting Europe. The opportunity has the potential to be phenomenal, if the continent manages to get all its ducks in a row.

Tom Rampulla, managing director of Vanguard Investments UK, says: “There is a lot of talk around DC and although the market is still small, it’s growing.”
But Kite adds: “There are some fairly big hitters competing for a currently small cake. So until the cake gets bigger, there’s not going to be much room for other players who have good offerings in the US.”

Research from consultancy firm Cerulli Associates shows that total DC assets in Europe have risen from just over €1 trillion in 2004 to €1.3 trillion in 2008, representing a compound annual growth rate of 6.3%. The indicators imply that growth will continue and likely accelerate. According to Cerulli’s estimate, a combination of market appreciation, as well as stronger contributions, will bring the 2009 figure to a new high of €1.5 trillion.

Enskat says: “US fund managers who don’t already have a presence in Europe are considering it. If there was a structural change in the market they would certainly look to push target-date funds because they would have a competitive advantage.

“We’ve seen a number of fund managers not already in Europe looking to make a big push into the region – mid-sized managers who weren’t already established in the region, like Eaton Vance Investment Managers and Dimensional Fund Advisors.”

He says these firms are becoming very interested in Europe, either because they’ve done very well in the US or because they can see a clear opportunity here. Europe is a big opportunity for US managers. It’s almost a tactical move for them, says Enskat.

“Even firms that have been active in the region for a number of years are committing new or additional resources to the growing opportunities around third-party fund distribution in Europe, with distributors looking for independent asset managers as they are restructuring their business models and selection criteria post-crisis.”

Rampulla says: “The US managers who already have experience with target-date funds have been talking about moving into Europe.”

Asked why Vanguard decided to make the leap, Rampulla says it was all about priority and timing.

“We launched our funds, which are building blocks for target-date funds, last June and now we’re working on developing the right glide path for the UK market… for us it made sense to move into this market.”

According to Rampulla, an increase in the take-up of DC pensions will not only bring US managers to the UK and European shores. “Managers around the world are smart and if there’s an opportunity in these markets then we’re just as likely to see non-US managers coming into Europe as we are to see those from the US.”

©2010 funds europe

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