The pension system is broken in most developed nations. This is not news, but now the situation is spilling over into some of the oldest and most prestigious UK universities.
Proposed changes in pension benefits, meant to deal with a £6.1 billion deficit in the Universities Superannuation Scheme (USS), have led to strike action that could potentially impact final exams and harm students.
An analysis of pension systems throughout Europe suggests that public social security pension arrangements, the so-called first pillar of retirement systems, are seriously weakening – most so-called funded systems are severely underfunded and the sustainability of pay-as-you-go systems is threatened by ageing populations.
In the UK, it has been estimated by the consulting firm Mercer that the deficit of the funded public pension system will grow to reach $33 trillion by 2050, representing 11 times the current annual gross domestic product.
With this deficit, workers in the UK can expect public pension programmes to replace a mere 29 per cent of working-age income, in contrast to the average 63 per cent coverage ratio for Organisation for Economic Cooperation and Development (OECD) countries.
The situation is not much better in countries such as France or Germany, among others, that have unfunded, pay-as-you-go systems. In these countries, rising demographic imbalances with ageing populations are slowly but surely making the systems unsustainable.
In terms of private pension funds, regarded as the second pillar of pension systems, recent developments in accounting and prudential regulations have led a large number of corporations to close their defined-benefit pension schemes to reduce the impact of pension liability risk on their balance sheets and income statements.
Overall, a massive shift from defined-benefit pension to defined-contribution pension schemes is taking place across the world, implying a transfer of retirement risks from corporations to individuals.
This is precisely the problem with the UK university pension proposal to switch from a defined-benefit scheme, that gives a guaranteed retirement income, to a defined-contribution plan, where the retirement risk is fully borne by individuals.
In the case of the UK’s university lecturers, the situation has been exacerbated by some vice-chancellors proposing changes that mean, in some instances, that academics could potentially lose up to half their retirement income.
In the context of such a massive shift of retirement risk to individuals, the investment management industry is facing an ever greater responsibility in terms of the need to provide suitable retirement solutions to be used within the context of private defined-contribution pension funds and individual retirement accounts.
Unfortunately, current investment products distributed by asset managers or insurance companies hardly provide an adequate response to investors’ and households’ replacement income needs in retirement.
Given that the biggest risk in retirement is the risk of outliving one’s retirement assets, securing replacement income in retirement can be achieved with annuities.
Annuities, as well as variable annuities, which are annuity products that offer participation in the upside of equity markets, suffer from a number of fatal flaws. Namely, their unavailability early on in the accumulation phase, their cost-inefficiency due to the prohibitive cost of capital for insurers offering formal guarantees, as well as a severe lack of transparency and flexibility, which leaves investors with no exit strategy unless they pay high surrender charges.
These elements undoubtedly explain the low demand for annuities, otherwise known as the “annuity puzzle”, that is when annuitisation is not incentivised or mandatory.
In the UK, the 2015 Pension Act, which has nullified the compulsory annuity purchase, creates a tremendous opportunity for asset managers to launch meaningful forms of retirement solutions.
Existing investment products include life-cycle funds (also known as target-date funds), which are often used as a default option in retirement plans, since they are inherently designed as long-horizon strategies that explicitly benefit from mean-reversion in the equity risk premium.
Such target-date funds, however, generally focus on reducing uncertainty over capital value near retirement date regardless of the beneficiaries’ objectives in terms of replacement income in retirement.
As a result, they offer no protection to investors with respect to unexpected changes in interest rates, inflation and longevity, which are the key risk factors in retirement. Ironically, part of the answer to the problem can potentially be found in academic circles.
Simple risk management principles grounded on solid academic foundations can actually be used to design retirement investment strategies that meet the needs of individual investors preparing for retirement.
To address the looming pensions crisis, investment managers need to focus on the launch of such meaningful mass-customised retirement solutions.
This challenge is a unique opportunity for the investment industry to add value to society as a whole.
Lionel Martellini is the director of the EDHEC-Risk Institute, part of the EDHEC Business School, which has campuses in Lille, Nice, Paris, London and Singapore.