LONDON - Adoption of more flexible funding limits and prudent-man investment rules are needed to boost equity market development and enhance private pension coverage in Europe, according to a new report.
The report on European equity markets, the first study issued by the European Capital Markets Institute, London, examines barriers to European stock-market integration. It follows the Jan. 1 adoption of the European Union's investment services directive. That directive is supposed to provide a passport for financial services firms to operate across the EU, although only half of EU states have adopted implementing legislation to date.
Various regulations heavily influence the level of equity investments made by European pension funds. In 1992, average equity investments ranged from 2% in Sweden to 80% in Great Britain.
While portfolio restrictions on pension fund investments are well known, just as insidious are funding and accounting rules, according to E. Philip Davis, an official at the European Monetary Institute in Frankfurt, who wrote the study's chapter on pension funds.
Funding rules are intended to protect the security of plan participants, but can be counterproductive when they steer pension funds toward lower-returning bond investments, according to the study.
Some examples of funding restrictions that inhibit equity investment are:
In Germany, employers are required to fund projected benefits based on inflation expectations. But employers cannot deduct contributions to cover inflation risks, thus impeding the growth of externally funded pension funds.
Also, German accounting rules requiring employers to show underfunding in corporate accounts discourage equity investments. These are on top of severe restraints on investing in stocks.
In some countries, tax rules encourage employers to place pension liabilities directly on the employer's balance sheet instead of advance-funding them. This book-reserve system, common in Germany, Luxembourg, Austria and Sweden, keeps cash within the sponsoring employer and does not help development of secondary stock markets.
In the Netherlands, the government sets a maximum real interest rate for discounting future liabilities at 4%, close to the real returns available from bonds. Also, overfunding by Dutch funds has led regulators to plan a special tax levy.
In contrast, the United Kingdom permits funding up to 5% over the projected benefit obligation, allowing for future wage growth, and possibly encouraging equity investment.
What's more, the U.K. actuarial rules value pension assets on current and projected cash flows and not on current market values, making greater use of more volatile equity investments possible.
Accounting standards, while in the process of being toughened, support this practice. New minimum funding rules, however, might encourage a greater emphasis on bond investments.
Other factors also affect levels of equity investments across Europe. For example, higher taxes on bonds than equities make bonds more attractive to tax-exempt investors, Mr. Davis noted.
In addition, bonds have provided better real returns in Germany, Denmark and the Netherlands than in other countries. Trustees' reluctance to take on risk also has caused many Dutch investors to shun equities, he added.
The effect on returns has been enormous. British pension funds, with the highest level of investments in stocks, obtained the highest annual real return in the 23-year period from 1967 through 1990, at 5.8%.
In contrast, Swedish funds, with their heavy concentration in fixed-income investments, earned only 0.2% a year.
The difference in cost of providing an inflation-adjusted pension is huge. While U.K. and Irish funds can replace 60% of pre-retirement pay, Swedish funds can meet only a 14% replacement ratio, the study said.
"Conversely, to obtain a pension equal to 40% of average earnings, U.K. and Irish funds need a contribution rate of 6.7%, and Swedish funds, 29%.," Mr. Davis added.
Among other findings in the report:
Trading systems. Institutional investors are by far the most critical factor in determining future European market structures, the report said. Nearly 70% of European investors expect more than one in 10 European stock trades to be transacted through new proprietary trading systems by 2000.
Proprietary trading systems also are expected to outperform the London Stock Exchange's Seaq International system in many ways, including transaction costs and anonymity. European exchanges will have to undergo painful reforms to remain competitive, the report said.
The investment services directive creates a potential barrier to liberalizing stock trading through its vague definition of a "regulated market," and rules permitting member states to prohibit creation of new markets, the study added.
Corporate governance. European corporate governance practices impede development of more uniform and liquid secondary markets. But more effective corporate governance - such as barring dual-class stock capitalizations - does not necessarily improve liquidity, the study said.
"In general, corporate governance reform is a risky means of improving liquidity, and liquidity should therefore be addressed directly, rather than through restricting ownership concentration," the report said.
Instead, the study urged European companies to fully disclose their governance practices, including board composition, existence and role of other board committees, nominating procedures, executive compensation and internal and external controls.
Capital standards. The EU's capital adequacy directive is flawed in a number of respects, thus failing to meet its goals of providing financial stability and investor protection, and ensuring a "level playing field" for EU securities firms, the study said.
It said different capital standards for the trading book and the banking book make no sense, because the risks incurred on each book (the account of outstanding positions held by the firm) are not segregated.
In addition, the study said banks can fund their securities trading with cheap, protected bank deposits, giving them a competitive edge. Also, the directive fails to take proper account of portfolio diversification in meeting capital adequacy tests.
Accounting rules: Varying accounting practices across European create a potential barrier to international equity investment, the report said. But European investors said these barriers "are relatively insignificant in comparison with those deriving from such factors as liquidity and currency risks," the study added.
Some 45% of respondents to a survey said they assign a higher risk rating to companies that disclose insufficient information; 35% avoid investing in such companies altogether; and 26% require higher returns from them.
Fifty-six percent of investors said they were more likely to invest in a foreign company that met domestic accounting standards; 57% would be more likely to invest if the company met International Accounting Standards; and 44% would be more likely to invest if reports complied with U.S. generally accepted accounting principles.
The report's authors urged a cautious approach by regulators. European corporate issuers are highly reluctant to supply additional accounting information prepared under different accounting principles, although they are a bit readier to supply additional disclosures.
But imposing "an additional layer of accounting requirements is likely to outweigh the benefits to the wider market," the report said.