Outlook 2005: International

European pension plans will spend 2005 juggling their need for investment returns with new accounting standards, regulatory requirements and liability-led investing.

Meanwhile, money managers specializing in high-return asset classes and alternative investments are best placed to win new business, said Bill Muysken, head of global manager research at Mercer Investment Consulting, London.

"In terms of new placement activity, I think alternative investments will continue to be the hot area," he added.

But while specialist money managers might be wallowing in new assets, Mr. Muysken warned these new mandates might bring capacity constraints.

Capacity is a perennial issue in specialist asset classes, but the recent popularity of specialist managers among plan sponsors means many firms will have grown to the point where they cannot manage assets effectively and may need to temporarily or permanently stop taking new business.

Independent consultant Koen De Ryck of Pragma Consulting, Mechelen, Belgium, believes the biggest challenge facing European pension plans in 2005 will be to continue to squeeze good risk-adjusted returns from their existing assets.

Mr. De Ryck does not expect to see particularly strong returns from fixed income in 2005 as the possibility of higher interest rates might reduce investment returns.

But plan sponsors hoping to increase their allocations to equities in 2005 might be hobbled by new accounting standards and increased "meddling" by regulators, which was creating distortions in the market, he said.

Sponsors with less well-funded pension plans may find themselves forced by regulatory penalties to put more money into liability-matching assets such as fixed income. The greatest pressure from regulators for liability matching is happening in the Netherlands, Denmark and to some extent in the United Kingdom, and is leading to lower equity allocations in these markets, according to consultants.

If investment markets stay stable over the next 12 months, U.K. pension plan equity allocations could fall by five percentage points because of the push for liability matching, said Gareth Derbyshire, executive director of the European pensions group at Morgan Stanley, London.

Nonetheless, pension plans will continue to put more money into specialist asset classes such as emerging markets and small-cap and midcap stocks, said Mr. De Ryck. But he warned that alternatives such as real estate and commodities are increasingly expensive strategies in which to invest despite generally good returns.

"We think there will be more pressure to move to more specialist mandates, so the opportunities for money managers will be there," he said.

Mercer's Mr. Muysken believes pension plans will continue to invest in hedge funds of funds, currency overlay and currency funds, global tactical asset allocation strategies, private equity and global real estate, which is a relatively new strategy for European pension plans.

European plan sponsors are also for the first time considering new asset classes such as infrastructure-linked investments and timber funds. Some of the new allocations may be funded from shaving allocations to core passive strategies. Plan sponsors will only reallocate assets to active strategies if they are sure the money manager will outperform the market, said Morgan Stanley's Mr. Derbyshire.

"Pension funds are moving from a situation where in the past they relied on the market return and to only a small extent on the return from active management. Now they are relying more on active management returns," said Mercer's Mr. Muysken.

"But the balance is shifting. Traditionally they have relied only on equity market returns but now they are looking for better returns from other asset classes such as fixed income, real estate, private equity," he added.

A number of European plan sponsors have already lengthened the duration of their fixed-income benchmarks, and many are considering interest rate swap programs as a means to implement this change, said Morgan Stanley's Mr. Derbyshire.

Some plan sponsors are increasingly willing to give their fixed-income managers greater discretion in investment mandates and allow them to hold a broader range of asset classes, even permitting them to short the market. "We are just starting to see that but only a handful of European pension plans have expressed an interest in it," said Mercer's Mr. Muysken.

These changes to fixed-income mandates and plan sponsors' focus on liability-led investing have been driven by new accounting standards and pension regulations among European Union member states.

U.K. plan sponsors are facing a specific challenge to rethink the best way to outperform their liabilities with the introduction of Financial Reporting Standard 17, said Mercer's Mr. Muysken. The new rule requires plan sponsors to value their liabilities at market rates in company accounts.

Starting in January, other EU states will introduce International Accounting Standard 19, which allows some smoothing of liabilities and is not as onerous as FRS 17. Still, it will force corporate plan sponsors to take a hard look at the interest rate and investment risk and the impact these have on company accounts, said Mr. Derbyshire.

Many of the regulatory changes taking place within individual countries are in anticipation of the September 2005 implementation of the much-anticipated European Union Pension directive. Under EU law, individual member states have to bring their pension legislation in line with the directive. Officials are busy tackling existing solvency requirements, funding rules and investment guidelines.

The new directive holds out the promise of cross-border pension plans, long the holy grail for multinational plan sponsors operating in Europe. But it might be some months before a cross-border pension plan is created and even then it may initially only be for defined contribution arrangements, according to Alan Pickering, partner at Watson Wyatt Worldwide, London, and former chairman of the European Federation for Retirement Provision.

"A prerequisite for (cross-border defined benefit plans) is mutual trust among the regulators and we won't have that by September," he said. There is a high risk that pension regulators will overregulate cross-border plans unless supervisors in different countries work together.

"Overregulation could marginalize defined benefit (plans) and we are seeing that in the U.K. and the Netherlands. Everyone must understand that absolute security and risk-free pensions are not deliverable," he added.

"You would have to be a saint as an employer" to continue to provide defined benefit pensions in the face of the new accounting standards and regulatory changes, said Mr. De Ryck.