The political response
In terms of the political response to this quandary, one of three things may happen:
(i)Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā The regulator may decide to subject the pension industry to the new rules as well. This could have massive implications for the relative performance between bonds and equities, as large amounts of capital would have to be re-allocated from equities to bonds across Europe.
(ii)Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā The regulator may turn around and soften the directive to lower the impact on an already beleaguered insurance industry. The introduction of Solvency II has already been delayed once amid fears that a swift introduction would do too much harm to the industry. Any such change would be bullish for equities but could cause bond yields to rise ā potentially significantly so.
(iii)Ā Ā Ā Ā Ā Ā Ā Ā The regulator may do nothing.
The prevailing view today seems to be that option (iii) is the most likely. I am not so sure. My moles are telling me that there is a lot of lobbying from both sides in the corridors of Brussels and that the ultimate outcome is impossible to predict. There is tremendous pressure on Brussels from the insurance industry to include the pension funds but, at the same time,
there is also a growing realisation that low interest rates could do serious damage to the industry. Knowing how Brussels usually operates, a compromise whereby pension funds are forced in, but the rules are relaxed somewhat, is a possible outcome. It is difficult to predict how stocks and bonds would react to such a compromise, as it depends on how far the regulator is prepared to go in terms of making concessions to the pension fund industry.
Low bond yields are bad news
Going forward, the main issue facing the industry (and that is the same for insurers and pension funds) is the relentless drop in bond yields. As yields come down, so does the discount rate which is used to calculate future liabilities. A lower discount rate in turn leads to a falling solvency ratio3. In the first half of this year alone, solvency fell by 13% on average as a result of falling bond yields4. With Solvency II only two years away, a deeply worrisome situation is developing whereby low inflation forces bond yields down which again forces insurers and at least some pension funds to reĀbalance their portfolios in favour of more bonds and fewer equities, which will push bond yields even lower. This self-perpetuating mechanism amplifies an already unstable situation.
I am not sure if policy makers understand how potentially dangerous this situation is. We are on the road to insolvency. And, even if pension providers manage to stay solvent, future generations of retirees are likely to run into serious financial difficulties as their retirement savings earn next to nothing, because our political leaders forced new rules on the industry, the implications of which they did not grasp.
Ageing related liabilities are a monster we have to deal with for many years to come (see chart 4). Demonstrating a lack of responsibility which defies belief, policy makers continue to more or less ignore the problem. Meanwhile, many countries are getting sucked into a deflationary spiral which only makes the problem worse ā in fact much worse. Adding to that the likelihood of life expectancies continuing to be extended (a one year extension translates into an increase in pension liabilities of approximately 5%), and countries across the OECD are left with a real shocker of a problem.
Entire countries may have to (read: will) default on their pension obligations either overtly or covertly. A few countries have already started to adapt to the new reality by delaying the retirement age by a year or two; however, in order to solve a problem of this magnitude, we need a work force that is prepared to work until the age of 75. Expect some hard fought battles in the streets of Paris, Madrid and Athens!
The casino solution
Interestingly, there is a solution. Solvency II does not require for insurance companies to hold any capital against EEA5 government bonds. As pointed out by Deutsche Bank in a recent research paper6, this looks an extraordinarily brave decision by the regulator, considering recent developments in peripheral Europe. But rules are rules. If you can see your pension fund sinking like the Titanic, but you know you have a good shot at saving the ship, if only you fill up the portfolio with high yielding government bonds, it must be very tempting to stuff your portfolio with Greek (10-year currently yielding 10.7%), Irish (6.6%), Portuguese (6.4%) and Spanish (4.1%) government bonds. It is one heck of a gamble but, then again, desperate people do desperate things.
