In June 2015, I published an article entitled “A capital guarantee: but at what price?” in which I explained that in an environment of ultra-low interest rates capital-guaranteed products had lost their ‘raison d’être’. At the time the 10-year OAT (French government bond) was yielding a little less than 1.30%. Since then, the ECB’s massive programme of bond purchases has driven down the yield of the 10-year OAT to a level of about 0.30%.
In light of this, it is reasonable to assume that capital-guaranteed products no longer offer any potential for performance in the current interest-rate environment, even when it is still possible to construct them.
Exhibit 1: French government bond yield curve
Source: Bloomberg as of 18/10/2016
The vast majority of capital-guaranteed products launched in recent years, which are very often based on Max NAV mechanisms (guaranteeing a net asset value at a high-water mark at maturity), have now been monetised, due to the extent of the fall in yields.
It is now clear that it is no longer possible to generate additional income for retirement without taking investment risk. Government bonds are no longer the flagship investment solution for retirement. This is reflected in the offering of investment solutions, whether within a life insurance contract or via a pension fund.
European insurance companies are phasing out capital-guaranteed products
French legislators were concerned that insurers could be weakened by a spike in interest rates or a sustained plunge into negative territory. They therefore amended the Sapin 2 law (Article 21 bis), which now allows the suspension, delay or limitation of the payment of redemptions, the switching option, or the payment of contract advances for all or part of the portfolio. In other words, the permanent guarantee of euro-denominated contracts could lose its liquid character. Insurance companies, meanwhile, are promoting their euro funds less aggressively, and some of them even require a simultaneous purchase of a UoA (‘Unit of account’ – stock market) fund. As for “Euro-croissance” contracts, which were meant to take over from euro contracts by offering a guarantee upon maturity (eight to 30 years) in exchange for a greater potential performance, it will be possible under certain conditions to transfer the euro contract’s unrealised capital gains to Euro-croissance to try to mitigate its low expected return arising from the low-interest-rate environment.
For the moment Germany has decided not to abolish guaranteed rates, which potentially undermines the profitability and creditworthiness of German insurance companies. Since 1 January 2015 the guaranteed rate on new contracts has been reduced from 1.75% to 1.25% and will fall to 0.9% at the start of 2017. Generali, Zurich, Talanx (HDI, Targo, Hannover Re), Munich Re and Ergo have already stopped issuing guaranteed-rate products. La Baloise has ended part of its life insurance activities with a view to disposing of them.
Pension funds prefer defined-contribution plans to defined-benefit plans
Defined-benefit pension funds must match their assets to their liabilities (i.e. the benefits promised after retirement). They therefore face several types of risks: those of longevity, inflation and, most of all, interest-rates. When interest rates fall, liabilities automatically rise and to cover them, pension funds must increase their bond allocations (they can assume greater risk if regulations allow them to do so but the sponsoring company still faces the risk of having to cover the loss from a poor performance by the investment). However, the time now comes when this is no longer possible, given how low interest rates have fallen, and corporate pension plans are moving into deficit, dragging down company earnings.
This has fuelled the recent acceleration in market share of defined-contribution plans. This trend is illustrated over a period of 10 years by the diagram below, which aggregates in a percentage the assets under management of defined-benefit (DB) and defined-contribution (DC) plans in six countries with highly developed pension funds.
Exhibit 2: Trends in defined-benefit (DB) and defined-contribution (DC) plans of pension funds in a selection of countries (US, UK, the Netherlands, Japan, Canada, and Australia) from 2010 to 2015
Source: Tower Watson as of 10/18/2016
The switch to a defined-contribution system relieves the obligation to match liabilities and can allow greater risk-taking to generate additional potential income upon retirement. The risk, however, is borne by the employees rather than the corporate sponsor.
What lessons can be drawn from this trend?
Not only do risk-free assets no longer generate a return of any significance, they actually cost money! (Cash is at a negative yield of -0.40% and you have to go beyond an OAT of eight-year maturity to obtain a positive yield). To generate additional income to finance one’s retirement, risk premiums have to be sought out that are compatible with one’s investment horizon, i.e. equities, small and micro capitalisation stocks, non-listed shares and corporate bonds, loans and direct loans in the interest-rate universe etc.
Of course, diversification rules still apply, along with the principle of risk reduction as the retirement date approaches. Target-date funds are packaged solutions that have proven themselves in recent years in the United States as a solution preferred by pension funds (USD 680 billion in AuM). Across Europe, there are not yet any similar systematic approaches but interest-rate restrictions could very well change that. In France, for example, the Macron Law encourages companies to use target-date funds as a default solution for PERCO retirement savings plans by including microcap shares.
Admittedly, these target-date funds are not risk-free, but diversification combined with reduced risk does provide some safe-guards over the long term.
Even greater capital protection is possible. Although the capital guarantee is no longer an option for pension savings in the current environment, more flexible options with formal capital protection at maturity developed over the past few years have showed that it is possible to combine capital protection and performance advantageously. These solutions also have the clear advantage of having a value proposition that remains valid during phases of rising yields.BNP Paribas Asset Management’ research into this issue has yielded some innovative solutions in terms of target-date funds with capital protection.