Individual savers investing in guaranteed pension products could stand to lose a six-figure sum (in euros) as a result of a combination of guarantee costs and ongoing low interest rates. This finding appears in a study entitled “Garantiekosten in der Altersvorsorge – Entwicklung eines Garantiekostenindexes” (The cost of guarantees in pension provision – developing a guarantee cost index) recently published by Frankfurt School of Finance & Management. In the study, Professor Dr Olaf Stotz analyses the costs incurred by individual investors with long-term savings plans linked to 100-percent guarantees underwriting their paid-in pension contributions. In a typical example, he calculates that a 25-year-old woman who starts paying monthly contributions of 50 euros into her pension plan right now, and continues to do so until she reaches retirement age at 67, could incur costs of around EUR 140,000 for a 100-percent repayment guarantee. This is five times more than her total contributions.
The study analyses guarantee costs by comparing two savings plans. The first is a savings plan with a 100-percent guarantee, the second a plan without any guarantee at all. The guarantee costs are defined as the difference between the median terminal values (final assets) of the two savings plans. In order to better compare the effects of the savings process as such, as well as the different ways in which the sums invested are allocated, the comparison does not take other costs into account. The result of this final comparison illustrates the opportunity costs of a rigid 100-percent capital repayment guarantee over the preceding years. For the first time, the study assigns a hypothetical euro value to guarantees in the form of a tangible “price tag”.
The reasons for this enormous difference are first, the drastic increase in guarantee costs resulting from the current low-interest environment, and second, the mandatory contractual structure imposed on pension providers. Providers must cover contracts by investing in low-risk instruments such as government bonds. However, as the latter currently yield very low returns, the proportion of the saver’s capital contributions that must be used to safeguard the funds is very high. The remainder available for growing the capital – by investing in stocks and shares, for example – is disproportionately small.
Dr. Stotz believes these results illustrate a very clear trend: in recent years, the cost of guarantees has skyrocketed due to the marked decline in interest levels. While guarantee costs at the start of the period under observation (in 2000) were still lower than the total investment contributions paid out by savers, in more recent years they have exceeded them by a significant margin. This key finding applies consistently across various classes of investor and when making a variety of assumptions about capital-market conditions.
In the study, Dr Stotz concludes that: “In the absence of transparency concerning guarantee costs, it is highly probable that investors in pension plans are unable to make well-founded decisions. While investors are aware and may approve of the benefits of a guarantee, very few of them will be aware of the costs of such a guarantee, or the sharp rise in these costs over the last few years. If they were aware of these costs, they could weigh up the cost of the guarantee against its purported benefits and make better decisions about their pension provisions based on actual price-performance ratios.”
Comparison with other countries such as Australia and the USA shows that this phenomenon is not confined to Germany. In Stotz’s view, this indicates a global trend away from systems that prioritise secure returns towards systems driven by contribution levels. For Germany, he recommends a flexible guarantee that could be configured in various ways – by basing it on individual savers’ preferences, for example, or on current capital market conditions, or by mitigating individual risk using redistribution mechanisms.
Frank Breiting, Head of Private Pension and Insurance Plans in Deutsche Bank’s Asset Management division, comments that: “To date, national governments have viewed the guarantees associated with certain pension plans as an inherent part of the service provider’s duty of care to savers. But the prolonged interest-rate drought has turned this long-held assumption upside down. Guarantees are forcing savers into investment plans that not only fail to cover their pension requirements, but do precisely the opposite – whereas investing in productive capital could definitely meet their needs. And yet the government makes this impossible for pension savers. So now, it is imperative that guarantees become more flexible. Indeed, with respect to the basic, state-assisted pension, this has been the case for years. So why not apply the same principle to direct insurance contributions and government-subsidised private pensions?