Chapter 3 // Insured guaranteed pension plans: the hidden cost of the guarantee !

In my last instalment, I estimated the true cost of a pension scheme with a guarantee at around 3%, 1% of which is operating costs and the other 2% of which is the hidden cost of the guarantee. To arrive at this estimate, I started with a hypothetical question: what return could the insured expect if they gave up the capital guarantee and the guaranteed minimum rates?

And here, I’d like to use the French market to illustrate my point. If you compare the performance of Aviva’s AFER (Association Fran?aise d'Epargne et de Retraite) guaranteed fund with the performance of an investor who placed all their holdings on the CAC 40 (French equities) between the end of 1976 and 2019, you come out with annual performance of 6.88% for guaranteed rate products and 10.76% for riskier investments in equities.

The difference between the two is 3.88% per year, which I would therefore argue is the cost of the guarantee – in terms of lost opportunities for the insured.

It may be slightly higher than we would see during a different timeframe, as the performance in general is exceptionally high due to the period of double-digit inflation that the whole of Europe experienced in the 1970s and until the early 1980s.

However, over periods ranging from 20 to 30 years, stock market performance always remains above guaranteed scheme performance – whatever timeframe you choose. What’s more, for countries where I was able to do a similar study, such as Italy and Belgium, I got similar results: between 2% and 4% difference in annual yield depending on the country or the period (stabilising at around 3% over longer timeframes).

Of course, you could object that this 3% difference includes the 0.74% costs that the insurance companies need, on average, to operate even if they were not to offer a guaranteed rate. (see the chapter 2 of my article, published last week in Linkedin)

But even if we assume these unavoidable costs at 1%, this still has enormous consequences for the future retiree.

The difference between 1% and 3% might not seem all that significant. But when applied to a pension fund over 40 years, paying 1% could result in a 60% larger pot.

Today, my belief is therefore that a DC scheme with a guarantee is not the right solution for the employee. Arguably, it’s not the right solution for the insurer either, given the problems related to Solvency II and the associated decline in profitability. And it’s certainly not the right solution for the employer, who in many countries has a legal obligation to cover liabilities if the insurer does not meet its objectives or goes bust.

Of course, it’s not easy to close guaranteed pension plans that are in force and that will remain active for decades to come – that’s why so many insurers continue to offer them. But for compensation and benefits managers in a position to take a different approach, now is the time to open discussions with employees.