An act of nurture: the growing market for pensions presents a promising, but complex, opportunity for insurers.

Life insurers in the world's most advanced economies are facing a unique challenge--a vast and potentially lucrative market is opening up before them, but how they should take advantage of it is not entirely clear.

The market is pensions, and the challenges include designing new products that will meet the needs of rapidly aging populations that can no longer be fully supported by state-funded systems, training and deploying skilled financial advisers to market those products and anticipating legislative and regulatory changes that are certain to come.

The potential of pension markets comes through in estimates with dazzling numbers. John D. Ladley of Ernst & Young's retirement income research team estimates that the amount of capital poised to shift as the baby boomers roll into retirement--in the United States alone--ranges from $12 trillion to $15 trillion. "That's pretty certain to occur in the next 10 years or so," he said.

A joint study between Deloitte Research and Goldman Sachs on the future of pension markets in Europe estimated that the long-term savings market will be worth about 26 trillion euro (about $30 trillion) by the end of 2010--compared with 12 trillion euro invested in 1999. About 4 trillion euro will be invested in private retirement schemes by then, and by 2030, that figure will rise to 11 trillion euro.

The study concluded that "the old system of state provision for retirement is breaking down" across Europe. The continent's "much-envied social model" of state provision for retirement is beginning to crack under the weight of increasing pension liability. "For Europe's life and pensions companies, and the wider financial-services community, this dark cloud has a very rich silver lining," said Andrew Power, a partner in Deloitte's London office and coauthor of the study.

All of these trends are focusing the attention of major global insurers. At the 39th annual conference of the International Insurance Society in New York in July, the chief executives of global insurance giants ING Group, Fortis and Sun Life Financial Services Inc. all trumpeted pensions as an important, worldwide growth market. Ewald Kist of Netherlands-based ING said insurers "have a huge challenge before them" to fill the growing gap between public and corporate pension systems and the needs of retirees.

To that end, ING this year created a Global Pensions Division, headed by Executive Committee member Jan Nijssen. The division is responsible for rolling out and implementing a global pension strategy over the next three years.

Fred R. Donner, industry sector leader for the insurance practice of accounting and tax firm KPMG LLP, said pensions have become "a timely topic as many insurers rethink what markets they commit to." There are changes taking place in public pension systems, both in Europe and the United States, driven by increasing swains on those systems, he said. Life expectancy is lengthening, and the number of retirees is growing, especially as most of the baby boomers head to retirement.

"There are shifts in the types of pension plans both in Europe and the United States, from public plans to funded plans, and from defined-benefit plans to defined-contribution plans," said Donner. "These shifts are causing investment risks to be shifted to the individual. It's become the individual's responsibility to direct funds into plans, creating opportunities for insurance companies to design products to assist them. Individuals are increasingly relying on the capital markets, which is causing a lot of rethinking about how to direct funds for a retirement plan."

Markets Evolve Differently

According to Power, there are "huge differences" in the nature of the pension markets between the United States, the United Kingdom and Canada, on one hand, and continental Europe on the other. The former group is characterized by a mix of public, corporate and private strategies, with an orientation toward equities as a funding mechanism. In continental Europe, non-funded government plans dominate, with some limited occupational plans and few private plans.

While the shift to privately funded pensions has been somewhat evolutionary in the United States, Canada and the United Kingdom, European economies such as Germany, France and Italy appear to be heading toward a more tumultuous reckoning. Throughout 2003, workers in both France and Italy have staged massive strikes to protest government-proposed pension reforms that would curtail some aspects of government pensions. Germany, which instituted pension reforms in 1992, 1997 and 2000, this year adopted further limits to the state-supported system.

In the United Kingdom, the government in 2001 passed a law that made it easier for private insurers to market stakeholder pension products to lower- and middle-income consumers. The Association of British Insurers said this year, however, that sales have been disappointing, and it is lobbying for further liberalization of the rules, including raising the current 1% limit on charges and changing the penalty-free exit provision.

In Germany, insurers have seen increased pension sales related to the so-called Reister contracts, a government-supported pension contract first introduced in the summer of 2001 and designed to phase out German workers' dependence on government social security. Allianz AG, in particular, has sold more than 600,000 such contracts, giving the company a leading 20% share of the market. Paul Achleitner, a member of Allianz's board of management, said in a statement that further pension reform across the European Union is imperative. "The longer we wait, the greater the pain will be," he said.

A draft report issued jointly by the European Commission and the Council of the European Union earlier tiffs year concluded that, while member states of the European Union "are committed to ensuring the adequacy of their pension systems," many states face rapidly rising costs that "could seriously undermine the sustainability of public finances in the long term."

Although all 15 member states have instituted pension reforms since the 1990s, some "even radical," further reforms clearly are needed, the report found. Among those reforms are raising the retirement age for citizens as life expectancy rates continue to rise, a reform of the structural and financial aspects of public pension systems, and legislative changes designed to encourage greater private-sector participation.

As governments in countries from Germany and Italy to the United Kingdom and the United States seek to limit the cost of pension systems to public coffers, there is a concurrent movement to allow individuals more choice and control over how their own pension funds are managed, said Power. "These changes are also driven by a trend leading many companies to close their defined-benefit plans due to the cost and contingent liabilities," he said.

Some countries have recently adopted policies that pave the way for private pension arrangements, along the lines of defined-contribution plans, said Donner." There has been a shift from defined-benefit to defined-contribution plans going on for several years in the United States," he said. "We're starting to see that shift in Europe, particularly in the United Kingdom, where many defined-benefit plans have closed to new employees."

Stumbling stock markets over the past three years have given the trend a push, as pension plans and life insurers began to get hurt by investment losses that once fueled defined-benefit schemes. "Retirement plans have been very generous over the past 30 years, but the recent hits in stock prices have hit the value of these assets, along with changes in life expectancy," said Donner.

There are both "enormous opportunities and risks" in the pension business, as developed countries shift from the defined-benefit to defined-contribution models, said Ladley, a consulting actuary and partner with Ernst & Young. As more responsibility for making pension decisions is shifted to the consumer, there will be increasingly complex shifts in funds from savings formats such as 401(k) plans and mutual funds to other, evolving plans. "Those savings will have to move from where they are to some sort of different structure once the individual retires," he said." If insurers are not going to be on the forefront, I think they are going to be at great risk. If they are on the forefront, and do things right, and are prepared for it, there is tremendous potential for market-share growth in an expanding business."

Regulatory and Legislative Issues

Ladley said pensions are "very complex" because they involve specific legislation such as the Employee Retirement Income Security Act in the United States, as well as specific tax laws. The possible impact of future legislative or tax changes on pension products and marketing strategies is a major complication for insurers.

Insurers will have to anticipate future regulatory, tax or legislative changes when designing pension-related offerings, said Ladley, a task that would require a move away from what he calls a "straight-line or signal scenario." Insurers will have to work with trade-offs or what-if scenarios, maintaining some level of flexibility in anticipation of regulatory changes. "A good example is the recent changes in U.S. tax rates," he said. "It wouldn't be a good idea to devise a 40- or 50-year retirement plan based solely on current tax rates."

Stress-testing under various scenarios will be more and more important as pension products become more prevalent and sophisticated, he said.

Adviser's Role Is Key

One thing upon which all parties involved in the pension markets seem to agree is the central role of the financial adviser, which for insurers might typically be the agent, Ladley said. "There's no disagreement that the adviser is key to all this," he said. "The idea that these products could be self-directed or direct-marketed has not taken hold."

That factor gives insurers an upper hand compared with banks or mutual funds, neither of which has the same kind of established track record working through a financial adviser or agent.

But the increasing reliance on distribution through financial advisers carries with it increased risk for insurers, said Ladley. "It's incrementally more complex than anything we've dealt with before," he said. "Simply putting excellent products out there is not going to be nearly enough. Distributors are going to have to have some consistency and context for using those products, and having planners or distributors invent or create their own approach is not an optimal situation for insurers. They will want to get some control over the use of those products."

Mis-selling charges leveled by regulators against life insurers have been a problem in both the United States and the United Kingdom, and will likely arise in the European market as well. "Some of the problems encountered in the past was simply due to the fact that insurers hadn't thought through the controls," said Ladley. "One example is the use of variable-interest-rate products, and letting a third party control those rates. That has caused a lot of trouble in the past. Insurers have the ability to maintain control over those issues."

Another concern is whether insurers' sales forces, including independent financial advisers, can be sufficiently trained to market increasingly sophisticated products and educate consumers about those products. "We've seen it ha the U.S., where the sales practices of major life insurers have been brought into question, and fines have been levied," said Donner. "Over the past couple of years, the financial-services industry has made a major commitment to raising public awareness of the need for financial protection. And this has called into question whether the individuals selling these products are adequately trained. Companies have invested in the training of their advisers, to make sure they can offer the best products and give the best advice."

Insurers as a whole are fairly well-prepared, in that they do have a large number of well-trained advisers, more so than providers such as mutual funds, said Ladley. "Insurers have products that are uniquely able to meet pension needs, particularly payout annuities and life insurance," he said. "Other organizations can't write those products, so the only way they can offer that is by using an insurer as a partner."

Mutual-fund providers, which offer retirement advice, have been particularly aggressive at offering educational opportunities for both advisers and buyers, through a variety of courses and informational formats, both in person and online, said Donner.

The insurance industry, as a whole has done "a pretty good job" of educating consumers on retirement products and financial services, he said.

The cross-discipline nature of pension products--which lend themselves to distribution by banks and asset-management firms, as well as insurers--might boost merger and acquisition activity among such companies, said Donner. But that activity will likely take the form of insurers acquiring other insurers, rather than insurers and banks merging, for example.

A survey of 100 senior insurance executives, conducted by KPMG and unveiled at the firm's recent annual insurance industry conference in Chicago, shows that distribution related to retirement products is a concern among insurers and is sometimes a driver in merger-and-acquisition activity. The survey showed that a growing number of insurance executives see banks as competitors--12% said they did in 2003, compared with 4% in 2000. Other insurers were identified as major competitors by 62% of respondents, compared with 32% in 2000. The number of respondents who see brokerage firms as major competitors has increased to 7% from 5% over the same time frame.

If a number of large life insurers step up their efforts to gain business in the pension markets, would the resulting business growth put any of them at risk in terms of a payout bubble in the future, as today's new business becomes tomorrow's retirees? Donner doesn't think so. "These companies are experts at measuring, packaging and pricing risk," he said. "That's the way products have been developed over the years. They've become pretty good at measuring risk so that they don't find themselves in that situation."

Public Costs of Pensions

Europe's model of state provision for retirement
is beginning to crack under the weight
of increasing pension liability.

                Dependency        Public Pensions
                  Ratio *       Expenditure % of GDP **

              2000   2050 ***       2000   2050 ***

Country

E.U. 15       24.2    49            10.4   13.3
Austria       22.9    54            14.5   17.0
Belgium       25.5    45            10.0   13.3
Denmark       22.2    36            10.5   13.3

Finland       22.1    44            11.3   15.9
France        24.4    46            12.1   15.8
Germany       23.8    49            11.8   16.9
Greece        25.5    54            12.6   24.8

Ireland       16.8    40             4.6    9.0
Italy         26.6    61            13.8   14.1
Luxembourg    21.5    38             7.4    9.3
Netherlands   20.0    41             7.9   13.6

Portugal      22.6    46             9.8   13.2
Spain         24.5    60             9.4   17.3
Sweden        26.9    42             9.0   10.7
U.K.          23.8    42             5.5    4.4

* Dependency ratio = People age 65 and older as a
percentage of people age 15-64.

** Gross Domestic Product

*** Projected

Source: Draft report by the European Commission and the
Council of the European Union on adequate and sustainable
pensions, March 2003.