Europe’s investment challenge: can pension funds play a role?

Leveraging pension fund capital and expertise could be a key way to boost Europe’s competitiveness – and in the process benefit pension funds themselves, argue two pension fund experts.

Europe is striving for higher economic growth for many reasons but this requires higher private and public-sector investments. We see possibilities to support this effort through a substantial contribution from the pension sector. Creating room for pension funds to invest more in real assets serves two objectives: preserving the purchasing power of future pensions and financing a large part of the required investments.

Boosting economic growth

Tackling low economic growth, almost non-existent labour productivity growth and lagging growth compared to the US and Asia, are long overdue items on the policy agendas of governments all over Europe. The Draghi report on the future of European competitiveness, published in September 2024, affirms that there is no time to waste. We broadly follow its clear analysis of the problem and its solutions.

Against the backdrop of persistently low labour supply growth, the solution to the economic growth problem will have to come from elsewhere. In addition, growth needs to be stimulated in sectors characterised by high productivity and innovation by investing in and improving the (knowledge) infrastructure. But reallocating labour to high-productivity sectors and increasing the labour supply by working longer (in hours and in years) are also high on the agenda.

A massive investment programme is, therefore, a top priority, partly allied to the already substantial investment in the energy transition.

Investments in Europe, both private and public, lag in comparison to the US. This is in some ways ironic as the savings rate in Europe is much higher than in the US. Evidently, these savings do not find their way towards productive investments. Figure 1 below from the Draghi report illustrates this.

The sheer volume of what is required is so immense, that all forces will have to be mobilised, particularly to fund the innovation that is so badly needed to boost economic dynamism. This is particularly the case in the ICT sector where enhanced labour productivity growth is concentrated.

The US approach

How does the US finance these huge investments, which shift technical boundaries? For one, the federal government is an active investor in this area, including through the DARPA programme. At the same time, the US has deep capital markets in which corporations can easily collect capital and where private enterprises can become public ones through IPOs and vice versa. In other words: efficient capital markets boost economic dynamics.

Another explanation may lie in the US competition authorities’ approach of permitting the creation of (near) monopolies with accompanying profits, as long as this serves technical progress. The US favours a market-led approach, more or less supported by government initiatives, which is clearly aimed at shifting the ‘technical frontier’ by investing in high-tech companies. This requires huge investments, but they give a lucrative lead.

In Asia, countries seek to bridge the gap with the US through high corporate investments, often supported by national governments (China, Korea, Taiwan). In many countries (China is a case in point), the government clearly takes the initiative and, in the process, triggers many of the large shifts in economic structure.

Europe trails

Europe lags far behind. European governments invest primarily in public infrastructure, albeit less than before, as well as in individual companies or specific sectors. In addition and on a modest scale, they create generic instruments such as investment funds or investment regulations to channel funding.

The sums involved are modest, with the exception of southern Europe (see Figure 2). Direct investments often look more like state intervention and life support for unproductive companies – hence the low success rate.

In the face of growing criticism of such ‘useless spending’ – which essentially supports ‘middle tech’ companies facing strong competitive pressure from China rather than the ‘high-tech’ segment – attitudes to investment are changing.

From a mercantilist approach before, focused on export-led growth and the creation of semi-independent state enterprises, attention has shifted gradually towards the creation of investment funds. They have the potential advantage of focusing on economic rejuvenation but a key disadvantage is that they are subject to political interference and bureaucracy.

Bigger role for the market

We would advocate an entrepreneurial way of operating, away from politics and red tape. This is a new situation for European Union politicians and bureaucrats, and also ties in with Draghi’s recommendations.

Figure 2 Investment grants paid by the government (% GDP)

His proposed growth strategy rests on several pillars, of which more investment, less red tape and lower risk aversion are all key to strengthening the European industry’s competitive position.

But he also advocates a greater role for the market alongside a stronger government role – the reasons being that markets cannot handle long-term climate projects; European capital markets are not deep enough; and savings stock is not sufficiently available for risk bearing in Europe.

Draghi favours an approach that prevents counter-productive direct company support and misallocation of capital through a larger role for the European Commission. He believes more hope can be derived from the creation of EU investment funds, financed by both governments and private capital on the condition that they are managed at arm’s length of the government, have their own profit and loss accounts and have a governance structure comparable to market practice.

There is, however, a weak spot in the proposals. The required capital comes, for the most part, from issuing euro bonds and they are – incorrectly – characterised as ‘common safe asset’^[1].

Finding the right balance between market forces and mercantilism is not easy. Full market orientation might not be the best approach in a mercantilist world and some guidance might be useful – but from whom? Mercantilism at a European level only gains momentum when it is supported by successful local initiatives.

The Netherlands – where relatively large pension funds have helped turn initiatives such as Invest-NL into a success – can be instructive here with a model that could potentially be replicated across the EU.

The role of funded pensions

Funded pensions can fulfil an important role in Europe’s investment challenge, both in the market model and in the mercantilist model.

This role is based on the objective, or, at least, the pension funds’ ambition to protect future pensions against inflation without excessive contributions. Based on fair contributions, indexation requires high real returns, which can only be expected when investing sufficiently in equity and other real assets.

A good example is the allocation by the large sovereign funds, the Canadian pension funds and the reserve funds in Australia and New Zealand. The OECD provides numbers per country (see Figure 3). European pension funds invest substantially less in real assets and have been and still are reducing this allocation^[2]. This calls into question the functionality of the risk framework for pension funds.

The immense importance of asset allocation for long-term real returns comes to the fore when we compare the returns of Dutch and Danish pension funds with a rather conservative mix against those of reserve funds in countries such as Canada and Norway which allocate more to real assets. The table beneath gives an indication.

Figure 3: Real yearly arithmetical investment returns over 10, 15 and 20 years (in %)

Country	Type of fund	2022	10-yr avg	15-yr avg	20-yr avg
Australia	Future Fund	-10.7	6.3	4.9	-
Canada	Pension Reserve Fund	- 2.9	7.4	5.7	6.5
New Zealand	Superannuation Fund	4.3	8.6	7.2	7.2
Norway	Government Pension Fund	- 9.7	5.2	4.3	5.6
Netherlands	Pension Funds	- 28.0	1.3	1.8	3.1
Denmark	Pension Funds	-21.1	1.9	2.6	3.3

_{Source: OECD, Pensions at a Glance, 2023}

The focus on fixed income is misguided

Traditionally, European pension funds are not extremely risk averse; under current national regulations, instigated by EIOPA, however, the barriers against taking market risk are fairly strict. EIOPA more or less adopts an insurance framework under which long-duration government bonds are considered low risk and the rest actually high risk.

The national risk frameworks stress short-term solvency and therefore discourage investing in categories with high short-term volatility but a high long-term return. It is often argued that this is not an efficient way to manage a pension fund, which is obviously not an insurance company, but a scheme for long-term capital accrual, based on mutual ownership.

A funded pension system is only attractive when the nominal return is at least equal to the growth rate of the domestic wage bill. This is not the case when government debt is a large part of the assets.^[3] In other words, regulation should permit sufficient real assets in pension funds’ balance sheets.

Figures 4 and 5^[4], are convincing in showing that long-term downside risks of government bonds are comparable to those of equities.

Recently, the Dutch Scientific Board for Government Policy (WRR) published a report entitled ‘European ageing in focus: coping with pension and budget risks’, which concluded that funded pensions in a low-growth environment are risky. It notes that at a time of weak economic growth with limited room to raise taxes and large budget deficits, government debt cannot be considered risk free.

The wider question, therefore, is whether funded pensions can play an important role in the task of financing the investments Europe needs. The answer is they can, in both market and mercantilist models. In the market model they can invest in equity and securitisations and/or by participating in investment funds aimed at start-ups and private equity. In the mercantilist model they can by financing illiquid long-term large-scale infrastructure.

The Dutch Invest-NL initiative is a case in point. When mandated clearly to invest in high-productivity, innovative corporations, this scheme is fit for purpose. Its clout could be leveraged with pension money, which would strengthen its position against intervention from politics. Moreover, it could benefit from the pension sector’s expertise.

Justifiable suspicion toward politicians and objectivity in choosing suitable projects can only be overcome by a market-compliant governance structure and with expertise from the pension sector. As such, Invest-NL could simply be enlarged to ‘Invest-EU’, particularly when the market model is used, and new shareholders could simply buy in.

While the Netherlands has an ideal starting point with its relatively large pension sector, other European countries have sizeable pension plans as well. In countries with mainly private savings, finding the way to banks, real estate and family corporations is not always easy. The Draghi report fails to address this issue.

Favourable knock-on effects for pension funds

Our analysis shows that under the right conditions, a win-win situation can arise with pension funds both contributing to the realisation of European objectives and benefiting from an improved long-term allocation of their assets, in turn resulting in good (real) pensions.

In summary, the pension sector can provide a boost to the Draghi programme and, vice versa, the Draghi programme can spark a fertile change in pension regulation.

One question remains: is it sensible to invest in Draghi’s euro bonds? We think it is, but only on condition that this leads to additional investment and that the bonds do not serve as a cheap financing alternative for existing local investment plans.

The combination of better market mechanisms and a mercantilist government, as advocated by Draghi, seems a good approach in the current economic environment. When used properly, a growth impulse can reduce the future debt burden and can avoid a risky debt status. 

Anton van Nunen, PhD, economist, is adviser to several investment committees of institutional investors, and is the founder of the fiduciary management concept.
Jean Frijns, PhD, is an economist and former CIO of ABP pension fund. He has worked as an independent adviser and board member for pension funds, insurance companies and asset managers. He is currently a member of the supervisory board of a pension fund for medical professionals.