It now seems inevitable that the euro will come into existence with 11 participating countries on January 1, 1999, on schedule to replace most of the national currencies of western Europe by 2002. What will the impact of this event be for the pension funds of multinational companies and what, if anything, can they do to prepare for the change?

At first sight it is difficult to see what impact the euro will have on the liability side of pension schemes. There is, as yet, no legislation forthcoming to encourage harmonisation of pension benefits, so in many ways the liabilities will remain resolutely national and domestic.

However, one of the major effects of the euro will be transparency of prices and costs across national boundaries in a way that has been impossible before. This will include the price, or cost, of labour. In the past, there have been major variations in the cost of labour across different countries (with cost measured by wages and benefits including pension costs), but these differentials have been sustained by other factors, especially productivity. Labour cost in Germany has been very high but productivity has been high as well because of the application of more low-cost capital to each unit of labour.

One of the key changes resulting from the euro will be that the cost of capital will be, in effect, the same across all the member countries. So more capital will be applied to those areas where a higher cost of capital has previously made this uneconomic. Applying more capital at reduced cost should drive up productivity and potentially growth rates as well, but it will do so selectively. Those countries where the availability of labour with appropriate skills is at a lower cost (wages plus benefits) will attract capital and therefore production and employment away from the countries with higher labour costs.

This change has already been happening for a number of years but the advent of the euro will surely accelerate it, as the cost of capital is driven down and the obfuscation of currency translation disappears. The medium term impact will be a re-examination by multinational employers of labour unit costs in the euro bloc, with the strategy of migrating capital and production to the lower cost areas. The other way of approaching the issue for the employer is to focus on unit labour costs to see whether they could be adjusted" to bring them more into line across national boundaries, and to obviate the need for uprooting factories in Germany and building new factories in Spain.

A significant and increasing component of unit labour costs is represented by pensions. Multinational employers will need to analyse not only what current pension costs are but what they will be in the future - there would be no point in increasing employment in a current low-cost area if that cost advantage was set to disappear through higher pension costs in the long term. Equally, employees will be looking to ensure equivalent treatment by employers throughout the euro bloc, to ensure that they receive comparable benefits, especially pensions, to employees of the same company in other countries.

I believe that this will provide a strong force for harmonisation of pension benefits across the euro bloc in the long term. In the medium term companies will be compelled to relocate labour to lower cost areas, whilst at the same time ensuring that labour costs are increasingly equivalent across the whole region, including pension provision.

If the euro's impact on the liabilities of pension funds is likely to be very long term in nature, the impact on the asset strategy of pension funds may be much more immediate.

For the corporate pension fund, the creation of the euro bloc will mean the disappearance of any requirement for a nationally biased investment strategy. Investment strategy will now have to be considered in terms of euro assets and the rest of the world outside the euro. Arguably in both bonds and equities, the risk/reward trade-off will change significantly.

Taking the example of a Dutch pension scheme investing in Italian bonds and equities, in the past these offered higher returns (and arguably higher risk) but there was a risk diversification benefit in buying into another different market. Post the euro, the currency risk will have gone but so will the diversification benefit and probably the higher return as well. To achieve extra return by taking an additional risk and simultaneously benefiting from diversification, euro-based pension schemes will have to focus their 'overseas' strategies on economies and markets outside the euro bloc - in terms of bonds, for example, these will concentrate on the US and Japan whilst in equities the focus will be on North America and the Pacific Basin. The conclusion of these strategy reassessments will surely be more investment directed to those areas outside the euro bloc than is the case at present. In itself, this should provoke some interesting discussions: for example, if it was proposed that a pension scheme should commit more of its equity and bond assets to North America and the Pacific Basin!

There are two additional considerations:

q Multinationals will need to consider afresh all their suppliers of materials and services under the new euro regime in terms of whether they have the necessary attributes to continue as providers. This will apply to managers of pension funds as much as any others, and in particular the ability to manage pan-euro bloc portfolios of bonds and equities - focusing presumably on sector and stock selection rather than country choice.

q The euro's arrival will drive industry consolidation forward at a tremendous pace, including financial services and investment management. Be prepared!

Nick Sykes is a senior consultant with William M Mercer"

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