Why do US pension funds invest in equities but EU pension funds don't
EU Single market - Letter to the EU Commission
I would like to challenge one aspect of past EU legislation—the IORP I/II directives and the PEPP regulation. The EU Commission seems to believe large pan-European pension funds are essential to finance later-stage scaleups, but looking at the US, many big funds investing in VCs (e.g., CalSTRS, Florida SBA) source their capital from just one state.
It is not needed to create pan-european pension funds to catch up to the US.
In fact, it is better to have many mid-size capital providers because it increases competition among funds and allows a wider variety of investment themes to flourish.
The trend in the US is towards smaller funds, that are able to develop expertise and conviction in narrower segments of the economy. Large funds also lead to lazy capital allocation as investment managers prefer larger deals over smaller deals in order to deploy faster.
If the EU wants to close the later-stage investment gap it has to look at the differences between EU defined-benefits and US defined-benefits funds.
In many Member States, occupational pensions are treated as deferred compensation under labor law, meaning employers must guarantee those benefits—a liability often transferred to insurers.
In the US, even defined-benefit plans such as those managed by CalSTRS do not have guaranteed outcomes but instead have prudential obligations.
Investment strategies that have guarantees deal very badly with highly volatile investments such as equities, alternatives and other illiquid instruments.
This problem was exacerbated by the adoption of Solvency II, which requires insurance firms to calculate their guarantees daily and to maintain large capital buffers for volatile assets.
The regulator, however, interprets these guarantees as a hard requirement that pension funds must meet every day. If you hold volatile instruments, you can suddenly wake up one morning unable to meet the capital requirement. Worse still, any shortfall must be addressed immediately, which can force funds to liquidate equity positions in down markets, lock in losses, and redeploy capital elsewhere.
These constraints also discourage investments in illiquid instruments, since those cannot be quickly liquidated. Consequently, EU pension funds adopt preemptively conservative investment strategies. By contrast, no such guarantee exists in the US. Even when a US pension plan becomes underfunded, it can develop a multi-year recovery strategy rather than having to immediately liquidate positions.
The absence of pension funds and insurance firms in the equity market means that the entities with the lowest return requirement and the deepest pool of capital are absent. Creating a meaningful gap in later-stage funding and exits for ambitious projects and fundamentally harming EU competitiveness on the global stage.
For reference, Valuations at every stage are 2x lower than in the US and there are 2x more funding rounds at every stage in the US.
Similarly, large acquisitions significantly trail the US despite the EU having a larger population.
Option 1: Implement the US solution
Adjust Solvency II requirements to allow for grace periods for insurance firms to meet their future capital obligations and allow them to implement recovery plans to meet future guarantees.
Option 2: Let the ECB underwrite economy-wide risks
Personally, I believe that the ECB’s role is misunderstood and it’s real role is to insure economy-wide risks.
As such, I believe the ECB should explore a role as a reinsurer. Specifically in this case the ECB could develop an instrument that allows life insurers to insure short-term market risk that would allow them to meet Solvency II without divesting.
Alternatively, the ECB could reinsure the guarantee all together.