Insights

Graphic VO: Citi GPS: Digital Disruption. How FinTech is Disrupting Banking To a Tipping Point.

Ronit Ghose - Global Head of Banks, Citi Research

FinTech is one of the most interesting areas of finance today. From California to China, a lot of money is going into FinTech. In our report that we've published, we look at the products, the geographies that FinTech is investing in right now. What's surprising about FinTech is that so far, all of the money, nearly all of the money is going to consumer.

Graphic VO: Figure 2. Capital Deployed in Private FinTech Companies by Segment. Personal & SME: 73%, Asset Management & Wealth: 10%, Insurance: 10%, Investment Banking: 4% and Large Corporate: 3%.

Figure 3. Capital Deployed in Private FinTech Companies by Business Area. Lending: 46%, Money Transfer: 3%, Payment: 23%, Savings & Wealth: 10%, Insurance: 10%, Digital Currency: 3%, Equity Crowdfunding: 2%, Institutional Tools: 3%.

Source: CBInsights, KPMG, Crunch Base and Citi Research; Based on c120 private companies from CBInsights FinTech Periodic table Dec 2014; KPMG's top 50 most prominent Fin Tech innovators Dec 2015; Valuation based on Crunch Base Total Equity Funding for private companies and exit value for acquired companies.

In our report, we looked at over 100 private deals that have been done in FinTech so far. Over 70% has been invested in payments and consumer, some in small business, very little is gone into b2b, but that will change going forward. In our report, we also looked at some of the geographic aspects of FinTech in the West in the U.S., in Europe - FinTech is really still at a discussion stage. There are some interesting companies, but it hasn't really disrupted finance yet. In countries like China, though, FinTech has already disrupted. FinTech is real. The big Chinese FinTech companies have hundreds of millions of clients.

Yafei Tian - European Banks, Citi Research

So why are Chinese so ahead of others in terms of FinTech? I think there are two major reasons. The first is that you have a relatively underdeveloped banking system that is focused more on the corporate side of the business. And then secondly, the FinTech companies in China, are led by a few internet giants, the likes of Alibaba or Tencent. So they already have a customer base that are as large if not larger than the major banks in China. So they have both the technology and the customer base to make a huge impact in the FinTech space. In the U.S., the internet giants, the likes of Facebook, Amazon, Google, and Apple, they are slightly behind relative to the Chinese. The Chinese started about a decade ago, and you only see the like of Apple Pay coming in last year or so. So that's why the China (is) a lot ahead. But the likes of Amazon, they are catching up with China, India is going to be the next China because India has a very large population of 1.2 billion, and around 300 million of population is unbanked. So there's a big opportunity out there to be grabbed. And the private companies are leading in this space. There are a lot of government initiatives already to increase the population banks in India.

Ronit Ghose - Global Head of Banks, Citi Research

At a product level, we look at the differentiation between companies that are simply cheaper or faster and companies that are truly different. FinTech companies that are truly different will have a sustainable advantage. Think of, for example, Klarna in eCommerce payments, or marketplace lending when they first emerged. FinTech companies that are about cost-to-serve being cheaper, for example, the robo-advisors, they will probably struggle in the long term. There's also more regulatory challenges around the marketplace lenders right now. Some of the winners in FinTech amongst the new entrants, the eCommerce companies. Among the incumbent banks, there are huge cost saving opportunities. The Scandinavian banks, the Dutch banks lead right now. They have already some of the leading banks in those parts in that part of the world have already cut 50% of their branch networks from their peak levels.

Graphic VO: Figure 10: Commercial Bank Branches per 100k Adults by Region. 2025 Forecasts: United States -33%, Euro area -45%, Nordics -50%

And there's more to go. Success begets success. Take DNB for example, DNB - one of the most efficient banks in the world - announced late last year, they're going to cut another half of their branch network. So in Scandinavia, in the Netherlands, maybe in other parts of Europe and now in the future in the U.S., the incumbents will reduce branches, and related headcount. We think headcount could fall substantially from here. Headcount so far is down about low double digits from the peak levels. Headcount could go down another 30 to 35% in many of these countries. That will lead to lower costs, and there could be considerable cost savings. One really interesting area of FinTech though maybe for the longer term is blockchain. Right now, it's still in an R&D phase. But if it takes off, it could transform the rails, the basic rails of finance, particularly the b2b space. In areas like Supply Chain Finance, it could be very interesting, but it's one to watch right now, rather than a 2016 event

Graphic VO: Citi GPS: The Coming Pensions Crisis. Recommendations for Keeping the Global Pensions System Afloat.

Charles Millard- Head of Pension Relations, Citi Markets & Security Services

Our report focuses on the challenges of underfunded pension plans around the world. Governments face unfunded retirement obligations. Corporate plan sponsors do. And it's an enormous problem. And it really is based on three principal difficulties: demographics, underfunding, and the cost and volatility of long-term liabilities. So demographics. You have many more people living to old age. When they get to old age, they live longer in old age. You have far fewer workers supporting those people in old age and far fewer people being born for the future support of retirees. When you look at underfunding, you don't have governments publishing the real numbers of what their underfunded retirement obligations are. So for example, in a bucket of 20 OECD countries, we looked at all the sovereign debt of those 20 countries and the total of the sovereign debt on their balance sheets that anybody could find is $44 trillion. What's not on their balance sheets, which you won't find, is the unfunded existing retirement obligations in all those countries, and those total an additional $78 trillion.

Graphic VO: … but Public Sector liabilities are potentially staggering. Average public sector pension cost-to-GOP is expected to rise from 9.5% in 2015 to 12% by 2050.

Average contingent liability to GDP from public sector pension liabilities is ~190% of GDP on average. Contingent public pension liability is 2-3 (times) the size of 'conventional' public debt-to-GDP rations in most countries.

$44trillion = Value of published national debt. $78trillion = Value of unfunded or underfunded government pension liabilities.

So imagine if you thought that your mortgage was $440,000 and then the bank called up and said, "Well, actually, it's $1.3 million." It's like an iceberg underneath the water. And it's a ticking time bomb but it won't explode because these are long term obligations. They will be painful to pay, but we will see them in fewer police officers in Philadelphia, or fewer existing corporate pension plans, because corporations want to get out of it. And the reason that people want to avoid these obligations is because they're very volatile in their funding, because the size of your liabilities rises and falls with interest rates. So with rates constantly falling in recent years, corporations just say I can't handle the funding obligations for these liabilities. And they say I can't handle keeping these liabilities on my books for not just 10, not just 20, but 30 and 40 and 50 years. So we make some suggestions. We don't have a silver bullet. But some of the solutions include raising retirement ages - when social security was started, people expected to spend 12 years in retirement if they got to be 65. Today, a 65 year old expects to spend 20 years in retirement. So, we need to have a sensible amount of retirement age that we cover.

We need to publish the actual numbers so people don't have to search to find the $78 trillion that I mentioned, and that that should be just as available to anybody who wants to understand what their governments face. We should use what we call soft compulsion, which is tax incentives, and plans where you're automatically enrolled in the plan, and you would have to opt out. And we believe that corporations should probably get out of the business of being in insurance. When you run a pension plan, you really are an insurer of long term obligations. Insurance companies are better at that than corporations. So if your pension plan is already frozen, you should probably get out of it. You should make your contributions now, instead of waiting until you find an unfunded iceberg. And we believe that both governments and corporations should use what's called collective defined contribution plans. Basically, that allows for an individual to have their own plan. The company puts money in and then is off the hook. But the plan is collective so people who die early subsidize people who die late. People who die when markets are fantastic, will get something less than they otherwise might get but they will subsidize people who die when markets are poor. And the pooling effect is incredibly powerful, and it means that individuals in their 401k don't have to be Chief Investment Officer of Pension Actuary and Chief Risk Officer when they never were trained for any of those things.

The news is not all bad. Because there is opportunity here. If governments require private pension savings, with soft compulsion and tax incentives, it's an enormous opportunity for insurance companies and asset managers. Asset managers can help pensions solve some of their problems. There are liability-driven solutions and private pension savings opportunities and my colleagues will talk about some of those opportunities.

Farooq Hanif- Head of European Insurance Research, Citi Research

In our research on the pension crisis, one of the most staggering numbers that we came up with just the size of the government commitment pensions. This comes from social security and also underfunded commitments to public sector workers. For selected developed countries, this number is a pretty big number. We think it's two times GDP if you express this pension as a liability, as a debt. Some of the largest costs come from Europe actually where you see countries such as Italy, Germany, France, or the U.K., with pension debt-to-GDP ratios of over 300%. For 20 countries that we look at in this report, this number actually adds up to a staggering $78 trillion of debt.

Graphic VO: Figure 15 Collated Estimates of Contingent Government Pension Liabilities as a %of GDP.

Poland: Public Sector Employees approx. 25%, Social Security approx: 350%

Austria: Public Sector Employees approx. 100%, Social Security approx: 350%

France: Public Sector Employees approx. 75%, Social Security approx: 350%

Denmark: Public Sector Employees approx. 50%, Social Security approx: 325%

Germany: Public Sector Employees approx. 50%, Social Security approx: 325%

Italy: Social Security approx: 325%

United Kingdom: Public Sector Employees approx. 75%, Social Security approx: 325%

Portugal: Public Sector Employees approx. 100%, Social Security approx: 325%

Spain: Public Sector Employees approx. 25%, Social Security approx: 300%

Finland: Social Security approx: 300%

Sweden: Social Security approx: 275%

Hungary: Social Security approx: 275%

Netherlands: Social Security approx: 250%

Slovakia: Public Sector Employees approx. 25%, Social Security approx: 225%

Belgium: Social Security approx: 200%

Czech Republic: Social Security approx: 200%

Japan: Unattributed approx: 175%

USA: Unattributed approx: 100%

USA: Unattributed approx: 100%

Australia: Public Sector Employees approx. 25%

Note: Most data based on 'Freitburg' model calculated on 2006 data; UK, Australia and Spain based on National calculations based on 2010 data; US, Japan, and Canada based on 1996 data estimated by Chand and Jaeger. Source: Kaier and Muller (Freitburg University), DNB, OECD, Citi Research.

Graphic VO: … but Public Sector liabilities are potentially staggering. Average public sector pension cost-to-GOP is expected to rise from 9/5 % in 2015 to 12% by 2050.

Average contingent liability to GDP from public sector pension liabilities is ~190% of GDP on average. Contingent public pension liability is 2-3x (times) the size of "conventional" public debt-to-GDP rations in most countries.

$44trillion = Value of published national debt. $78trillion = Value of unfunded or underfunded government pension liabilities.

It's quite easy to look at this debt or this liability, as we should call it and not really consider it as debt because actually it isn't -it's a commitment to pay pensions over the long term. This could take 20, 30, 40, or 50 years to pay. So it's not like conventional debt. However, it does have an implication for government finances. Currently, we estimate that 9.5% of GDP is being spent in the OECD on paying pensions, this number could rise to 12% by 2050, in our view. So we think governments have to control these costs, we've come up with a number of recommendations in our report.

Graphic VO: Publish the amount of underfunded governmental pension obligations so everyone can see them.

Firstly, we think it's really important that governments publish these numbers and make them publicly available so we can start at least discussing the issue; you can't deal with a problem unless you measure it. This might require coordination. It would be good if different countries could provide the data on a similar basis, similar economic assumptions, for example. Secondly, I think it's really important that governments reevaluate what they're promising to the public. You can't do this immediately there lots of political ramifications for changing benefits but we do think social security should be what it says it is, which is that it's a safety net for people who don't have the adequate standard of living. It shouldn't be provision of pension for everybody economy, including the rich.

One of the other things I think you have to do is control the retirement age.

Graphic VO: Raise the retirement age.

So if people are living comfortably into their 80s, and in the future into their 90s, we think retirement ages should be linked with longevity. And in some way, the decision should be taken away from governments. And, lastly it's important to encourage private pension saving. We need to see the private sector bearing the cost for pensions, not the government balance sheet. So one way of doing this is maybe to introduce a system that we have in the U.K., such as auto enrollment, which is a form of compulsion.

Graphic VO: Create powerful 'soft compulsion' incentives to ensure that private pension savings increase.

You have to set up pension schemes, but you're not forced to save into them if you don't want to. And that's accompanied with huge fiscal benefits to savings. So you get tax relief on any money you put in, which I think is fair, and it encourages savings. So if we put this all together, we think there's a very large opportunity in private pension savings in both developed and developing economies. We think the number for private pension savings could be up to $5 trillion. We see most of this money going into defined contribution schemes where the risk is borne by the people who are saving, rather than in defined benefit schemes where the costs are too high in a lower rate environment.

This number could rise to $11 trillion, if we look outside of the OECD at some developing countries, or emerging countries. The main kind of areas of saving growth we think is in Europe, globally in the OECD, in economies where there's a huge public sector burden currently and relatively low dedicated private pension savings. In Asia, one of the biggest markets is clearly China, which could account for a large part of the long-term growth. So we think insurers have - and asset managers also have - a strong part to play in this growth. They will have to help manage this money and to be successful in this area they will need scale. They're not going to be able to charge a lot of money for mass market product. They're going to have to have the right distribution relationships and they're going to have to invest a lot in technology and digital enabled technology to connect with their customers and improve customer service levels. Something I don't think the insurance sector in particular has been very good at historically.

I think another area of very important investment in growth will be in what we call de -cumulation. So if there's a large growth in defined contribution saving, that will introduce a lot of uncertainty. People will be managing their own investment risks. So we think that insurers should definitely invest in developing new products to help people manage their retirement income. This might include guarantees or ways of reducing risk when people need their money the most. Another solution would be a halfway house between defined benefit and defined contribution schemes - something that we refer to in our note as collective defined contribution, which has the benefits of institutional management for defined benefits, but with without the guaranteed risk for corporates.

Eric Bass. U.S. Life Insurance Analyst, Citi Research

So I'd like to focus on three key topics and opportunities that we see for insurance companies. First is pension risk transfer. Second is the retirement savings opportunity. And third is the need for guaranteed lifetime income. Starting with pension risk transfer or "PRT". We view this as a $750 billion opportunity globally over the next five to 10 years. A lot of this will be in the U.S., which we estimate is a $200 to $350 billion opportunity. But there are also significant markets in the U.K., the Netherlands, and we see Canada, the Nordic Region. and Australia as potential emerging markets. As Charles alluded to earlier, corporations would like to get out of their defined benefit pension obligations. So this is creating a secular trend that we expect to continue. And if plan funded status improves, largely would likely be driven by a rise in interest rates, our estimates could even prove conservative. From my perspective, this is good business for an insurance company. Longevity risk is a natural offset to mortality risk and the business is generating attractive returns. We estimate about 12 to 14% ROEs for us insurance companies in double-digit IRRs for European insurance companies.

The second opportunity is around private retirement savings. We identified in the report, current private pension gaps of about $5 trillion in OECD countries, and another $5 to $6 trillion globally. So in total an $11 trillion opportunity. And we think a lot of this will move to defined contribution type plans. And we think that insurers and asset managers are well positioned to take advantage of that. They both have strong capabilities in plan management and record keeping, as well as on the investment side. Of that opportunity, a lot of it does exist in Europe so we think the European insurers are particularly well positioned there.

The second biggest opportunity is in Asia. So companies that have strong local capabilities and distribution relationships are best positioned to benefit. Then the final opportunity is around retirement income, which is going to be a huge need as the population ages and people are at risk of outliving their savings. Currently, the biggest solution is annuity products, which insurance companies are uniquely positioned to provide. The challenge has been that annuities have not been that popular with consumers. In the U.S. you've seen penetration rates remain at about 8% of retirement assets for the last 20 years. So, even as people are aging, you haven't seen greater use of these products. To address this, we think that companies need to make the products simpler to understand for consumers, probably bring down the cost as well, and even explore direct solutions. So this is a huge potential market opportunity given the aging population, and we think it's something that insurance companies have to get right.