Dealing with the new giants
Pension funds are, together with insurance companies, the largest institutional investors in global financial markets. Their holdings of equity and bonds currently account for about a quarter of stock-market capitalisation and about 10%of bond-market capitalisation in the OECD. Pension funds are growing rapidly, albeit not everywhere and with different features from country to country.
The role of pension funds as financial intermediaries is to help individuals save for their old age and protect the value of their pensions. By sharing risks effectively, both along time and across individuals, pension funds can also support innovation and growth.
To explore these various issues, our report brings together several dimensions: financial illiteracy and the related need to delegate financial life-cycle planning to institutions such as pension funds; governance and principal agent issues associated with this delegation; the need for clear accounting and funding standards; the potential of financial engineering to reduce mismatch risk between
pension funds' assets and liabilities; the role of companies and governments in absorbing risks; optimal risk sharing arrangements between the participants of pension funds; and labour market and human capital policies aimed at a longer and more flexible working life.
The microeconomics of optimal delegated saving and portfolio behaviour over the life cycle is the starting point for our normative analysis.
At the same time, however, we consider the macroeconomic implications of various pension arrangements for financial and macroeconomic stability as well as human capital, entrepreneurship, innovation and growth.
Rather than following the usual two-handed approach of economists, we take a clear stance on a number of controversial issues. The common thrust of our recommendations is to avoid a scenario in which public pay-as-you go (PAYG) pension systems crowd out private funded savings for retirement, private pension funds shed risk to banks and to governments, and inflexible labour markets harm the accumulation, maintenance and use of human capital, resulting in early effective retirement and low fertility rates. With workers unwilling to bear any risks in this scenario, pension funds invest mainly in low risk assets and government bonds. This weakens fiscal discipline, crowds out productive investments and hurts innovation and long-term growth.
A second, polar scenario involves greater portfolio diversification in retirement savings with a greater role of private pension saving by high-income individuals, public PAYG pension systems that are more closely targeted on providing a basic pension to low-income individuals, and more human capital investments resulting in higher and more flexible effective retirement age and higher fertility rates.
Moreover, flexible labour markets support entrepreneurship and allow workers to bear risk as they can more easily vary work effort over the life course. In this second scenario, pension funds continue to invest in risk-bearing assets, thereby facilitating innovation and entrepreneurship. At the same time, low demand for fixed-income instruments matches the limited supply of public bonds as a result of governments restraining their fiscal deficits.
Why reform is needed
In order for the second rather than the first scenario to happen, reforms of public pensions systems are essential. Without further reforms, payroll taxes are bound to increase further, thereby crowding out private saving through pension funds. The PAYG system should continue to offer a pension for those with low lifetime incomes.
Those with higher incomes should supplement this basic public pension with private pension provisions in order to maintain their standard of living in retirement. Reforms involving a higher retirement age and lower pension benefits face serious political obstacles. We therefore favour automatic adjustments in PAYG pensions, such as indexing pension benefits to the evolution of the wage bill and longevity. Notionally Defined Contribution (NDC) systems incorporating such automatic adjustments are being gradually phased in in Italy, Latvia, Sweden and Poland. The explicit risk-sharing agreements in these NDC systems alleviate political risks and facilitate planning for retirement.
Addressing financial illiteracy
Households typically lack the basic financial knowledge and computational ability to implement complex financial planning over the life cycle. In addition, the distribution of individual pension plans involves high marketing and management costs and, as evidenced by recent episodes in the UK, a substantial risk of misselling. Mandatory participation in collective pension plans offering a limited number of default choices can avoid this.
More sophisticated life-cycle investment by pension funds on behalf of long-term investors also serves financial macroeconomic stability. We thus prefer limited freedom of choice for individual participants, but substantial competition for various asset management and other services that pension funds can contract out, thus taking advantage of an integrated market for financial services. Competition thus occurs on the wholesale rather than the retail level.
Governance is key
We favour a two-tier governance structure for pension funds. The two-tier structure involves, first, a supervisory board or board of trustees representing the interests of participants and, second, a professional executive board to deal with the funds' daily operations.
An investment committee should decide investment principles. This committee can be a subset of the supervisory board - provided that its members are financially qualified. Voted representatives of the participants in supervisory boards should benefit from financial education, and participation of outside professionals should be compulsory. We favour minimum harmonised standards for reporting on pension rights and the performance of pension funds. This facilitates portability of pension rights and enhances the financial literacy of individuals.
Mark-to-market accounting is welcomed
Defined-benefit liabilities are increasingly disclosed on a mark-to-market basis. We welcome this development because it enhances market discipline and transparency and facilitates better risk management with financial market instruments. In particular, financial engineering involving, for example, swap overlays allows pension funds to get rid of the interest-rate risk inherent to their liability structure without giving up diversification and returns.
Accounting and funding standards should be harmonised among each other and across countries in order to provide for a level playing field. In this connection, the swap discount curve should be used for discounting defined benefit obligations. Moreover, public regulations should do justice to the ambition of pension funds to index pension benefits to inflation. By focusing on nominal pension benefits, some regulations give into money illusion and expose participants of pension funds to inflation risk, which could otherwise be hedged.
The risk factor
Thinking that pension funds can shed all their risks to financial markets would be an illusion. There has been a growing trend to redesign portfolios to match the guarantees in defined-benefit pension plans, the so-called "liability-driven investment".
A shortcoming of such a strategy is that young individuals fail to take advantage of the risk premium of
equities; buying guarantees is indeed quite expensive in terms of lost expected returns. By shifting financial risks to other parts of the financial system, pension funds cannot act as a stable long-term investor on behalf of participants with a long-run investment horizon.
Moreover, extensive liability-driven investment aimed at matching risk-free pension promises may endanger macroeconomic stability and growth. As long-term safe interest rates are driven down by the demand of pension funds for bonds, guaranteed pension promises become evermore expensive, thereby requiring even more pension saving.
This process may set in motion a deflationary spiral and distort the signals sent by asset prices. At the same time, the supply of risk-taking capital may dry up, thereby harming innovation, employment creation and growth.
Indeed, additional demand for fixed-income assets may generate a negative risk premium on long-term yields and undermine fiscal discipline and widen global financial imbalances by simulating private borrowing.
Finally, pension risks may end up being absorbed by governments (that is, by households themselves), or
worse still, they may pile up on investment banks' balance sheets, creating substantial risks to financial stability.
To avoid losing their relevance as financial intermediaries, pension
funds should therefore restructure their liabilities rather than simply restructuring their assets to better match these.
Occupational DB schemes
Occupational pension schemes in which corporate sponsors guarantee pensions to their employees are being increasingly replaced by standalone pension funds in which participants share risks among themselves and on capital markets. We welcome this development. Capital markets
increasingly allow workers and
retirees to diversify financial risks.
Increasingly mobile workers should not rely on guarantees of firms in
which they already have invested their human capital. Modern capital and labour markets help emancipated workers to become less dependent on the firm they work for. Indeed, the employer's objective of using
a defined-benefit plan with back-loaded benefits to tie employees to
the firm becomes less important.
In any case, firms cannot offer much security in an increasingly competitive world economy. Companies do not want to become insurance outfits in which pension-related risks dominate the risks associated with their core business. Furthermore, stand-alone pension funds can focus on serving the interests of the participants alone rather than having to serve the objectives of the employer as well. This avoids conflicts of interest.
As private financial and non-financial institutions are de-risking their
balance sheets in response to new accounting rules, households as explicit residual risk bearers have to manage more explicit risks. In the design of risk sharing within stand-alone pension funds, a number of issues should be addressed.
First of all, just as governments in NDC schemes, pension funds should be explicit about how participants share financial market and demographic risks in order to reduce political risks.
Furthermore, reliance on fluctuating recovery pension premiums
to share risks between young participants who are long on human capital and old participants who are long on financial capital is increasingly costly in terms of adverse demand- and supply-side effects. We thus favour hybrid pension systems, which
imply that participants transform their risky, defined-contribution type claims into guaranteed defined-benefit type claims as they grow older and become more dependent on pension wealth for their consumption.
This hybrid system in which the young, active participants bear financial-market and demographic risks is consistent with optimal investment behaviour over the life cycle. Indeed, the active participants who are not yet retired, and especially the young participants who still are endowed with substantial human capital, hold mainly soft equity-type claims, being in fact the owners and residual risk bearers of the fund.
Workers therefore are important owners of equity and the associated control rights. They thus control an important part of the economy's capital stock. The retired participants, by contrast, hold secure claims in the form of debt and annuities.
The existence of liquid markets for wage-indexed and longevity-indexed bonds would lessen the need for such internal risk-sharing mechanisms by allowing participants of a pension fund to trade also with those who do not participate in the pension fund. Such markets, however, do not currently exist.
Establishing intergenerational risk
By exploiting the long horizon of young workers to buffer shocks, pension funds enhance macroeconomic stability by reducing the tension between facilitating macroeconomic stabilisation and enforcing the market discipline associated with mark-to-market valuation.
ndeed, the marginal saving propensity out of pension wealth is smallest for young households exhibiting the longest horizons and the largest human capital. These participants should thus be stable long-term investors who are in the best position to absorb financial-market volatility associated with mark-to-market valuation.
By implementing more efficient risk sharing, pension funds can continue to invest in risk-bearing assets. The continued supply of risk taking capital facilitates innovation and growth, while the lower demand for fixed-income assets with longer durations fosters fiscal discipline and discourages excessive private, non age-related borrowing.
The need for labour market reforms
Ageing societies should not only raise financial saving through more funded pension schemes but also increase investment in human capital so as to protect long-run labour supply.
Ageing challenges not only fiscal budgets but also risk taking, human capital accumulation and employment. It thus calls for more accumulation, better maintenance and more intense use of human capital in addition to fiscal discipline and additional private saving. Indeed, human capital allows households to buffer more risks.
Protecting fertility in an environment in which the human capital of women has become more valuable requires new institutions for the reconciliation of work and family.
Among other things, a longer active working life facilitates greater flexibility in employment patterns over the life course by loosening the link between age and career progression. This reduces career pressure at the biologically determined time when parents rear young children, thereby promoting gender equality, fertility and child development.
Investing in the human capital of young children thus becomes less costly in terms of depreciated human capital of the parents. This also
requires easing entry and re-entry in the labour market, by phasing out overly strict employment protection regulations and greasing the wheels of the access to permanent contracts, preventing the development of dual labour markets, which often go hand in hand with two-tier pension regimes.
Raising the retirement age
A higher effective retirement age also raises the return on human capital by lengthening the horizon for investments in human capital. Phasing out various public schemes facilitating early retirement and linking annual pension benefits or the age at which citizens are eligible for pensions to life expectancy should encourage social partners
to attune workplace cultures to the needs of older workers, to nurture the employability and adaptability of younger workers, and to increase labour market flexibility more generally.
More flexible labour markets complement a longer and more flexible work life. They allow the speed and extent of phased retirement to act as a buffer for absorbing aggregate financial market and aggregate longevity risks. Moreover, flexible labour-market institutions should enable parents of young children to easily enter, re-enter and remain in the labour market. Endowed with sufficient human and financial capital, adaptable individuals are empowered to embrace the non-verifiable, idiosyncratic risks associated with creative destruction in a dynamic competitive world economy. Moreover, pension funds can continue to supply risk-bearing capital, thereby boosting innovation and growth.
Growth can be stimulated through not only human capital investment and ample supply of risk-bearing capital but also by lifting the fences protecting domestic markets, particularly within the European Union.
Countries should encourage workers' mobility, facilitate cross-border merger and acquisitions, and should not be able to use their pension regulations as an implicit instrument of industrial policy to protect their national industry.
This provides another reason for harmonising funding requirements and accounting rules across countries—and at some stage this may call for the creation of a single European Pension Regulator.
Tito Boeri, Lans Bovenberg, Bernoît Coeuré and Andrew Roberts are co-authors of Dealing with the New Giants: Rethinking the Role of Pension Funds, Geneva Reports on the World Economy 8 July 2006, International Center for Monetary and Banking Studies (ICMB) and Centre for Economic Policy Research (CEPR).
Lans Bovenberg is professor of economics at Tilbury University in the Netherlands.