Ageing populations present problems for social security schemes around the world. Low birth levels and increasing life expectancy will lead over time to increased numbers of elderly people and fewer people of working age to support them.
Most social security schemes operate on the pay-as-you-go principle, whereby contributions made by the working population, together with those paid by employers, are used year by year to meet the expenditure on pensions and other benefits. Such schemes are clearly directly affected by the ageing of the population.
The UK has by far the highest level of funded pension liabilities in Europe, accounting for about 75% of all the assets of European pension funds. Funded pension schemes are also important in the Netherlands and Ireland, and to a lesser extent in Denmark, Finland and Sweden.
In France the complementary schemes are run on a pay-as-you-go basis, relying on solidarity between the generations (and between employers) for security. In Germany the majority of complementary pension liabilities are backed by internal book reserves within the sponsoring companies and not by any externally invested funds. Security is provided for vested pension rights, in the event of insolvency of a sponsoring employer, by insolvency insurance.
However, an increasing number of politicians, economists and actuaries now believe that it would be advantageous to increase the level of external funding of future pension liabilities.
Investment in pension funds held externally to the employer’s business is clearly important in creating security for pension scheme members. However, funding accruing pension liabilities is not only a question of providing security. It is arguably also more effective in avoiding the granting of unaffordable promises.
With the advent of European Monetary Union and changes in attitudes towards corporate governance, more widely diversified equity shareholdings look set to become the pattern and external funding of pension liabilities should be seen as the norm for complementary pension schemes throughout Europe.
Many of those who advocate funding believe that putting more money into funded vehicles will fuel economic growth and have a beneficial effect on the economy. Funding encourages responsibility: it fosters a sense of ownership, letting people see that their pensions savings belong to them. Moreover, moving pension provision into the private sector, through funding mechanisms, largely removes it from the political arena, providing greater flexibility.
However, the switch to more funding will not automatically produce economic benefits. Funding does not always create real investment, since it may replace other forms of saving. It may also simply force up stock prices, with too many investors chasing a finite volume of financial instruments, unless the availability of investment monies leads to additional worthwhile projects being pursued.
Funding pension liabilities does not necessarily avoid the problem of the ageing population, although the problem may be manifested in different ways. Unless we can find a way of investing outside our economic system, or can create significant hedging by investment in economies which have a quite different ageing cycle, the wealth people are creating at any time will very largely be used to finance the lifestyle of people at that time. With a funded pension system, it is still the workers of tomorrow who will create the resources that will fund the income of tomorrow’s pensioners, although the transfers will take place through dividends on the shares pensioners own through their pension funds. In practical terms there will be competition between workers demanding higher wages and shareholders (largely pension funds in 30 years’ time) demanding higher dividends and higher retained earnings.
It is clear that individuals can defer consumption by saving, and enjoy the fruits of that deferral later, but many believe it is it a fallacy to apply this argument to the national economy.
The demographic changes will not only affect competition for resources; they will also have an impact directly on market prices. At the moment, with the volume of pensions savings growing (and likely to grow even more as funding becomes more widespread through the EU), the flow of inwards investment will help to keep prices buoyant. By the 2020s and 2030s, however, more and more people will want to disinvest savings. This will put downward pressure on prices.
Some of the risks of relying too heavily on funding are evident. There is the risk of failure or insolvency of pension providers, and the possibility of mismanagement, malfeasance or fraud.There are the problems which can arise with undue concentration of investments in particular classes, markets or individual companies, especially if these investments perform badly. Then there can be market crashes and prolonged periods when market returns fail to keep up with inflation. These could result in inadequate pensions in a defined contribution system or excessive costs in defined benefit schemes.
Transaction costs will also usually be much higher under a funded system, particularly for personal pensions. Many of the costs of marketing, and giving advice to potential customers, simply do not arise with a national pay-as-you-go scheme, where there are also clear economies of scale.
Does this imply that we should adopt a more cautious attitude towards increasing the level of funding? We should certainly avoid presenting the arguments in too one-sided a way, as there are advantages and disadvantages in both the pay-as-you-go and the funded approach. Funded pensions are likely to be of increasing importance throughout the EU over the next 20-30 years, but this will bring its own problems of achieving and maintaining a satisfactory regulatory regime. If too much emphasis is placed on DC vehicles linked directly to investment performance, a significant part of many peoples’ retirement income could become subject to the vagaries of the market. This may result in an unacceptable level of volatility. Pay-as-you-go social security schemes will still have an important role to play in most countries as a cost-effective way of providing a stable underpinning retirement income.
Chris Daykin is the UK Government Actuary