How Can Capital Markets Serve Pension Systems in the EU28? Part 1
Today’s post is by Markus Schuller, Panthera Solutions
The global financial stock has quadrupled between 1990 and 2010. As capital markets exist to serve society and not the other way round, this article will address the following questions:
How can the changing demographics in EU28 be better managed through benefitting from capital market access and techniques?
As a consequence, how can we strengthen the third pillar (private pension provision) in times of rising inequality, equity market/risky assets discrediting and the dominance of non-value adding financial instruments for end investors?
We are entering the fifth year of financial repression in the EU28, meaning that policies have been put in place by governments and central banks that result in savers earning returns below the rate of inflation while providing cheap loans to governments to reduce their burden of repayments. Only recently public debates began addressing the negative implications of this in the context of the ECB’s quantitative easing preparations. The delay in public perception should not surprise. It is driven by a cognitive dissonance for which slow, gradually progressing changes are difficult to detect and to classify by the individual. Inequality trends, “cold progression” and financial repression qualify for this definition. The latter is a well established tool. Both, the United States and the United Kingdom used it successfully after WWI to support the deleveraging of their economies. Keynes would define it as follows in The Economic Consequences of the Peace (1919).: “By a continuing process of inflation, [note: negative real interest rate] governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
Since the Great Recession, financial repression also contributed to the inequality trend in our societies that started to dynamically accelerate back in the early 1980s. Despite the strong rebound of risky asset prices, especially of listed equities, the wealth effect for the vast majority of European citizens remained insignificant, thanks to their lack of direct or indirect capital market participation. In my OECD Financial Round Table contribution of autumn 2014, I highlighted the lack of a risk equity culture across Europe as an important obstacle in benefitting from rising risky asset prices. In Germany, only 13,8% of the population invests directly (7,1%, 2013) or indirectly via funds (6,7%, 2013) in listed equity securities, compared with around 50% in the US (45% in 2008, ICI Survey / 52% in 2014, Gallup Survey). Both the US and Germany saw a slight deterioration in equity ownership from 2000 until today, explained by the long-term effects of the dot-com bubble during the 2000s and the pro-cyclical behaviour of retail and institutional investors, leading to a reduction in their exposure caused by the Great Recession.
The 20th century has seen the evolution from economies being driven by the primary and secondary sectors to the services sector playing the dominant role. Time doesn’t stand still. The late 20th century is dominated by the rise of the fourth sector, information technologies. In short, servicing digital natives in a knowledge-based economy. The shift from sector three to four is driven by a classic carrot/stick situation. Entrepreneurs moving the frontier of what can be done versus the stick called automation technologies that squeeze out traditional job profiles from primary, secondary and, increasingly, tertiary sectors. The consequent bifurcation of job markets is causing a headache.
If that was not enough, industrial espionage by governmental and non-governmental agencies puts the fourth sector in danger. Innovation-driven, knowledge-based economies with global reach require the assurance that market forces and not secret services are deciding who benefits economically from an invention. Not that espionage is new, but the scale definitely is. The thrust of the labour force entering the 4th sector while a level playing field is not assured is like two trains on a collision course.
Given there are no wars, epidemics or asteroids causing “black-swan” like disruptions, forecasting demographics is rather feasible. In 2012, just over a quarter of the EU population (26 %) – around 130 million people – received at least one pension. The proportion of the population receiving a pension is highest in Lithuania (31.5 %) and also exceeds 30 % in Bulgaria, Estonia and Slovenia, but is below 20 % in Ireland, Spain and Malta and only 14.8 % in Cyprus (source: EC Social Protection Statistics).
In Eurostat’s latest population projections (EUROPOP2013) the EU-28’s population is projected to increase to peak at 525.5 million around 2050 and thereafter gradually decline to 520 million by 2080. During the period from 2013 to 2080, the share of the population of working age is expected to decline steadily, while older persons will likely account for an increasing share: those aged 65 years or over will account for 28.7 % of the EU-28’s population by 2080, compared with 18.2 % in 2013. The old-age dependency ratio for the EU-28 was 27.5 % on 1 January 2013; as such, there were around four persons of working age for every person aged 65 or over. The old-age dependency ratio ranged across the EU Member States from a low of 18.4 % in Slovakia to a high of 32.7 % in Italy (with Germany and Greece also recording values above 30 % according to EC Population Structure & Ageing)
Governments have defined “adequacy of pensions” as one of their primary goals for the first pillar of their pension systems. As the EC Fiscal Sustainability Report puts it: “Pensions – mostly from pay-as-you-go public schemes – are the main source of income of older people in Europe. European pension systems are facing the dual challenge of remaining financially sustainable and being able to provide Europeans with an adequate income in retirement. Income provision in old age that is adequate to allow older people to enjoy decent living standards and economic independence is the very purpose of pension systems. Pensions affect public budgets and labour supply in major ways and these impacts must be considered in pension policy.”
It has been well established in pay-as-you-go public schemes that governments finance possible gaps between contributions and payoffs out of their public budgets. In Austria for example, the government spent around 13.5% of its 2014-budget to close the gap in its pay-as-you-go system, in addition to its civil servant pensions gap contribution of 8.8%. All together, more than 22% of the budget is dedicated to first pillar pension gap payments for a system that is supposed to finance itself.
Even if EU28 governments express the political will to keep financing the gaps, the increasing demographic pressure and tight public budgets will force them into reducing pension claims by reducing gross pension replacement rates (ranging between 33% in the UK and 91% in the Netherlands), by lowering gross pension payments – at least their purchasing power – or by increasing the retirement age. All together this will redefine what “adequate income in retirement” will mean when it comes to first pillar payments (see Oxford Institute of Ageing).