Romain Despalins, OECD Directorate for Financial and Enterprise Affairs
In 2016, private pension assets reached their highest-ever level at over USD38 trillion in OECD countries, according to Pensions Markets in Focus. Investment losses resulting from the financial crisis have been recouped in almost all reporting OECD countries. However, the low-interest rate environment continues to exert pressure on pension providers through lower yields on the bond portion of their portfolio investments, which may affect their ability to maintain promises to plan members. This has given rise to concerns that pension providers could increase their exposure to riskier investments in a search for potential higher yield.
Funded and private pension arrangements continued to expand in countries such as Australia, Canada, Denmark and the Netherlands where pension assets exceeded the size of the GDP. This reflects a trend which has seen pension assets grow faster than GDP in most countries over the last decade. This trend is most pronounced in countries with large private pension markets.
Pension providers experienced positive real investment rates of return, net of investment expenses, in 2016 in 28 of the 31 reporting OECD countries and 25 of the 32 reporting non-OECD jurisdictions. These rates of investment return were above 2% on average both inside and outside the OECD area. Annual returns were also positive over the last decade in most countries, with the highest average annual real investment rates of return (net of investment expenses) observed in the Dominican Republic (6.3%), Colombia (5.8%) and Slovenia (5.2%).
This new OECD report on trends in the financial performance of private pension plans covers 85 countries. It assesses the amount of assets in funded and private pension plans, describes the way these assets are invested in financial markets, and looks at how investments have performed, both in the past year and over the past decade.
References and links
Read the report at www.oecd.org/pensions/pensionmarketsinfocus.htm
Read the OECD Observer’s roundtable on pensions at http://oe.cd/25M
Joanne Yoong, University of Southern California Center for Economic and Social Research
In a letter to his friend Jean Baptiste LeRoy in 1789, the American Founding Father Benjamin Franklin wrote “In this world, nothing can be said to be certain except death and taxes”. Franklin’s letter far predated the United States’ Social Security Act of 1935, which set up a social insurance programme for American workers, providing them with at least some degree of certainty about income after retirement. But, in today’s environment, to what degree do Americans feel secure about their retirement? How well do they understand their own role and that of Social Security in contributing to retirement security?
Researchers at USC conducted a new study in 2016 to collect data on American’s understanding of retirement preparedness and the perceived role of Social Security. A special-purpose survey was designed and fielded as part of the Understanding America Study (UAS), a panel of approximately 6,000 individuals aged 18 or over representing the entire United States. The survey results highlight a worryingly-low level of retirement–related financial literacy.
Seventy percent of survey respondents are relatively uncertain about their retirement-related financial literacy, rating themselves either “somewhat” or “not too” knowledgeable. More worryingly, both self-assessed and actual knowledge of retirement-related financial principles are lower compared to the 2009 results. This is consistent with findings reported by Annamaria Lusardi from the US National Financial Capability Study, which found that basic financial literacy has been declining in each survey wave since 2009. Just as worryingly, disparities in knowledge by age, income and education remain present across all our measures of knowledge and preparedness, with Hispanics and Blacks at a particular disadvantage relative to non-Hispanic Whites.
The survey also shows that respondents are more pessimistic about Social Security, in comparison to the 2009 study. In particular, most respondents do not feel confident in the future ability of the Social Security system to pay their promised benefits, and a majority expect the Social Security system to fall short of providing enough for a reasonable standard of living.
Results also suggest a clear gap between respondents’ expectations about Social Security, and their actual understanding of how it works, suggesting that many Americans may not be maximising their benefits, or may not even be aware of their full entitlements. While most people are able to identify the general features of the Social Security system, a sizable group do not grasp critical details relevant to the impact of their own benefit claiming choices. About a quarter of future beneficiaries mistakenly believe that benefits need to be claimed at the time of retirement, while one in five are unaware that claiming early can reduce benefits. Just over 10% are not aware of disability entitlements, almost 20% are unaware of survivor benefits for children, and almost 40% do not know that spousal benefits can be claimed even if they do not have children.
Combined with the findings of the OECD/INFE Survey of Adult Financial Literacy Competencies on the correlation between financial knowledge and retirement planning, the UAS results suggest the potential for further negative effects.
Previous research has established a causal relationship between financial literacy and long-term planning. This new study reinforces that becoming and staying informed is a decision in itself that poses its own challenges.
Most UAS respondents feel that it is very important for the Social Security Administration to educate people about how to prepare financially for retirement. When asked to assess different sources of information, UAS respondents were most likely to trust the accuracy of retirement-related information either from Social Security or financial professionals. However, in practice, they most often turn to their social networks or receive information from their employers, rather than proactively seeking information from these trusted sources. A pragmatic and forward-looking financial education policy therefore requires working with diverse groups of both private and public stakeholders, not only to provide the right information but also to prevent the spread of wrong information.
How will policy makers and practitioners know which strategies are most effective at reaching which consumers, and how effective they are at altering behavior or financial outcomes?
Some of the responses to these questions may be found in the 2016 OECD Pensions Outlook. In parallel, recent data collection efforts such as the NCFS and the UAS and, more generally, the OECD/INFE survey that are focused on tracking both financial knowledge and behavior are helping to generate new and relevant findings. The ability to follow individuals over time, and to link financial knowledge to other types of knowledge and behavior is equally essential. Matching survey responses to actual financial transactions data and re-administering modules regularly will allow assessment of behavioral changes as well as the respondents’ financial status over the longer-term as the economic and policy environment evolves.
For now, it is important to support both initiatives that aim to improve retirement preparedness as well as sustained investments in measurement and evaluation to ensure that such initiatives are effective. It may be impossible to provide absolute certainty about financial well-being in old age, but more can certainly be done to ensure that expectations are properly aligned and that Americans are making informed decisions about retirement, including decisions about their own Social Security benefits.
 The UAS panel is Internet-based, which means that respondents answer surveys on a computer, tablet, or smart phone, wherever they are and whenever they wish to participate. While most panel members have their own Internet access, those who do not are provided with Internet access by USC. Surveys are designed by research teams around the world and final datasets are posted on the USC website with sample weights. A number of these surveys, including ours, focus on economic and financial decision-making. These areas are also highlighted in the work carried out by the OECD/INFE.
 See Lusardi and Mitchell, “The Economic Importance of Financial Literacy: Theory and Evidence,” Journal of Economic Literature, March 2014, vol. 52(1), pp. 5-44.
Stefano Scarpetta, Director, OECD Directorate for Employment, Labour and Social Affairs and Adrian Blundell-Wignall, Director, OECD Directorate for Financial and Entreprise Affairs, based on their editorial in the publication
The 2015 edition of Pensions at a Glance marks the tenth anniversary of the OECD’s flagship series on pension systems and retirement incomes. Ten years of scrutiny of member and G20 countries’ pension systems and policies, ten years of assessing and predicting workers’ pension entitlements, and ten years of recommending reforms that lead to more financially sustainable pay-as-you-go pensions and respond to citizens’ need for stable and adequate incomes in old age.
The good news is that the OECD’s call has been heeded in most countries around the world. The last decade has seen intense reform, with governments changing key parameters of their retirement income systems and, in some cases, overhauling the design of the pension schemes, often scaling down the ambition of public pensions and giving a larger role to funded defined-contribution retirement provision. The most visible progress has been made in raising official pension ages: 67 is the new 65, and several countries are going even further towards ages closer to 70.
Raising the pension age has been politically difficult in many countries as it is a parameter that is easily understood. Most citizens are not happy having to work longer, often for the same benefit, even though the time spent in retirement is still growing due to continuously increasing life expectancy. Setting a legal norm does not mean that all people actually work up to these higher ages. Workers still leave the labour market well before reaching the official pension age in several OECD countries. The gap between official and effective retirement ages, however, is gradually shrinking. Over the past ten years, employment rates of workers aged 55 to 64 years have been rising substantially in many countries: from 45 to 66% in Germany, for example, from 31 to 46% in Italy, and from 52 to 57%, on average in the OECD.
The combination of cuts in future pensions through higher pension ages, fewer options for early retirement, changes in the way benefits are calculated, and lower adjustments of pensions in payment on the one hand, and more people working and contributing longer, on the other hand, has greatly improved the financial sustainability of pay-as-you-go pension systems. The European Union’s Ageing Working Group, for example, foresees a stabilisation of public pension spending as a share of GDP between 2015 and 2060 for most European countries, and in some cases, even reductions in spending, although from a much higher levels than projected just a few years ago.
Does this mean that all is well and that countries have managed to solve the pension puzzle we described in previous editions of Pensions at a Glance? Unfortunately, the answer is no. Fixing the financial challenges of pay-as-you-go pension systems is only one part of the equation. The other part relates to social sustainability and whether pensions in the future will be sufficient to provide adequate living conditions for older people. Today, the majority of OECD pensioners enjoy as good living standards as the average population. This is not surprising: many of today’s retirees, at least men, have worked for most of their active years in stable jobs. However, a “job for life” and even a “career for life” are rare for people starting out today.
Unemployment rates, in particular among younger groups, continue to be high in many countries. While older workers were less hit by the economic crisis than in previous downturns, their long-term unemployment rates are still unacceptably high. And we need to be realistic: working longer is not an option for everybody. Some people will have to retire early due to job strain and declining health no matter how high the pension age is set. Time out of work means time out of the pension system. Even though many countries provide pension credits during periods of unemployment, maternity or sick leave, future pension entitlements will be lower for many workers. And for the most unfortunate of tomorrow’s pensioners, those young people who do not manage to enter the labour market, the outlook is even more dire.
The second major challenge relates to the investment of retirement savings. When the financial crisis first struck, public attention focused on the impact on pension funds and the losses that some workers had to shoulder. In most countries vulnerable retirees were largely protected from falling into old-age poverty through the interplay of private and public pension systems, but many middle-class workers who were close to retirement were forced to radically change their plans for their life after work.
New longer-term difficulties have emerged in the aftermath of the crisis. The current low-growth, low-interest rate environment is making it difficult to earn the returns necessary to reach adequate pension levels, both for individual savers and financial service providers who have to honour offer life insurance and annuity contract obligations. In addition, mortality tables used in many countries do not fully incorporate projected improvements in life expectancy. This can lead to pension funds and life insurers starting to look for higher yields and to pursue riskier investment strategies that could ultimately undermine their solvency. Apart from posing financial sector risks, this behaviour potentially jeopardises both current and future retirement income security. Pension savings are ideally made over a long period over which returns might substantially rise again, but this is difficult to predict with any degree of certainty.
One trend that is certain, however, is the shift from defined-benefit schemes, where the employer shoulders the risk, to defined-contribution schemes, where the risk lies with the individual worker. This trend, well entrenched in occupational pension schemes, is also observed in public pension schemes with much closer links between workers’ contributions and their pension benefits, and benefit formulae which more and more often take into account increases in life expectancy.
After putting pension systems on a more sustainable financial track, policy makers now have to ensure that pension systems provide adequate retirement incomes to all workers. All countries have old-age safety nets in place, but in some cases these are still not strong enough to protect most of the elderly from falling into old-age poverty. But adequacy is not only about preventing poverty. More than ever, we need consistent and coherent coordination of labour market, social, pension and financial sector policies to ensure that people’s careers and life-courses are accompanied by the most effective measures to help them maximise their chances of retiring comfortably.
Many countries are offering pension calculators in order to show people what benefits they may expect in the future based on their personal career and contribution developments. These real-life tools complement the OECD’s pension calculator and can help raise awareness both among individuals and policy makers. Let us make sure that they are used in time and prompt action to prevent people from encountering nasty surprises when it is too late to change course.
We at the OECD are looking forward to the next decade of supporting countries and policy makers around the world in their analysis of pension systems and their design of pension reforms.
Ladies and gentlemen, let us be clear: as a society we are increasingly attracted to simplistic solutions, be it in the form of religious denominations or through the populist promises of salvation of parties on the right and left margins. Now, we could also utilise this escape route in the financial industry we work in, on the grounds that simplification has been accepted in other areas of society. But not so fast. Our position and status as well-educated, well-paid and (often) with high self-esteem brings responsibilities with it. We must not surrender to the call of simplistic answers. How then does our industry transcend the simplistic?
On what is feasible
The passionate debate on efficient markets and rational investors is no longer needed. It has been decided. Markets are not efficient, nor are investors rational (see On Market Efficiency). On the other hand, markets are not completely inefficient, but adaptive. People are not completely irrational, but oscillate between emotion and reason (see Unethical Asset Allocation Methods).
What remains the biggest obstacle in regards to change management is changing the behavioural patterns of employees along the investment process.
Does the employee have to be at the centre of the process in order to get closer to the knowledge boundary in asset allocation? Are high frequency trading and RoboAdvisors not evidence enough that humans may not have to play a role in the investment process? Slow down. All quantitative methods and algorithms are based on assumptions of market patterns and how these can be made utilisable as best as possible. Who decides on the assumptions? That’s right, the human developers. In order to lead investment methods closer to the knowledge boundary of asset allocation, this only leaves the focus on the investment team and the investment process it experiences.
What is feasible now? In one sentence: “More conscious and therefore rational investment decisions by means of proactive management of cognitive dissonances and an analysis focus on causality instead of correlation in regards to understanding market correlations create a higher probability of anti-cycles in the investment process.” (Schuller).
If you were searching for the Holy Grail, you have now found it.
Innovation & Asset Allocation
The asset management industry is currently being attacked on two fronts. Regulators increasingly see a systemic risk in asset managers and are trying to implement regulatory measures in order ensure a better handling; and Fintechs are questioning inherent business models and are increasing the margin pressure.
Other industries are already demonstrating the two solutions for this increasing limitation of room for manoeuvre. The temporary solution is economies of scale. This is already the case in our industry. There are regulatory and organisational constraints in regards to the oligopolisation of industries. It is only a temporary solution.
The sustainable solution is specialisation. Competitive advantages by means of specialisation can be won through innovation. This is the only sustainable solution.
In our industry, innovations are rare. Innovation means a shifting of the knowledge boundary on asset allocation, a measurable improvement of the service provisions of corporate finance compared to the real economy. The innovative ability and motivation of the investment teams (investment committee, foundation chairpersons, family office managers etc.) therefore comes into focus. The sustainable competitive ability of an investment process stands and falls with the investment team. Let us refer to them as high performance investment teams (HPIT) to uqse Panthera’s terminology.
Reducing behaviour gaps
Creating a concept is one thing, establishing and managing HPIT is another. There are a number of well-tested starting points, including skin in the game–based incentive systems, transparent governance structures, and quantifiable, transparent performance measurements. But here we’d like to concentrate on reducing the behaviour gap.
The “behaviour gap” has been sufficiently researched and quantified from an academic point of view. A result of the pro-cyclic behaviour of market participants, explained by emotional and wrong decisions. It is self-explanatory that this structural underperformance leads to significantly reduced returns for investors over time compared to buy-and-hold.
(Source: Vanguard, Bogle Financial Markets Research, Dalbar)
Although Bogle is mainly highlighting the cost penalty, his research shows the even larger potential for improvement when it comes to minimizing the timing and selection penalty. For reductions of selection penalties, we refer to our initial point, namely the necessity of high performance investment teams.
Implications for private pensions (Third pillar of pensions)
Within ongoing demographic change, a significant shift in pension policies can be observed. Private pensions (the “third pillar”) become increasingly important to close the pension gap, opened by the pillars 1 and 2 (state and employer plans). This puts European trustees in the difficult position of becoming long-term investors for their own private pension plan, with all the difficulties like selecting the right asset allocation and investment vehicles – and the right insurance company. Our trustee should keep three concrete facts in mind:
- Costs matter. In a secular low yield environment, each basis point in fees is spent unnecessarily. A focus on passive replication is recommended. If active management fees are justified, the investment products used within the private pension plan should be institutional share classes without distribution costs.
- By incorporating strategies based on the body of knowledge led by behavioural asset management, a higher emphasis of rule-based investment processes and dynamic asset allocation strategies could be a way to structurally increase equity allocations in private pension plans. Structurally higher equity allocation will transform mid- to long-term to higher expected returns for private pension trustees, which can alleviate the expected drag of the other main pension pillars due to demographic change.
- Insurance companies offer to pre-select and perform due diligence on investment products. Trustees then select from this shortlist, trying to assemble a feasible asset allocation for their pension plan. How can our thoughts on HPIT be of relevance for insurance companies? During an insurance company’s due diligence process of selecting investment products for private pension plans, it should only consider those with a stringent rule-based investment process committed to high performance investment teams. Like that, the whole investment industry would be forced to focus more on the most important risk and performance driver, namely the man at the centre of the investment decision.
Pablo Antolín-Nicolás, OECD Directorate for Financial and Enterprise Affairs
Pension systems of all types are facing crucial and far-reaching challenges because of demographic trends, the continuing impacts of the economic crisis, and the environment of low growth, low returns and low yields. As a result, meeting pension commitments and having adequate pensions could become quite a challenge. The OECD Pensions Outlook 2014 discusses ways in which countries are addressing all these challenges, including the demographic challenge.
Ageing is the result of lower fertility rates and, especially, higher life expectancy, which results in an increase in the average age of the population. The impact of population ageing on pensions can be separated into the “baby boom”, a temporary factor, and improvements in mortality and life expectancy, a more permanent factor. Once the “baby boom” generations pass away their impact is gone. However, improvements in mortality and life expectancy are here to stay.
Most people including myself would consider living longer a good thing, so let’s prepare for it. An increase in life expectancy while keeping the number of years saving for retirement constant means that the ratio of years contributing to finance retirement to years in retirement will fall. Therefore, the same amount of savings will have to finance more years, and unless someone assumes that cost (e.g. governments through defined benefit public pensions or employers through defined benefit funded pensions) people will have lower annual pensions, although the sum of all pension payments throughout retirement will remain constant.
In the case that governments and/or employers assume the extra cost of more years in retirement relative to years saving for retirement, they may suffer problems of solvency or fiscal sustainability. There will be a problem of adequacy when people accumulate assets to finance retirement in defined contribution pension plans and they bear the risk of living longer. If they buy a life annuity the risk is transferred to the annuity provider.
Therefore, as the Pensions Outlook shows, population ageing and, in particular, the continued improvements in mortality and life expectancy, create problems of adequacy in defined contribution pensions, solvency in defined benefit funded pensions, and financial sustainability problems in PAYG-financed public pensions.
The Outlook argues that contributing more and for longer, especially by postponing retirement as life expectancy increases, is the best approach to face these challenges. The way to address the problems posed by improvements in life expectancy is to maintain the ratio of years saving for retirement to years in retirement constant, increasing contribution periods as life expectancy increases; or to increase overall contributions. So what are countries doing?
Many countries have responded to population ageing by increasing the statutory age of retirement. Some have linked retirement age to life expectancy.
The fairness of this solution, however, can be questioned when we look beyond the average. Gains in life expectancy have not necessarily been distributed equally across society. A skilled executive, for example, can expect to enjoy nearly four additional years in retirement compared to a manual labourer; this assuming that “retirement” begins at age 65. The inequality becomes more apparent when considering the period before retirement. Not only can the manual labourer expect to receive his pension for fewer years, but he can also expect to have made contributions to the system from an earlier age, as the highly skilled worker likely spent a number of years in higher education and began working later. Given the same retirement age, the unskilled labourer pays relatively more into the system to receive his pension for a shorter amount of time.
Mechanically linking retirement age to increases in life expectancy across the board may therefore be regressive. Life expectancy, time of entry in the labour market and improvements in life expectancy are not homogenous across the population, they vary across different socio-economic groups (e.g., low skill, low income groups). Hence, the best approach may be to link the number of years contributing to life expectancy. Unfortunately, the data needed for this is not available across all countries and the application across different socio-economic groups may be far from straightforward.
To compound the problem, future improvements in mortality and life expectancy are uncertain. Gains may continue as in the past, they may accelerate or decelerate. Improvements vary across different population sub-groups; they may converge or diverge further.
In defined contribution pension plans individuals bear the risk of outliving their resources in old age. They can insure themselves against this longevity risk by transferring the longevity risk to annuity providers, e.g., life insurers, as we said above. The OECD Roadmap for the Good Design of DC Pension Plans recommends default partial annuitization to provide protection from longevity risk. In defined benefit pension plans (e.g., PAYG financed public pensions or funded pension) the government, pension funds or employers who assumes the longevity risk.
Pension funds and annuity providers need financial instruments to mitigate the longevity risk. The OECD work on Mortality Assumptions and Longevity Risk examines the longevity risk that pension funds and annuity providers may be exposed to by looking at the (regulatory) mortality tables used to provision for future improvements in mortality and life expectancy and, in this way, be able to fulfil their pension promises. This OECD work also discusses several approaches for pension funds and annuity providers to manage longevity risk.
The first step is to recognise the existence of longevity risk and provision accordingly. For this, regulators and policy makers should ensure that pension funds and annuity providers use regularly updated mortality tables that incorporate future improvements in mortality and life expectancy. In addition, these mortality tables should be based on the mortality experience of the relevant population.
The regulatory framework could also help to ensure that capital markets offer additional capacity to mitigate longevity risk, for example recognising the reduction in risk exposure of using index-based financial instruments to hedge longevity risk, and by publishing a longevity index to serve as a benchmark for the pricing and risk assessment of longevity hedges, improving the standardisation, transparency and liquidity of these markets.
The issuance of a longevity indexed bond could be considered, though with care. While it may be helpful in kick-starting the market for longevity hedging instruments by providing standardisation, a benchmark for pricing and liquidity, it would also significantly increase the exposure of the government to longevity risk, while many governments already have significant exposure on their balance sheets
Demand for protection against longevity risk will only increase as individuals are expected to live longer, and the sustainability of pension funds and annuities providing this protection for individuals has to be ensured. Sufficient provisioning for longevity is essential to guarantee that future payments will be met, and the ability for providers to manage and mitigate this risk will allow them to continue offering protection in the future.
Today’s post is by Markus Schuller, Panthera Solutions
The trends we discussed in Part 1 are influencing how we structure financially feasible pension systems. EU28 pension systems are well researched by European institutions and the OECD (here, here and here for example) They are rather moderate in their conclusions as these tend to carry politically explosive messages, notably: the first pillar is becoming more and more an anti-poverty provision, leaving it to the second and third pillars to secure an adequate retirement income. So how can we stimulate Pillars II and III? (The “three pillars” come from a 1994 World Bank publication describing: “a publicly managed system with mandatory participation and the limited goal of reducing poverty among the old [first pillar]; a privately managed mandatory savings system [second pillar]; and voluntary savings [third pillar]”).
A total of EUR 1 717 billion (gross) was spent across the EU on pensions in 2012, representing approximately 13.3 % of the EU GDP. Expenditure varies considerably between countries. Greece spent 17.5 % of GDP on pensions in 2012, more than any other country, while three others (Italy, France and Austria) also spent over 15 % of GDP. Estonia, Ireland and Lithuania, meanwhile, spent 7.9 %, 7.3 % and 7.7 % of GDP respectively on pensions (see EUROSTAT Social Protection Statistics).
The EU Commission and EU regulators are increasingly taking on the task to regulate and stimulate the use of Pillars II and III. On January 30th, 2015, the European Insurance and Occupational Pensions Authority (EIOPA) published a statistical database for occupational pensions in the European Economic Area (EEA). This publication represents an important financial stability data source allowing EIOPA to better monitor developments in the market and identify at an early stage trends, potential risks, and vulnerabilities. Currently 21 of the 28 EU jurisdictions have provided information for this database.
In July 2014, the EC called EIOPA for advice on the development of an EU single market for personal pension products. The original timeline, as mentioned in an EIOPA presentation from October 2014 has changed. EIOPA will now publish a consultation document on how a single market for personal pensions could be created in July 2015. As EIOPA’s Task Force on Personal Pensions has not yet drawn final conclusions, no documents are publicly available yet. Stakeholders will be asked to respond to the issues raised in the consultation document between the beginning of July and the beginning of September 2015 during a public consultation. EIOPA will then answer to the Commission’s Call for Advice by 1 February 2016.
In short, the European Commission and EIOPA are currently trying to understand the market for personal pension products. The EC is asking the right questions in this document, from a push towards an EU-wide framework, over solving principal-agent issues to a push for multi-pillar diversification. In order to support the EU institutions in their orientation phase, I suggest the following for the third pillar.
- Include Single Market for Personal Pensions in Capital Markets Union (CMU) Framework
The European Commission’s Green Paper on establishing a Capital Markets Union until 2019 currently focuses on 5 aspects to facilitate capital market based debt financing for SME and infrastructure investments. Rightly so. Having said that, ensuring adequate income in retirement through direct capital market exposure is equally important. So far, the Green Paper does not even mention the third pillar. It only touches the second pillar lightly in two short paragraphs. The hopefully bold proposals from the “EIOPA Task Force on Personal Pensions” in Q1-2016 on how to strengthen the third pillar in EU28 need to be added as priority to the CMU framework.
- Product Structures in the Client´s Interest
Up to now, third pillar products like the Riester Rente (Germany) or the Private Pensionsvorsorge (Austria) are based on the belief of the Greater Fool Theory. Product managers and distributors hope to find an even greater fool that signs up for a fee-overloaded, inflexible, intransparent and strategy-constrained financial instrument. Consumers are taking the bait of a minor government subsidy while ignoring the significant downside of those products. And it works (see here, here and here). Instead, consumers need to be offered a low-cost, transparent, flexible and strategy-unconstrained vehicle to participate in the long-term rise of the global capital stock. US FinTech providers show the way. Traditional capital market access via costly gatekeepers like IFAs, Banks and fund managers needs to be avoided.
- Regulatory Approach
Personal pension plans (PPPs) are covered by many sectoral EU-laws, or none (21 out of the 80 PPP’s surveyed in the EIOPA database have no EU legislation applicable). PPPs should have their own simple and clear regulatory approach. It should facilitate competition amongst financial services providers to offer a low-cost, transparent, flexible and strategy-unconstrained PPP-vehicle. It also needs to overhaul incentive structures to solve currently pressing principal-agent issues.
- Capital Markets Education & Cultural Change
Without educating the private investor on capital markets know how, PPPs will not achieve the reach and level of acceptance required. This education needs to take place in a cultural environment in which capital markets are not demonized by governments. This is a rather self-evident insight, though not necessarily followed by continental European politicians. Even if education and societal sentiment are in place, the inequality momentum will restrain large parts of the population from being able to sufficiently save money for capital market investments. Governments need to offer more significant tax shields – e.g. by automatically transferring parts of the paid income tax to the third pillar account of the citizen.
- Civil Society Research Support
Despite significant research being conducted on EU28 first pillar pension systems, the databases and research publications on PPP are nascent. In addition to EIOPAs current effort to establish the research infrastructure, civil society support should be facilitated to help conduct research and raise public awareness. Is it via lobby-like institutions like a TheCityUK for PPP topics or by installing a “Kapitalmarktbeauftragten” (capital markets commissioner) like in Austria – where a good idea failed due to political reasons. Such a commissioner could be appointed by the parliament and equipped with sufficient freedom and budget to promote the topic through new initiatives.
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).