How Can Capital Markets Serve Pension Systems in EU28? Part 2

Pensions Outlook 2014Today’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.

Useful links

OECD work on pensions

Capital Controls in Emerging Markets: A good idea?

Today’s post is from Adrian Blundell-Wignall, Special Advisor to the OECD Secretary-General on Financial Markets. The view expressed here is his own and does not necessarily reflect that of any OECD government.

A couple of years ago the IMF produced some (cautious) comments and studies arguing that currency management and capital controls were OK in some circumstances. Many emerging market countries took this as an endorsement of their approach to policy which has not been limited to temporary crisis measures.  The Figure below shows the national investment-saving correlations for the OECD countries over 1982-2010 and for a group of emerging countries (China, Brazil, India, South Africa, Mexico and South Korea) in the manner of Martin Feldstein and Charles Horioka.

In a 1980 paper, Feldstein and Horioka looked at two views of the relation between domestic saving and the degree of mobility of world capital. If capital is perfectly mobile, you would expect there to be little or no relation between the domestic investment in a country and the amount of savings generated in that country, since capital would flow freely to wherever the returns were highest. On the other hand, if the flow of long-term capital among countries is impeded by regulations or for other reasons, investors will be more likely to keep their money in their own country and increases in domestic saving will be reflected primarily in additional domestic investment. Feldstein and Horioka’s analysis supported the second view more than the first.

Three decades later, the OECD economies have more-or-less achieved an open economy without capital controls (led in large part by Europe). But the emerging markets have a high correlation of national savings to investment (0.7), indicating a prolonged lack of openness.

National Investment-Savings Correlations: OECD versus Emerging Economies

S-I correlations

Source: OECD

The growing gap between the correlations for the OECD (highly open) and the emerging economies (impeded) is pointing to a fundamental imbalance in the world economy. Does it matter? The IMF study mentioned above showed that countries with stronger capital controls had a lesser fall in GDP in the post-crisis period. While the original authors were cautious in interpreting their results, this was not so for the users of those findings. This is all the more worrying given that the OECD exactly reproduced the IMF study and found that the results were not robust to a simple stability test. In other words, the OECD tests show that these results certainly should not be used as a basis for claiming some form of general support for long-term use of capital controls.

The OECD also ran a simpler study using the IMF’s own measures of capital controls, with both the IMF’s original sample period and updating it. The OECD study found significant and contradictory results, which were much more consistent with an exchange rate targeting and “impossible trinity” interpretation of outcomes:

  1. In the good years prior to the crisis, capital controls are indeed good supporters of growth. This is likely because combined with exchange rate management there is a foreign trade benefit, companies are not constrained for finance, and containing inflows reduces the build-up of money and credit following from exchange market intervention (and associated asset bubbles).
  2. However, in the post-crisis period the exact opposite is found and the results are highly significant. Capital controls are negatively correlated with growth. The pressure on the exchange rate is down, not up, as foreign capital retreats, and international reserves are used up defending against a currency crisis (contracting money and credit). Companies are more constrained by cash flow and external finance considerations.  Just at the time when foreign capital is needed, countries with the most controls suffer the greatest retreat of foreign funding. Investment and GDP growth suffer.
  3. The full sample period (data from both before and after the crisis) shows significant negative effects of capital controls. That is, the overall net benefit appears negative compared to less capital controls.

These results have an intuitive appeal, consistent with economic theory. While it is early days, and some caution is required, the findings suggest that in the long-run dealing with the global investment-savings imbalances could be of benefit not only to developed countries, but also to the developing world itself.

Useful links
Capital Controls on Inflows, the Global Financial Crisis and Economic Growth: Evidence for Emerging Economies by Adrian Blundell-Wignall and Caroline Roulet of the OECD Directorate for Financial and Enterprise Affairs
This paper discusses the issues mentioned above in detail. It investigates whether countries that had controls on inflows in place prior to the crisis were less vulnerable during the global financial crisis. More generally, it examines economic growth effects of such controls over the entire economic cycle, finding that capital restrictions on inflows (particularly debt liabilities) may be useful in good times but may have adverse effects in a crisis.
Macro-prudential Policy, Bank Systemic Risk and Capital Controls by Adrian Blundell-Wignall and Caroline Roulet of the OECD Directorate for Financial and Enterprise Affairs
This paper looks at macro-prudential policies in the light of empirical evidence on the determinants of bank systemic risk, and the effectiveness of capital controls. It concludes that complexity and interdependence is such that care should be taken in implementing macro-prudential policies until much more is understood about these issues.

Financial Market Trends – OECD Journal

OECD work on Institutional investors and long-term investment

Always spend wisely ….

This post comes to us from Mark Hannam, honorary Research Fellow at the Institute of Philosophy at the University of London.

European governments face a problem.  They have borrowed to finance fiscal deficits during the recession and now they must repay their debts.  Taxes will rise and public spending will fall.  None of this is popular with voters, but it must be done.

In this era of austerity there is much talk about “doing  more with less”.  This is a worthy goal: who would be in favour of doing less with more?  But the rhetoric of public spending cuts disguises an important distinction between the level of spending and the quality of spending.

For economists “savings” are the excess of income over consumption, or deferred consumption.  We save now so we can consume later.  The balance between current consumption and future consumption depends upon our circumstances: in times of plenty it is prudent to save, in times of shortage in makes sense to consume.  It was ever so.

The idea that we should try to “get more for our money” is somewhat different; it suggests that we spend wisely, ensuring that we do not overpay for products and services.  It is hard to argue against the idea that we should optimise the value we secure for each pound, euro or dollar spent.

So, two rather different ideas: one proposes that we consider the balance between present consumption versus future consumption, the other proposes that we should always spend wisely, making the best of the resources we have.

Governments should always spend wisely, but today they have much less to spend.  As we enter several lean years of public spending we can be sure the politicians will tell us that they are doing more with less.  Very good.  But when the fat years come back, we should continue to insist that we get good value for our money.