Are defined contribution pension schemes socially sustainable? A conceptual map from a macroprudential perspective

Transcription

1 Are defined contribution pension schemes socially sustainable? A conceptual map from a macroprudential perspective Giuseppe Marotta Università di Modena e Reggio Emilia and Cefin IX International Summer School on Risk Measurement and Control

2 Outline i. MOTIVATIONS AND MAIN POLICY IMPLICATIONS (to slide 3) ii. iii. iv. FINANCIALLY SUSTAINABLE BUT SOCIALLY UNSUSTAINABLE DC PENSION FUNDS (to slide 5) PENSION FUNDS AS LONG TERM INVESTORS IN REAL ASSETS (to slide 13) EQUITY RISK PREMIUM AND LIFE CYCLE PORTFOLIO ALLOCATION (to slide 19) v. IMPLICATIONS FROM A MACROPRUDENTIAL PERSPECTIVE (to slide 22)

3 Motivations and main policy implications Starting points Basic pension rights for every individual to counter inadequacies in the labour market (career types, including part time work or self employment, discontinuities, gender risk) drive political consensus among ageing voters/pensioners Socially unsustainable public and private pension DC schemes, though financially sustainable, sources of politically driven contingent liabilities, on top of the implicit pension debt. A sovereign risk channel of medium term macrostress tests for financial stability should include these contingent liabilities.

4 Motivations and main policy implications Policy implications Required regular workers contributions, universal coverage, higher private savings, and better financial education (obvious but worth recalling as fundamentals on retirement income adequacy) Careful information on risky assets perspective returns, to deflate unreasonable expectations (not so obvious and worth emphasizing) Means tested subsistence retirement income (or zero pillar) levels in macrostress testing tools (main point, also for research) (back to outline)

5 FINANCIALLY SUSTAINABLE BUT SOCIALLY UNSUSTAINABLE DC PENSION FUNDS Replacement rates, out of public and private pension schemes, below a socially accepted subsistence income, undermine the credibility of a no recourse to public finances DC private ones (most often legislatively mandated and tax incentived) and notional DC public schemes), though in principle financially sustainable, are therefore liable to a political risk a textbook case of dynamic inconsistency when consensus seeking overwhelms financial stability considerations in the utility function of elected short sighted policymakers.

6 FINANCIALLY SUSTAINABLE BUT SOCIALLY UNSUSTAINABLE DC PENSION FUNDS Pensions as passive gold pots for governments: a first example High budget deficits caused by the 2007 financial and economic crisis and the consequent desire to circumvent existing EU fiscal rules pushed a number of Central and Eastern European countries to weaken (or fully scrap) their second fully funded defined contribution pension pillars. Implication: reduced budget deficits in the short run but how such moves will be detrimental pensioners standard of life and to a country s long run fiscal position?

7 FINANCIALLY SUSTAINABLE BUT SOCIALLY UNSUSTAINABLE DC PENSION FUNDS Stylized facts on public DC schemes A PAYG NDC pension scheme, like the ones introduced in Sweden and Italy in the 90s and in Poland in 2003, is financially sustainable because it mimics, up to a certain extent, a DC private pension scheme but is it socially sustainable? Replacement rates for PAYG NDC public pension schemes are indeed projected to fall in next decades in EU countries, even for full career workers. See in following slides figures from from Grech (2010) for EU OECD countries, with estimates excluding and including private pension benefits, for average and low earners.

8 FINANCIALLY SUSTAINABLE BUT SOCIALLY UNSUSTAINABLE DC PENSION FUNDS

9 FINANCIALLY SUSTAINABLE BUT SOCIALLY UNSUSTAINABLE DC PENSION FUNDS

10 FINANCIALLY SUSTAINABLE BUT SOCIALLY UNSUSTAINABLE DC PENSION FUNDS

11 FINANCIALLY SUSTAINABLE BUT SOCIALLY UNSUSTAINABLE DC PENSION FUNDS DC private pension scheme by definition financially sustainable but is it socially sustainable, even combined with first pillar schemes, even under the assumption of universal membership of active workers in non mandatory schemes? NO: a shortened contribution period and/or low contributions, because of a late employment and/or an early exit from the labor market and/or a working career with several discontinuities. In addition, less than universal membership because of liquidity constraints, low financial education, low realized returns on pension assets. As for coverage rate in voluntary schemes

12 FINANCIALLY SUSTAINABLE BUT SOCIALLY UNSUSTAINABLE DC PENSION FUNDS (back to outline)

13 PENSION FUNDS AS LONG TERM INVESTORS IN REAL ASSETS Pensions as passive gold pots for governments: a second example? To counteract through GDP growth unsustainable public debt dynamics subscribers run proof private DC pension funds could be picked by policymakers as growth enhancing long term finance providers, especially when funds are in the accumulation phase. Good rationale : Unleveraged pension funds could commit resources on long term investments, better able to incorporate technical progress and thus enhance total factor productivity.

14 PENSION FUNDS AS LONG TERM INVESTORS IN REAL ASSETS Investment in infrastructures. Estimates of global infrastructure needs range as high as US$ 3 trillion per annum with public finances increasingly unable to meet these needs (WEF 2011) Interestingly, the WEF report concludes however that there will likely be a decline in (spontaneous) long term investing by pension funds because of the shift from DB to DC schemes. A recent OECD project (Della Croce et al, 2011) focuses on the role of institutional investors, such as insurance companies and pension funds, as investors in new infrastructure to be built, rebuilt, and retrofitted. Any political risk of contingent liabilities?

15 PENSION FUNDS AS LONG TERM INVESTORS IN REAL ASSETS Against the backdrop of few truly long dated bonds, of the waning risk free asset status for government bonds, and of a shrinking equity risk premium (see later), the perspective of investing in infrastructure projects could be of interest both for debt constrained Governments and pension funds as well as for society at large. Infrastructure is in principle a long dated asset that matches the liabilities to pensioners and generates inflation linked monetary income over a long period of time. The long term investment horizon in principle would allow pension fund subscribers to take advantage of any illiquidity premium attached to long term investments, and, by holding investments over the longer term, could also reduce turnover within portfolios, and thereby costs. Possible positive externalities for ageing societies: pension funds could be able to uncover as yet unmet economic needs and inject capital to meet them, rather than look for assets in the market.

16 PENSION FUNDS AS LONG TERM INVESTORS IN REAL ASSETS Fact: less than 1% of pension funds worldwide are invested in infrastructure projects, excluding indirect investment in infrastructure via the equity of listed utility companies and infrastructure companies. Risks in infrastructure investment Investment risk. An asset class based on infrastructure investment may well match a demand, on the part of pension schemes, for long term investments with stable returns. Government would however need to play a role in inflation proofing and underwriting part of the financial risks ( moral hazard).

17 PENSION FUNDS AS LONG TERM INVESTORS IN REAL ASSETS Construction risk. Pension funds argue that too many large construction projects don t deliver, pointing to cost overruns and delays in completion on projects. Hence their preference for investing in so called brownfield sites, involving the maintenance of existing infrastructure, than in building new capacity. Yet new capacity is precisely what is needed in areas such as energy, transport and waste management. The government could solve the problem of construction risk by simply underwriting potential losses, with consequent contingent liabilities arising from such an openended risk, and, again, moral hazard.

18 PENSION FUNDS AS LONG TERM INVESTORS IN REAL ASSETS A direct investment option for pension funds in portfolio allocation (in real assets, productive or real estate), when combined with a home bias, either because of regulatory or political constraints, so to restrict the geographical asset diversification, would amplify the pressures on policymakers to divert funds to help firms or sectors in troubles. The likely consequences of disregarding a proper economic assessment of the profitability prospects on the accumulation of the final assets to be annuatized could justify potential requests by eligible pensioners for future compensatory public funds. (back to outline)

19 EQUITY RISK PREMIUM AND LIFE CYCLE PORTFOLIO ALLOCATION The empirical evidence over the last quarter of a century raises doubts on two building blocks for strategic portfolio allocation of pension funds: the equity risk is consistently shrinking and government bonds, issued by advanced countries, as a risk free asset. One likely consequence: young workers will be discouraged from the membership in private pension funds, unless tax benefits overwhelm participation costs and psychological ones. On both accounts, political risks of contingent liabilities increase: an insufficient lifetime contribution to the second pillar of the pension system is bound to generate a reduced retirement income on top of the public one; tax expenditures to incentive membership imply lower fiscal revenues

20 EQUITY RISK PREMIUM AND LIFE CYCLE PORTFOLIO ALLOCATION The main rationale, assumed as an unquestioned fact in the financial literacy literature (for a recent example, van Rooij et al, 2011) as well as in the pension funds regulation literature (Antolin et al, 2009), to advocate the membership in a private DC pension fund is the opportunity of earning the equity risk premium. However:

21 EQUITY RISK PREMIUM AND LIFE CYCLE PORTFOLIO ALLOCATION Doubts on the risk free assets of government bonds impairs the second main underpinning of a life cycle portfolio allocation for pension savings, that OECD keeps recommending. With null or even negative equity risk premia, an all equity investment strategy does not appear therefore worthwhile, even in the early stages of a worker s career, compared to a safer (possibly inflation indexed àla Bodie) all bonds, provided sovereign risk is negligible. In addition, and more fundamentally, these developments question the traditional and stronger rationale for subscribing to private DC pension funds, instead of relying only on public pension schemes, that offer the added benefits of economies of scale in transaction costs compared to smaller private funds. Indeed, quoting from Holzmann (2012), some recent evidence for Chile shows that the expected rates of return on financial assets will not necessarily surpass the growth rate of wages, which is the rate unfunded systems are able to pay. (back to outline)

22 IMPLICATIONS FROM A MACROPRUDENTIAL PERSPECTIVE A higher political risk of contingent liabilities creates a negative feedback loop with sovereign risk, should the attempt to protect from the latter reduce the willingness to subscribe government bonds and worsen the conditions for public debt sustainability. Against the backdrop of a required protracted fiscal consolidation for most advanced countries, as a shield against markets doubts on public debt unsustainability since the subprime crisis, tax expenditures aimed at boosting the membership in private pension funds, with implied losses in fiscal revenues, should therefore be closely assessed as to their effective effects on public sector accounts. On the other hand, a persistent low coverage of private pension funds would increase the gap between (socially adequate) expected and effective combined retirement income.

23 IMPLICATIONS FROM A MACROPRUDENTIAL PERSPECTIVE A first policy implication participation be mandatory is hardly implementable, because fiscal consolidation means that the State is unlikely to divert resources to ease liquidity constraints on potential (young) contributors. Policy implications on financial education: To choose far sighted politicians: adequate information to young workers/voters on the financial risks of public and private pension schemes, in particular through the politically driven creation of contingent liabilities. Requests for fiscal outlays should be resisted, because the likely negative feedbacks on sovereign risk would jeopardize also the financial stability of banks and other intermediaries, through mark to market losses in their government paper, as well as higher funding costs (CGFS 2011a, b), with negative spillovers on economic activity.

24 IMPLICATIONS FROM A MACROPRUDENTIAL PERSPECTIVE Saving, retiring age and reverse mortgage a much more important than portfolio allocation for the US (Mitchell et al 2012): Working six months longer from 66.5 to 67 produces the same outcome as having all assets invested in riskless equities yielding a 6.5 percent real return, with no costs associated with the increased risk. Why? Because most households do not have significant financial wealth. Even for the top decile, asset allocation is not a particularly powerful lever Given the relative unimportance of asset allocations, financial advisers will be of greater help to their clients if they focus on a broad array of tools including working longer, controlling spending, and taking out a reverse mortgage. In an increasingly interconnected financial world are there assets that provide true diversification benefits?

25 IMPLICATIONS FROM A MACROPRUDENTIAL PERSPECTIVE A low correlated world (from FT Alphaville, source HSBC) IX International Summer School on Risk Measurement and Control G. Marotta revised draft 15/06/2012

26 IMPLICATIONS FROM A MACROPRUDENTIAL PERSPECTIVE A high correlated world IX International Summer School on Risk Measurement and Control G. Marotta revised draft 15/06/2012

27 IMPLICATIONS FROM A MACROPRUDENTIAL PERSPECTIVE Implications for macrofinancial supervision: Large DB or hybrid DC private pension funds, given the size of their (negotiable) assets relative to domestic financial markets, with tens of thousands eligible pensioners, are TBTF (and therefore potential recipient of public funds) because: expectations of public money infusions in case their obligations to pensioners could not be fulfilled the authorities can be expected to provide a backstop to either DB or DC large pension funds, in order to let these long term institutional investors act as contrarians, when sellers herding increases liquidity risks in financial markets.

28 IMPLICATIONS FROM A MACROPRUDENTIAL PERSPECTIVE Early warning systems on fiscal stance medium term sustainability: budget pressures should take into account, possibly with triggering thresholds, contingent liabilities arising from the gap between socially accepted minimum retirement income and the one effectively provided combining DC public and private pension schemes, under different assumptions on excess returns of funds portfolios over government bonds. A promising approach to operationalize this conceptual framework could be to proxy the subsistence level with a minimum guarantee, usually means tested, government provided age pension (also labelled zero pillar).

29 IMPLICATIONS FROM A MACROPRUDENTIAL PERSPECTIVE Warning: large variation in implicit pension debt estimates for standard public pension schemes (from Iza 2011)

30 Thank you for your attention Questions?

31 Selected references Della Croce, R., Stewart F., Yermo J. (2011), Promoting longer term investment by institutional investors: selected issues and policies. OECD Financial Market Trends, Issue 1, pp Grech, A.G. (2010), Assessing the sustainability of pension reforms in Europe, CASE wp no 140 Holzmann, R. (2012), Global Pension Systems and Their Reform, World Bank, wp no IZA (2011), Pension systems in the EU Contingent Liabilities and Assets in the Public and Private Sector, Research Report no 42 Marotta, G. (2012), Are defined contribution schemes socially sustainable? A conceptual map from a macroprudential perspective, Banks and bank systems, 7(1), and references therein. Munnell, A.H., Orlova, N.S., and Webb, A. (2012), HOW IMPORTANT IS ASSET ALLOCATION TO FINANCIAL SECURITY IN RETIREMENT? CRR WP OECD (2012) OECD Pensions Outlook 2012 World Economic Forum (2011), The Future of Long term Investing