The EU debt crisis is making further private funding of pensions more desirable. More
private retirement saving is necessary to maintain income in old age when public pensions are being cut due to the crisis. Indeed, the implicit debt in the extensive pay-as-you-go (PAYG) arrangements are an important reason behind the European debt crisis. The best way to address the crisis is to cut entitlement programmes in the medium to long term, while leaving more fiscal room to cushion the economy today.

Private saving in pension funds may also contribute to the stability of markets for government debt. Diverting risks from banks to pension funds reduces systematic risks in the financial system: pension funds are better able to deal with macroeconomic risks than banks because they use long-term investment strategies. Moreover, participants cannot withdraw their funds at short notice.

A larger role for private pensions helps to diversify risks within the pension system. Public pensions now seem less safe than most people thought. The debt crisis in southern Europe and Ireland illustrates the vulnerability of public finances and state retirement benefits to shocks affecting the domestic economy. One may in fact view PAYG pension schemes as a claim of citizens on future provisions by their national government. This leaves people heavily exposed to the credit risk of their own governments. With funded private pensions, credit risks can be diversified. Just as the European banking system becomes more robust if banks diversify their holdings of public debt across multiple countries, so European pension systems become safer if pension promises are backed by financial instruments in more than one country.

By organising private pensions in stand-alone (mutual) pension funds, one avoids the problem of traditional defined benefit pensions, which exposed participants to the specific risks of the sponsoring firm. Standalone funds back their obligations with financial assets and do not rely on sponsoring companies to guarantee them. So participants are not exposed to the credit risk of their own firm.

By stimulating private pensions and limiting the scope of PAYG arrangements, EU member states help to create a deeper, more integrated European capital market. Savers can finance investments in other EU countries and improve the security of their pensions by better diversifying country-specific and firm-specific risks. So widening international risk-sharing across Europe enhances financial stability and economic growth.

Finally, private pensions enhance the internal market for pension services. Each country
could set its own pension system on the basis of its own preferences and circumstances. A one-size-fits-all pension system is not on the horizon. However, the EU can develop the internal market for pension products and services by removing the remaining trade barriers and by strengthening - through co-ordination - the second pillar in EU pension systems.

In this way, each country has access to building blocks with which to build more retirement security for its citizens. And a larger internal market offers greater opportunities for specialisation. Indeed, pension services such as administration, communication, distribution, advisory services, investment, custody and insurance, benefit from economies of scale.

A good pension is a risky pension. Risk taking is good for the economy as a whole because it contributes to innovation and economic growth. Risk taking is good for individuals because it yields higher expected returns. Pension funds should therefore embrace risk by exploiting the trade-off between return and risk, and share risks among participants. Efficient risk sharing implies that shocks should be spread across multiple investors, including the elderly who own most financial capital. So EU regulation of financial markets should not prevent pension funds from exploiting the risk premia on financial markets, but should mandate funds to communicate to individual participants the risks that result from their investment policies and risk-sharing mechanisms.

Indeed, the investment perspective rather than the insurance perspective should dominate government supervision of pension funds. The supervision of pension funds and related EU regulations should therefore not follow the model of insurance companies providing guarantees.

Moreover, shocks should be smoothed over the remaining life-cycle of each participant: rather than severely adjusting consumption today, consumption should be modified over the rest of the life-cycle. The famous Merton-Samuelson model provides a useful benchmark for such optimal life-cycle risk management. This model implies that any shock in wealth should optimally lead to an adjustment in consumption of all individuals by the same percentage during the rest of their lives. For example, if a crisis leads to a permanent loss in income of 3%, the consumption of both the young and old (and future generations) should be permanently reduced by 3%.

This provides a useful benchmark for maximal risk-sharing between generations. This seminal insight can be interpreted to mean that each individual’s portfolio should feature the same exposure to each type of risk, irrespective of their age. Obviously, this result hinges on strong assumptions (eg, uniform risk aversion), and should therefore be considered as a stylised benchmark only. But it makes two principles clear. First, shocks in wealth should be absorbed over the full life-cycle; second, all individuals should share in aggregate risks - including the elderly.

More private pension provision means governments have important responsibilities. Governments can facilitate risk sharing in private pension funds by providing tradable financial assets, such as GDP bonds and longevity bonds. By buying these public securities to match their liabilities, private pension providers do not have to maintain substantial solvency buffers. Moreover, participants can hold individual accounts with transparent property rights that can be valued on the basis of objective market prices.

To prevent moral hazard due to intergenerational redistribution, governments should mandate individuals to participate in funded pension saving plans. Mandatory or semi-mandatory participation in specific pension plans can give private plans
sufficient scale.

Financial illiteracy combined with the nature of the pension products as an experience can give rise to serious agency issues. Collective stand-alone pension funds can play an important role as trusted partners facilitating intergenerational risk-sharing. The scale and type of collectives will vary depending on the institutional setting and preferences of the country. The welfare effect of more individual choice raising competition on costs is ambiguous and depends on the specific institutions.

The role of different forms of mandated pension plans implies that the EU should be very careful in imposing unlimited competition and individual choice in the market for pensions. Pensions are complicated ‘trust’ products that are not easily understood by financially illiterate consumers. The resulting governance and agency issues may call for various restrictions on free competition and individual choice. Moreover, intergenerational risk sharing may demand commitment, which also limits individual choice.

Institutions dealing with these problems differ substantially across countries and therefore require tailor-made approaches.

The full CPB policy brief, ‘Private Pensions in Europe,’ was presented at the Bruegel think-tank in Brussels on 7 September 2011

 

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