Pension funds as investors

Tito Boeri, Lans Bovenberg

16 May 2007




Pension funds are, together with insurance companies, the largest institutional investors in global financial markets. Their performance affects the wellbeing of million of citizens and influences financial markets as well as macroeconomic stability. These giants can support innovation and growth, by sharing risks more effectively across individuals, but they can also end up jeopardising retirement plans of older workers and “disrupting the smooth functioning of the financial system” (the words used recent by the President of the ECB, Jean Claude Trichet). We argue in a recent report* that better regulations are needed to guarantee a growth enhancing development of the pension fund industry. They concern both accounting and disclosure requirements, default options as well as the internal structure of pension funds. These regulations are more effective when accompanied with reforms of public pensions and labour markets. 

 Households typically lack the basic financial knowledge and computational ability to implement complex financial planning over the life cycle. In addition, the distribution of individual pension plans involves high marketing and management costs, as well a substantial risk of mis-selling. We thus favour mandatory participation in collective pension plans offering a limited number of default choices. Competition among pension funds should occur at the wholesale rather than at the retail level as pension funds can take advantage of an integrated market for financial services by contracting out various asset management and other services.

 Accounting and funding standards should be harmonized across countries in order to provide for a level playing field. Individual countries should not be able to use their pension regulations as an implicit industrial policy tool to protect their national industry. Harmonization should be pursued by evaluating liabilities on a mark-to-market basis in order to facilitate better risk management and enhance market discipline and transparency. Minimum harmonized standards for reporting on pension rights should also be defined, following the example of the “orange envelopes” sent to all contributors to public and private pensions in Sweden.

 Occupational pension schemes in which corporate sponsors guarantee pensions to their employees are being increasingly replaced by stand-alone pension funds in which participants share risks among themselves and on capital markets. We welcome this development. Workers should become less dependent on the firm they work for and companies do not want to become an insurance outfit in which pension-related risks dominate the risks associated with their core business. Furthermore, stand-alone pension funds can focus on serving the interests of the participants alone, thereby avoiding conflicts of interest. The new collective pension funds should, however, be explicit about how participants share various risks. Hybrid pension systems -- in which participants transform their risky, defined-contribution type claims into guaranteed defined-benefit type claims, as they grow older -- offer in our view the best risk sharing arrangement. By exploiting the longer horizon of younger participants to buffer shocks, pension funds can indeed alleviate the tension between facilitating macroeconomic stabilization and enforcing the market discipline associated with mark-to-market valuation. This enhances macroeconomic stability, allowing pension funds to continue to invest in risk-bearing assets, facilitating innovation and growth.

 Human capital allows working households to buffer more risks over a longer working life. Hence, more accumulation, better maintenance and more intense use of human capital and entrepreneurship is called for with the possibility to retrain and re-enter in the labor market at all ages. More flexible labor markets for elderly workers allow the speed and extent of phased retirement to act as a buffer for absorbing aggregate financial market and longevity risks. At the same time, a longer working life raises the return on human capital by lengthening the horizon for investments in training and facilitates greater flexibility in employment patterns over the life course by loosening the link between age and career progression. Policies reconciling family and work in an environment in which the human capital of women has become more valuable would protect fertility and this facilitates investments in human capital of young children. Moreover, indexation of pension benefits to the total wage bill and of the retirement age to life expectancy encourages firms to attune workplace cultures to the needs of older workers and to nurture the employability and adaptability of younger workers. Better functioning labor markets supporting the utilization and accumulation of human capital are essential ingredients for the pension fund industry to be able to conduct its key function of providing retirement income insurance in a aging society while contributing to growth and macroeconomic stability.

*'Dealing With the New Giants: Rethinking the Role of Pension Funds', Tito Boeri, Lans Bovenberg, Benoît Coeuré and Andrew Roberts, ICMB / CEPR, 27 July 2006. This is the 8th CEPR\ICMB Geneva Report on the World Economy Report.




Topics:  Financial markets

Tags:  Pension Funds, Labour Markets

President, Italian Social Security administration (Inps)

Professor of Economics and Scientific Director Netspar, Tilburg University and CEPR Research Fellow