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The importance of funded pension systems is growing and the move away from 'pay-as-you-go pension systems administered by the state, in particular in countries where they are still dominant, is gathering pace. As a result, the financial asset of pension founds have grown dramatically, and their impact on the worlds financial markets is increasingly attracting the attention of policy-makers. It is widely recognized that the development of funded pension systems should be supported by the simultaneous strengthening of the infrastructure of the financial market. The ability of pension founds to maintain living standards during the retirement of the contributors is indeed crucially dependent on the performance of financial markets. Consequently, the expansion of a funded-pension sector requires a sophisticated and well regulated financial market.
By the same token, funded pension systems are affecting financial markets and, indeed, the world economy as a whole. The magnitude of this effect can be gauged by examining the accumulation of retirement funds in relation to GDP. Total pension assets in the OECD area rose from almost 29 % of GDP in 1989 to almost 38 % (or around $ 8. 7 trillion) in 1998. From 1991 to 1998 the average annual growth of asset holdings by pension founds was 10. 9 %. But these aggregates hide a good deal of variation between individual countries: the figures range from 117 % of GDP in Switzerland and nearly 90 % in the Netherlands to 3 - 6 % in France, Germany and Italy (Table 1). US pension funds grew by 12. 5 % in that period and those in Canada and the United Kingdom by rather less -- 6. 5 and 6. 8 %, respectively.
Sometimes the difference is striking: Italian pension funds expanded by 37. 8 %, although from a very low base, and those in Germany by only 7. 9 %. The growth of Japanese pension assets has been 9. 5 %, and French pension assets had a growth rate of 13. 3 %. Table Assets of Pension Funds in OECD Countries, 1989 - 98 % of GDP 1989 1991 1993 1996 1997 1998 Australia... 17. 6 23. 9 30. 3 31. 4 31. 6 AustriBelgiuCanada 26. 4 30. 0 32. 8 37. 7 41. 0 43. 0 Czech RepubliDenmark (1) 10. 9 12. 4 16. 6 18. 9 21. 1 23. 9 Finland (2) 19. 7 25. 1 34. 7 39. 3 39. 6 40. 8 France Germany (3 w Greece... 6. 5 6. 9 10. 3 10. 9 12. 7 HungarIcelandIreland... 31. 5 30. 6 38. 9 40. 5 45. 0 Italy Japan 38. 0 37. 4 37. 3 49. 4 40. 6 41. 8 Kore Luxembourg 19. 5 19. 7 18. 8 20. 3 19. 6 19. 7 Mexico Netherlands 45. 5 78. 4 72. 1 85. 0 86. 6 87. 3 New ZealandNorwaPoland - - - - - -PortugalSpaiSweden (4) 33. 4 31. 0 29. 6 25. 7 30. 5 32. 6 Switzerland 74. 7 72. 5 74. 7 86. 5 104. 3 117. 1 Turkey - - - - - -United Kingdom 62. 3 59. 7 58. 2 69. 2 73. 2 74. 7 United States 35. 7 38. 1 48. 2 50. 6 58. 9 58. 2... not available. - nil or negligible (1. ) Including company pension funds as from 1995. (2. ) Financial assets. (3. ) Including company pension funds as from 1992. (4. ) Including first pillar assets up to 1992. This range provides a broad indication of the scope for further growth of pension-fund assets in countries with ageing populations but with relatively small pension funds (France, Germany and Italy are examples). Clearly, the potential impact on individual capital markets would be enormous if retirement assets grew from, say, 5 % of GDP to the current OECD average of around 38 % or, even more dramatically, to the US figure of around 60 %.
The composition of the assets of pension funds also varies considerably. For example, pension funds in Belgium, the United Kingdom and the United States hold the majority of their assets in equities, whereas those in Germany and Italy invest largely in bonds. Patterns of holdings have been changing, although not uniformly across countries. Equity holdings of pension funds increased remarkably in 1991 - 98. The increase was largest in North America, with Asian-Pacific pension funds recording the lowest increase. Pension funds and other institutional investors involved in providing retirement income are affecting the financial markets through different kinds of 'financial intermediation channels and functions, and the marked rise in cross-border transactions by pension funds means that these intermediation functions are carried out more and more on an international scale.
The size of pension funds has also had an impact on the structure of financial markets: countries with large funded pension schemes tend to have highly developed securities markets; in countries with small pension-fund sectors, capital markets are relatively underdeveloped (the equity market in particular). Small differences even of 1 or 2 percentage points the return of pension-fund assets can make an enormous difference both to contribution rates and to retirement benefits over a life-time. The potential impact of regulations on pension-fund investments therefore becomes an essential issue for the financial performance of funded systems. A second but equally essential issue for policy is the influence of the financial-market infrastructure on the ability of pension funds to implement investment strategies in accordance with planned or desired risk-return profiles. A well-functioning funded pension system requires a stable and efficient financial-market infrastructure: the legislative framework; the system of regulation and supervision; the financial-accounting system; clearing and settlement systems; and the micro-structure for trading securities. Most industrial countries have made considerable, if uneven, progress in the development of a capital-market infrastructure, including a solid regulatory and supervisory framework.
Differences in disclosure requirements among countries are marked, partly because of different legal systems. In most emerging markets, the ability of regulators to monitor and enforce disclosure is weaker than in more mature markets. And recent events in South-East Asia demonstrate that a weak financial-market infrastructure, coupled with lack of transparency and accountability as well as inadequate disclosure standards, can prolong or exacerbate a confidence crisis. Indeed, to regain the trust of international investors, several Asian governments have stepped-up their efforts in strengthening disclosure requirements and reforming financial markets generally.
Risk Management and Regulation The 'fundamental principle of risk-management as applied to the allocation of pension-fund assets is that benefit security is maximized when the maturity and unit of account of assets are completely matched to deliver promised pension benefits. But higher returns can be obtained only by taking on higher risk, which requires a deviation from this principle. The asset-managers of pension funds, both inside and outside the firm, therefore have to adopt integrated and sophisticated risk-management systems that carefully define the investment risks in relation to the expected liabilities of the pension funds. Regulation should take account of the extent to which the implementation of standards for sound risk-management for pension funds can be linked to a relaxation of regulatory constraints on the allocation of assets. The implementation of risk-management systems, in turn, requires the adoption of a proper risk-accounting framework. Analysts have suggested that financial accounting requires a fundamental overhaul to allow the inclusion of various aspects of risk.
Indeed, in practical terms financial risk-accounting is already being undertaken. Financial firms that deal extensively in complex securities have developed risk-accounting protocols as part of their internal management systems. With the benefits of real-world experience, these protocols could serve as prototypes for a new branch of standardized risk-accounting. Pressures on Prices Concerns have been expressed that the growing demand for high-quality private securities (equity and corporate bonds), associated with the growth of advance-funded pension systems in search of investment opportunities (thereby increasing the demand for financial assets) and falling public-sector borrowing requirements (thereby reducing the supply of government securities), would put strong upward pressure on the prices of financial assets. Here, the combination of the widespread privatization of state-owned enterprises and reform of pension systems brings the opportunity of killing two birds with one stone. Pension reform, which would increase the demand for equity, and privatization, which expands the supply, simultaneously permit a more balanced growth in private securities markets, at least over the medium term.
In a somewhat longer-term perspective, population ageing may have an impact on the risk-premium (that is, the difference between the returns on stocks and the yield on bonds). Because asset preferences vary across age-groups, the ageing of the baby-boom generation could affect both absolute and relative positions of stock and bond prices. On average, middle age is the portion of the fife cycle when saving rates are highest. Moreover, middle-aged workers generally are more able and willing to hold a riskier portfolio; that is, one weighted more heavily towards stocks than bonds. (The real return on United States stocks, for example, averaged 9 % over the period 1947 - 96 with a standard deviation of 17 %. This implies that there is about a 30 % probability of a decline bigger than minus 8 % or a rise bigger than 26 % in any given year. The average real return on long-term United States government bonds over 1953 - 96, however, is much lower -- 3 % -- but also less volatile these returns have a standard deviation of 2 %).
This is a consequence of two factors: first, while still working, a stockholder is better able to make up for any bad equity returns; second, middle-aged workers have a longer time-horizon and thus are willing to accept more risk in exchange for the expectation of higher returns. In this case, the ageing of OECD populations will tend to increase the price of stocks and bonds, decreasing their rates of return. Moreover, higher demand for stocks relative to bonds should increase the price of stocks relative to bonds, thus decreasing the equity premium. After the baby-boomers begin to retire, saving fates would tend to fall, stock and bond prices to decline, and the equity premium to rise as baby-boom retirees shift their portfolios away from stocks toward bonds. In a protracted period of depressed asset prices and returns, even the most prudently managed pension fund might find itself in difficulty. The danger that large numbers of investors might find themselves deprived of adequate income on retirement might once again generate pressure on governments to intervene, as they have done in the recent past.
Potential problems of what economists call 'moral hazard mean that them is a delicate trade-off here between individual and collective interests. Setting-up an explicit system of government pension-guarantees, for example, might inadvertently encourage excessive risk-taking or inadequate funding by private pension sponsors. The experience of policy-makers in the design and operation of deposit-guarantee systems is especially relevant in this context, as the same 'moral hazard r...
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Research essay sample on Pension Founds And Financial Market
