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 Jorik van Zanden,
co-founder of the Jasper Forum
The need for capital markets and proper advice
Why and how do we have pensions?
The provision of income in old age is one of the most precarious of all social benefits. At a macro level, how do we prevent our elders from falling into poverty once they are no longer working? At a micro level, how do we ensure that the income decline in retirement is not too steep, thereby maintaining living standards? Many books have been written on the question of why we have pensions in the first place – notably by professor Nicholas Barr of the London School of Economics, who identifies three goals for retirement: consumption smoothing, insurance against longevity, and poverty prevention.
Each of these points raise the question of “why”. We arrange for pension systems to smooth the consumption of what we earn now, across to what we will need later. We then need to ensure that we have enough savings to reach what we might euphemistically call the “end of retirement”. Lastly, and this is a macro-goal, we need to redistribute a portion of our wealth to ensure that workers who did not earn enough over their lifetime do not fall into poverty in retirement.
The “why” is relatively straightforward and not overly controversial. The question of “how” is another matter.
A German example
Recently, Germany announced plans to establish a new super fund to support its retirement system. Although the country has one of the oldest ‘modern’ retirement systems in Europe – dating from the days of Bismarck – the effects of its generosity combined with rapid demographic aging, today underscores the need for reform.
All over the world, governments are struggling to keep the traditional welfare state afloat amidst global ageing, a lack of affordable housing, and climate change. In many countries, this struggle is approaching the crisis stage. Germany annually spends over €110bn subsidizing its statutory pension fund – nearly 25 percent of its overall €477bn state budget.
The country’s recently approved super fund would have to raise €200bn by the mid-2030s and the projected return on investments should permit the distribution of €10bn annually. As a start, an independent public foundation would be created, which is expected to receive a first €12bn capital injection in 2024 – much like other state funds such as those in Singapore, Sweden, and Norway.
As a pension enthusiast, it is interesting to see Germany shift to the Nordic way, rather than toward the occupational defined contribution plans that are common in the United Kingdom and, soon, the Netherlands. The rhetoric against such reform – often heard in both Netherlands and Germany – involves accusations of casino capitalism disguised as pensions, financial market risk and, according to Germany’s IG Metall labor union, not a way to make pensions safer.
Capital markets
While I am open to listening to these criticisms, I cannot help but firmly disagree. The truly risky bet is the one in playing out today – allowing fully one quarter of the state budget to be spent on the provision of pensions alone. The systemic risk implied by this strategy, to my mind, is greater than undertaking long-term investments in well-regulated capital markets.
Other countries have demonstrated that market-focused retirement finance strategies can greatly benefit the economy. The European Union, via several platforms, over several years, has attempted to mobilize long-term capital. The real “casino-gamble” is to rely solely on pay-as-you-go financing for retirement benefits. With an ageing population, the proportion of retirees in comparison to workers (old-age dependency ratio) is rapidly rising. If current taxes are used to pay current retirement benefits, contribution rates will need to dramatically expand. The German example (this is not limited to Germany whatsoever) would mean a tax rate of 22.3% for pension contributions alone.
Add to this the costs of healthcare, which rises in tandem with age, and we are looking at a risk on par with climate change when it comes to sustaining our way of life.
Diversify
To stabilize European retirement finance, we must develop mutually-supporting public and private sector solutions. With individuals becoming more reliant on taking care of themselves, whether via a lack of indexation for state pensions or the wind-down of defined benefit plans, action is needed. And people do not like to take action, as we have learned from behavioural finance. Adequate and affordable advice is thus key in enabling people to make well-informed decisions.
Going back to Professor Barr, we need to focus on the cost of advice. Financial advisory costs money, so the value of that advice must be worth it. Not without some irony, the level of capital needed to make advice worth the cost, is rather high. Examples from the UK show that many people with only a small amount of savings cannot afford financial advice, since their capital is too small. Access to high-quality advice, in some measure, can be considered a luxury.
This produces a “doughnut hole” in the advisory market: middle class retirement savers that need sufficient capital to merit advisory services. We must reach out to policymakers and convince them that money flowing into the capital markets is not a casino, but a well-placed investment in a sustainable future. And that some form of automaticity will be beneficial so that there is capital to be advised upon to start with. A friend recently expressed doubts that that Germany’s €200bn investment may not be enough – but it surely beats the status quo in many major European economies.
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