How investment can help deal with the pension crisis

  • To understand what the current situation with pensions is globally.
  • To list the various changes in the pensions and investment industry.
  • To be able to discuss potential alternative arrangements for retirement.
How investment can help deal with the pension crisis

A major global pension crisis is threatening the two main pillars of pension systems 

Pension systems in most developed countries are based on two main pillars.

The first pillar, which is key for social cohesion, is made of public social security benefits and aims at providing a universal core of pension coverage to address the basic needs of retirement through funded public pension systems or unfunded pay-as-you-go (PAYG) systems.

The other pension system pillar comprises of private occupational pensions which are expected to provide additional replacement income for retirees. 

An analysis of pension systems throughout Europe suggests that pillar 1 pension arrangements are seriously weakening, as most so-called ‘funded systems’ are severely underfunded.

In the UK, for example, the deficit of the funded public pension system is currently estimated to be $4trn and is expected to grow to reach a $33trn by 2050.

For countries that have unfunded pay-as-you-go systems, such as France and Germany, the situation is also extremely worrying. In these countries, rising demographic imbalances with aging populations are slowly but surely making the system unsustainable.

Looking at second pillar, private pension funds have been particularly impacted by the shift in accounting standards towards the valuation of pension liabilities at market rates, instead of fixed discount rates, which have resulted in increased volatility for pension liabilities.

This new constraint has been reinforced in parallel by stricter solvency requirements following the 2000-2003 pension fund crisis.

The evolution of accounting and prudential regulations have subsequently led a large number of corporations to close their defined-benefit pension schemes to new members and increasingly to further accrual of benefits so as to reduce the impact of pension liability risk on their balance sheets and income statements.

Overall, a massive shift from defined benefit (DB) pension to defined-contribution pension schemes is taking place across the world, implying a transfer of retirement risks from corporations to individuals. 

Retirement products are inadequate

Available retirement products are mostly inadequate to address retirement needs. 

With the need to supplement public and private retirement benefits via voluntary contributions, individuals are becoming increasingly responsible for their own retirement savings and investment decisions.

This global trend poses substantial challenges, not only to individuals, who are typically lacking the expertise required to make such complex financial decisions, but also to policy makers and regulators.

In the context of such a massive shift of retirement risk onto individuals, the investment management industry is facing an ever greater responsibility in terms of the need to provide suitable retirement solutions to be used within the context of defined-contribution corporate pension funds, and individual retirement accounts, which form the third and last pillar of pension systems.

Unfortunately, the current investment products distributed by asset managers or insurance companies hardly provide a solution to investors’ and households’ replacement income needs in retirement.