How the Rise of Pension Funds Will Change the Global Economy in the 21st Century

How the Rise of Pension Funds Will Change the Global Economy in the 21st Century

November 15-16, 1996

There can be little doubt that the great economic policy challenge of the 21st century will be how to finance everyone's retirement. The world's population is aging rapidly in both the old industrial countries and in many developing countries. Only a few countries have well-funded private pension programs. As the divisions in the recent White House task force report on Social Security reform will testify, there is no consensus about how to reconcile the financial needs of the retired with other important policy objectives, such as raising national savings rates or controlling government budget deficits. There is also little appreciation of how the coming expansion of pension fund assets will influence issues such as corporate governance and international economic relations.

The problem of retirement funding will dominate debates about economic policy for the next quarter-century because the aging process now under way in human populations has no historical precedent. Two-thirds of all the people who have ever lived to the age of 65 are alive today. With birth rates falling and life expectancy still increasing, the ratio of retired people to working people is poised to rise dramatically during the next few decades. In the United States, the ratio of working to retired people will fall from 5.3 to 3.3 by the year 2040. It will plunge from 5.8 to 2.6 in Japan and from 4.5 to 2.1 in Germany. It took France 140 years to increase the fraction of its population over the age of 65 from 9 percent to 18 percent. China will pass the same demographic threshold by 2030 and have 400 million people over the age of 65, compared to 100 million today.

The great challenges that every society will have to confront is how to develop effective retirement funding systems for the elderly that do not undermine private savings and investment through crippling levels of taxation on the young.

Practically every country has some form of state-funded transfer payment program to the elderly, but there are great differences in how the systems are funded, the levels of replacement income they guarantee upon retirement, and the role of private pension funds in supplementing government programs.

The United States, Britain, Switzerland, Denmark, Holland, and other English-speaking countries have large, well-funded private pension programs with assets equal to 50 to 100 percent of gdp. These schemes provide retirement benefits for about 40 to 50 percent of the retired population, on top of government transfer payments, such as Social Security. The United States has encouraged the growth of private pension funds through tax deferrals on investment income for retirement, while Britain redesigned its state pension scheme during the 1980s to encourage widespread use of individual retirement savings accounts. A few developing countries also have established comprehensive retirement savings programs, with assets equal to half of national income, including Singapore, Malaysia and Chile. But in most other countries, private pension funds are modest and governments provide most retirement benefits on a pay-as-you-go basis. When the ratio of workers to retired people is five to one, it is not difficult to finance pay-as-you-go retirement schemes. But in the 21st century, these systems will impose such large tax burdens that there is likely to be great political conflict over the cost they impose on those still working.

Continental Europe probably faces the greatest retirement funding crisis, because it is aging rapidly and is lagging far behind the United States and Britain in developing private pensions. The oecd, for example, is projecting that pension costs in the year 2040 will be equal to 21 percent of gdp in Italy, 18 percent in Germany, 17 percent in Spain and 14 percent in France. In the United States, Britain, and Australia, by contrast, the development of private retirement savings and the accumulation of assets in the Social Security fund should hold public expenditure on pensions at under 8 percent of gdp.

The only good analogy to the magnitude of the fiscal challenge posed by the aging of Europe's population is war. During the past 200 years, countries such as the United States and Britain have seen their ratios of public debt to gdp rise above 100 percent only during periods of military conflict. In the aftermath of World War II, for example, the ratio of public debt to gdp in Britain was 200 percent, while in the United States it was 125 percent. During the past two decades, Europe's generous transfer payment programs have increased the European Union's ratio of public debt to gdp from less than 40 percent to 80 percent while a few countries, such as Italy and Belgium, have pushed their ratios above 120 percent. Many European countries also have enacted such generous retirement programs that their unfunded pension liabilities are now equal to 200 to 300 percent of gdp on top of existing ratios of public debt to gdp in the 80 to 120 percent range.

There are three possible ways in which Europe can respond to this fiscal challenge: reduce benefits, raise taxes, or increase labor force participation rates in order to spread the cost of retirement benefits over a larger workforce. Some European countries have such low labor force participation rates that they may be able to cope with aging by increasing the portion of the young population that is actively employed. In France and Germany, for example, labor force participation rates are below 70 percent compared to 78 percent in the United States while in Italy they are only 59 percent. As a result of their depressed economies and restrictive labor laws, most European countries also have high levels of unemployment, which further reduce effective labor force participation. Consider, for example, the impact of the low labor force participation rate and high unemployment rate on the French economy. If we disaggregate France's population on the basis of economic functions, 38 percent is actively employed, 5 percent is officially unemployed, 21 percent is voluntarily inactive, 20 percent is below working age and 15 percent is retired. The ratio of retired people to working people is 40 percent today and is projected to expand to 55 percent in the year 2020 if every other relationship remains constant. But if France can reduce unemployment to only 2 percent of its adult population and lower the share of inactive adults to 15 percent, the ratio of retired people to working people will rise to only 45 percent. In countries with large numbers of non-working adults, it should be possible to offset some of the increased cost of pensions by expanding the share of the population under age 65 that is actively employed. But the low labor force participation rates of France, Germany, and Italy are not an accident. They are the by-product of public policies that inhibit job creation by imposing large tax burdens on employers while providing generous transfer payments to the unemployed. The countries with low labor force participation rates thus face two challenges. They will have to contain the burden of funding future retirement programs by both liberalizing their labor laws and boosting their pension fund savings. The French government has been very cautious about modifying the country's restrictive labor laws because of concern about social unrest, but it has recently enacted legislation to create more tax incentives for pension fund savings. Chancellor Helmut Kohl has begun to chip away at Germany's burdensome labor laws, but his government has done little to promote the growth of private pension funds.

Japan is ahead of continental Europe in developing private pension funds. Private pension plans account for about one-fourth of the country's $1.8 trillion of pension assets. But the poor performance of the Tokyo stock market since 1990 has left many firms with significant unfunded pension liabilities. According to brokerage house reports, the low return on Japanese pension funds during the 1990s has created a funding gap equal to 15 to 20 percent of corporate equity at large companies. During the 1980s bull market, Japanese firms turned over their pension funds to local insurance companies and trust banks, which had little problem generating returns of at least 8 to 9 percent. During the past two years, by contrast, the life insurance companies have suffered such severe losses on their equity and real estate portfolios that they have had to reduce yields on their investment products to only 2.5 percent, despite the fact that corporations need returns of at least 5.5 percent per year to achieve their actuarial targets. Japanese corporations will probably respond to this shortfall by both increasing contributions and shifting responsibility for their pension funds to new managers. Until recently, Japanese corporations awarded fund management accounts on the basis of long-term relationships with banks and insurance companies. But as a result of the low returns on their pension plans during recent years and the international pressure on Japan to open its financial system to foreign competition, the odds are good that Japanese companies will diversify away from trust banks and insurance companies during the next few years.

The most dramatic progress in establishing pension funds is occurring in the developing countries. As a result of the financial crisis that followed Mexico's 1994 peso devaluation, most Latin American nations are now establishing comprehensive pension savings schemes modeled after the Chilean program introduced during the early 1980s. The Chilean pension program increased the country's savings rate to over 28 percent from 22 percent and now has assets equal to almost 45 percent of gdp. Brazil has pension assets equal to only 9 percent of gdp and Argentina 3 percent of gdp, but in 10 years their pension assets will probably exceed one-third of gdp. The success of Singapore and Malaysia in boosting their savings rates through pensions is now attracting the attention of Asian developing countries that have large current account deficits, such as Thailand and the Philippines. China provides retirement income for its state enterprise industrial workers on a pay-as-you-go basis, but the World Bank recently published a report on the introduction of a comprehensive pension program for the whole population. China already has a 40 percent savings rate, but it could fall rapidly during the next century in response to both the aging of the population and the introduction of consumer debt. The fact that China already has 25 million retail investors in stock markets re-established only six years ago suggests that there would be broad public support for tax-deferred pension savings programs if they were introduced.

There is now such widespread awareness of the coming crisis in retirement funding that practically all industrial and middle-income developing countries will soon have some form of universal pension savings program. What remains to be seen is how they will invest the money in their funds and how much they will permit benefits to fluctuate in response to investment performance.

The United States is becoming unique in having a Social Security Trust Fund that invests only in short-term government debt. The public pension funds of most other countries now invest in a mixture of government debt, equities, mortgages, and in some cases even foreign securities. Corporate pension funds are even more aggressive in diversifying their assets. In Britain, private pension funds have 80 percent of their assets in equities, while in the United States they have about 60 percent of their assets in equities. The case for investing in equities is very simple. The long-term real return on equities in the United States and Britain has averaged about 7 percent during the twentieth century compared to 2 to 3 percent on government debt. Some developing countries are also encouraging their pension funds to invest in equity in order to promote the privatization of state enterprises and the development of local stock markets. In the modern era, there has been a strong correlation between the growth of pension funds and the role of stock markets in the economy. The United States, Britain, and other English-speaking countries have high ratios of stock market capitalization to gdp in part because of a steady flow of pension fund income into corporate equities and debt. The German stock market is small and primarily a tourist attraction, because German pension funds are insignificant. The development of pension fund assets in Latin America is now also having a major impact on the growth of stock market capitalization in the region.

Some government officials are concerned that diversification of the U.S. Social Security Trust Fund away from government debt will drive up Treasury bond yields. But with the assets of the Trust Fund projected to expand to $3 trillion by 2020 from $400 billion recently, it is far from clear that the government debt market can absorb the tremendous growth projected to occur in Social Security investments. The stock of marketable U.S. federal debt is about $3.4 trillion while the U.S. equity market is now worth over $7 trillion. If the Social Security Trust Fund put only 25 percent of its assets in the equity market at the peak of its expansion, it would own about 15 percent of the total equity market at today's capitalization, compared to 30 percent of the current federal debt market.

The other issue that provokes great controversy in the management of private pension funds is defining the level of benefits. Should retirement income fluctuate in response to the investment performance of a pension fund?

Until recently, America's retirement savings programs were primarily defined-benefit plans that guaranteed a certain pension income irrespective of the return on the fund's assets. The Social Security System also functioned like a defined-benefit program. It guaranteed every retired person a certain level of income and then collected the taxes required to make the payments. But during the past decade there has been a significant movement in America's private pension programs away from defined-benefit programs to defined-contribution programs. In 1995, 42 million Americans belonged to defined-contribution pension programs with $1.3 trillion of assets, compared to 17.5 million people with $162 billion of assets in 1980. Defined-benefit plans, by contrast, now have 24.8 million members and $1.5 trillion of assets compared to 30 million members with $400 billion of assets in 1980. Under defined-contribution plans, individuals have far more responsibility for their retirement savings than was the case with defined-benefit plans. They are usually given discretion as to how much they want to invest in the program as well as some choice over how the assets are allocated between various categories of debt and equity mutual funds. One of the reasons the assets of the U.S. mutual fund industry have expanded to $3.4 trillion from $1.1 trillion in 1990 is the growth of defined-contribution retirement savings programs. About one-third of mutual fund assets now consist of various defined-contribution retirement savings programs. According to the Investment Company Institute, 37 percent of all U.S. households now own a mutual fund, compared to 6.0 percent in the early 1980's.

There is a risk that if financial markets perform poorly, individuals could have a smaller retirement income under a defined-contribution program than under a defined-benefit plan. Chile has tried to minimize this risk in its privately managed pension programs through careful regulation. All managers must contribute capital to a reserve. If their funds generate a return 2 percent below the industry average, they have to make up the difference with a transfer from the reserve. Managers with returns more than 2 percent above the industry average also have to transfer the surplus to the reserve fund. If the United States were to develop a privately managed Social Security system, it would probably impose comparable constraints on the investment performance of managers. But even if Social Security is never privatized, the sheer growth of private defined-contribution pension programs is already having a positive impact on American household wealth and retirement income.

It is also quite likely that the growth of defined-contribution programs will have a more positive impact on the country's aggregate savings rate than the old defined-benefit plans. Under the traditional defined-benefit program, the household sector was a de facto target saver--when a corporation satisfied its actuarial requirements for projected pension liabilities, it typically reduced contributions to the pension program and thus depressed the national savings rate. As pension funds had to be financed out of profits, there was no incentive for a company to maintain or increase contributions if a rising stock market produced large capital gains for the fund. On the contrary, there was a risk that if a corporation developed a large overfunded pension fund program, it would attract the interest of corporate raiders. In the mid-1980s, for example, Carl Ichan helped to finance his takeover of TWA in part by withdrawing surplus capital from the company's overfunded pension plan. While there has not been time to quantify the full economic impact of the recent movement towards defined-contribution pension plans, it may already be having a positive impact on the U.S. savings rate. Since 1994, the U.S. household savings rate has increased from 3.4 percent to 5.3 percent despite the fact that the household sector has enjoyed over a $2 trillion capital gain on its equity portfolio. In the mid-1980's, rising stock and bond prices helped depress the national savings rate by encouraging corporations to reduce contributions to their defined-benefit pension plans. The growth of defined-contribution pension plans has lessened the risk of rising equity prices depressing the U.S. savings rate during the 1990s.

In the past, there has been a weak link between the level of pension fund savings and national savings rates. Countries such as the United States and Australia have had lower savings rates than Germany despite the huge gap in pension fund contributions. As the share of household income devoted to pension funds grew, they often reduced other forms of savings and thus restrained the aggregate savings rate. But the growth of defined-contribution savings programs is likely to strengthen the link between pension fund development and national savings rates by creating incentives to maintain or even increase savings in the face of rising asset prices.

If defined-contribution pension plans have a positive impact on household savings rates, the U.S. need for foreign capital will diminish over time. Conversely, Japan and Europe could experience an erosion in their savings rates because of the cost of funding retirement programs for such large elderly populations.

The potential influence that pension funds could have on savings rates suggests that they will become an increasingly important determinant of global capital flows. In mature industrial economies, the high savers are usually old people preparing for retirement, while the debtors are young people establishing families. In the United States, for example, 80 percent of financial assets belong to people over the age of 55 years. As a result, it is not surprising that capital-importing countries are often young, newly developing countries, while the capital exporters are older and more mature industrial countries. What remains to be seen is how these patterns will change when some industrial countries have such large elderly populations that they consume most of the surplus capital accumulated to pay for retirement. Will their savings rates decline sharply, forcing them to import capital to finance their budget deficits? Will the erosion of their savings rates drive up domestic and global interest rates to a level that depresses investment? It would not be an exaggeration to suggest that the outlook for world interest rates in the 21st century will be heavily influenced by the speed at which the expansion of pension funds in the newly industrializing countries offsets the erosion of savings in the more aged societies of Europe and Japan.

How countries organize their retirement funding systems will have major consequences not only for their savings rates and current accounts: the structure of pension funds is also likely to have a profound impact on their systems of corporate governance. In the United States, Britain, and other English-speaking countries, pension funds have become an important force in encouraging corporations to promote a higher return on capital for their shareholders. In Japan and continental Europe, pension funds play a far less influential role in governing corporations, and management thus focuses on other goals, such as maximizing the growth of sales or assets irrespective of the impact on profits. Such differences in corporate objectives have played a major role in producing trade conflict and other commercial tensions between countries following the Anglo-Saxon model of shareholder accountability and alternative visions in Japan, Korea, and some continental European countries. But if all societies were to introduce comprehensive pension savings programs, the odds are good for more convergence in the goals of corporations all over the world. Instead of the Japanese and Anglo-Saxon forms of capitalism encouraging different investment agendas, pension fund trustees will require management everywhere to focus on maximizing the return to corporate shareholders, not stakeholders such as corporate suppliers, banks, or employees.

The crisis in Japan's private pension plans is already forcing corporations to reconsider the criteria they use for selecting fund mangers. The shift from relationship-based investment management contracts to awards based on performance will set the stage for a significant restructuring of the corporate cross-shareholding networks that have dominated the Japanese stock market since the 1960s.

The growth of pension fund assets in both industrial and developing countries is also likely to make the fund management industry a more important trade issue. It has been difficult to achieve an acceptable GATT framework for the financial services sector because of opposition by banks and insurance companies in developing countries to greater foreign competition. But since the fund management industry is a relatively new and undeveloped sector outside the English-speaking countries and Switzerland, there should be less entrenched opposition to permitting foreign entry than would be the case with a highly developed and politically influential industry such as retail banking. As American firms have a comparative advantage in many aspects of the fund management industry (technology, investment research, portfolio management) it would make sense for the U.S. government to focus more of its trade liberalization efforts in the financial services industry on sectors such as fund management.

When the Cold War ended in 1989, there were probably fewer than 100 million people in the world economy who owned shares of stock either directly or through some form of retirement savings program. In another quarter-century, it is not difficult to imagine the world's population of equity owners expanding to two billion because of the introduction of pension funds in all industrial and middle-income developing countries. The full consequences of this development for fiscal policy, the role of stock markets, corporate governance, and international economic relations are still only vaguely understood. But because the aging of the world's population appears to be such an irreversible force, there should be little doubt that the universal introduction of pension funds will be one of the dominant forces reshaping the behavior of all capitalist economies during the early 21st century.