Emma Dunkley speaks to Edward Whitehouse, head of pension-policy analysis in the social policy division at the Organisation for Economic Co-operation and Development (OECD) about how pension funds around the world have coped with the economic crisis
Emma Dunkley: How has the crisis affected pension systems?
Edward Whitehouse: The OECD average budget deficit in 2010 is expected to be nearly 9% of GDP. So we’re heading towards substantially higher public sector debt, from less than 75% of GDP on average before the crisis hit, to 100% in 2010. The UK has worse public finances in terms of deficit than other countries.
In some bank rescues, governments tend to get the money back, but for Ireland the IMF reckons that they will receive around 50% of it back
The economic crisis has implications for both public and private schemes. For example, last year Italy was spending 14% of its national income on pensions – the spending number in euros is unlikely to decrease with the economic cycle, so they have to finance that out of a much smaller GDP.
Emma Dunkley: What have governments done in terms of pension reforms to deal with the crisis?
Edward Whitehouse: Hungary and Australia announced major reforms in May, New Zealand has made some changes more recently. So countries are really addressing the long-term structural problems with their pension system as well as responding to the crisis in the short term.
For example, Australia’s pension funds were the second worst hit by the crisis after Ireland, so they have a series of questions as to how private pension funds are invested in Australia. Australia also has the fourth highest pensioner poverty rate of OECD countries after Korea, Mexico and Ireland again.
So there’s a problem in Australia in terms of their old age safety net and they’ve addressed that through a big increase in the means tested pension. The target for that benefit would go from 25% of average earnings to 27.8% meaning, if you divide 27.8% by 25%, an 11% increase in target pensions.
In Ireland, they’ve so far used 40% of the accumulated pension reserve fund to bail out the banks. So the pension fund portfolio now is mainly preference shares in Irish banks. In some bank rescues, governments tend to get the money back, but for Ireland the International Monetary Fund (IMF) reckons that they will receive around 50% of it back. So that’s a problem here – some of the reserve fund’s asset values have been hit by the crisis, but then the government is raiding them.
Emma Dunkley: Should governments do more to help the situation?
Edward Whitehouse: For defined benefit occupational plans in Ireland, the funding ratios are similar to the UK – about 75% – so that means their liabilities are a quarter larger than their assets.
The problem in Ireland is they don’t have anything like the UK’s Pension Protection Fund (PPF), and the Irish minister has quite rightly said that they’re not introducing a PPF. These are dangerous black holes and we’re in potential danger of seeing a lot of resources sucked into them. The Pension Benefit Guaranty Corporation (PBGC) was basically insolvent on the day it opened, and the PPF I think could face serious difficulties soon.
In Germany, for example, they’re expecting a couple of pension funds to go under – Opal (GM Europe) and a retail firm – they believe if both of those go, which is quite likely, they will have to quadruple the levies on the pension schemes for the insurance scheme.
I think for Opal, the pension fund might have to be rolled out, as I don’t think the new Opal would carry that on. But Germany is complicated because there is a lot of book reserve financing, so it’s not the trust based system where there is clearly separated assets, as in English-speaking countries.
Emma Dunkley: In terms of investments were those countries that were worst hit the most exposed to equities?
Edward Whitehouse: Very clearly. The reason Ireland lost the most is that they had the most in equities. Interestingly the UK has a lot in equities and has done better than one would expect. The UK has a similar equity share to Australia and the US, but has experienced smaller losses – 17.4% in the UK and around 26% in Australia and US.
For Hungary and Iceland, even the money they had in government bonds has crashed so not all government bonds were a safe haven last year.
Overall in 2008 equity markets were down 43% and bond markets were up 7.5%.
Emma Dunkley: So you still advocate diversification strategies, but you also believe in a lifestyling approach with a change to safe-haven investments towards retirement?
Edward Whitehouse: We believe that people in their 20s should probably have up to 100% of their money in equities and people in the run up to retirement perhaps just 25% to 35%.
However, the problem in the US is that although two-thirds of the 401(k) plans offer some sort of lifecycle investing – such as a target date fund – the equity share for people in their 20s is 90%. This is fine, but it is still around 53% for people between 60 and 65 which is a little on the optimistic side in terms of rewards and risks.
But of people in the two thirds of 401(k)s with a lifecycle option, only a quarter of the members actually invested at all in the lifecycle fund. Even then they didn’t put much of their money in it. So overall, only 7% of assets in 401(k) plans in the US are in lifecycle funds.
In Australia, there is investment choice but most people stick with the scheme’s default option which is usually a standard balanced fund, with 60% in equities 40% in bonds and other things. However, this is a one-size-fits-all portfolio. Investors should have a higher equity share if they are younger, while this is not appropriate for people in the five years running up to retirement.
So the detail requirement on the design of lifecycle schemes is important. Also, how can we make sure most investors are invested in them? Most countries are trying to move towards this, particularly Eastern European countries, which established their compulsory private pensions only recently, in the late 90s. But I would find it difficult to see how one could run something like this in the US or in Australia. It’s difficult legislatively and politically, because you have to carry the providers with you, be they industry funds or retail funds in Australia or 401(k) providers in the US.
In Chile, each provider has to offer five funds, with the riskiest having, broadly speaking, around 80% in equities, which is then 60%, 40%, 20% and 0% respectively moving to the less risky portfolios. With age, investors are automatically moved by a default which switches them to the less risky funds as retirement gets closer. This means that for older workers, it’s not possible to reject the default and pick the riskiest option.
This is where some of the detail design comes in because there is the problem that people are jumping between these different portfolios and there is a real time issue, because you don’t want to hit your 50th birthday and go from 60% equities to 40% equities. Investors want the transition to be smooth, so I’m not sure this is the optimum design for these funds. A lot of careful thinking needs to go into this, to get the precise design right. But certainly the US experience is that it’s not sufficient just to offer lifecycle portfolios, people need to be guided towards them.
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