Mandatory Pension Funds in Europe: ¿What is their Future? Klaus Schmidt-Hebbel

1. Mandatory Pension Funds in Europe: ¿What is their Future? Klaus Schmidt-Hebbel Former Chief Economist, OECD Catholic University of Chile FIAP Seminar on Investments and Payouts in Funded Pensions Systems Warsaw, 28-29 May 2009

2. Outline Global Financial Crisis and World Recession: the OECD’s and most recent Projections for 2009-2010 Financial Crisis and Private Pension Funds in Europe and beyond Lessons from the Crisis for Funded Pension Systems Reform Challenges for Europe’s (and other Industrial Countries’) Mandatory Pension Systems Conclusion

3. 1. Global Financial Crisis and World Recession: the OECD’s and most recent Projections for 2009-2010

4. OECD assessment and projections are based on “OECD Economic Outlook: Interim Report” (March 2009) http://www.oecd.org/document/59/0,3343,en_2649_34109_42234619_1_1_1_37443,00.html

5. Global Financial Crisis and Recession Worst financial crisis since the Great Depression Deepest and longest world recession since Great Depression Intensified by international synchronicity due to world integration of world goods and capital markets Ameliorated by most radical policy response in history: Support and rescue of systematically important financial institutions Massive conventional and unconventional monetary policy easing Major discretionary fiscal easing, complementing automatic stabilizers

6. World Recession and Recovery Annualized growth rate of seasonally-adjusted quarterly GDP Note: The non-OECD region is a weighted average, using 2000 GDP weights and PPPs of Brazil, China, the Russian Federation, and India, which together accounted for about half of non-OECD output in 2000.2. Trend growth for the non-OECD is the average over the period 2000-07. Source: OECD.

7. Most severe and synchronous OECD-area Recession Percentage of OECD countries with 2 quarters or more negative GDP Note: The last historical observation is for 2008q4. Source: OECD.

8. Main OECD Projections for 2009-2010

9. Large Rise in Unemployment Percentage of Unemployed in Labor Force Source: OECD.

10. Major Decline in Inflation 12-month Consumer Inflation Rate Note: Inflation is based on consumer price index (CPI )for Japan, PCE deflator for the US, and harmonised index of consumer price for the Euro area. Source: OECD.

11. More recent Projections Some recent real indicators – “green sprouts” – suggest that inflection points for activity good be attained before early 2010 Supported by partial but sustained recovery of stock prices (leading indicators) and commodity prices since March 2009 Partial but encouraging real-sector for the U.S. and China Yet disappointing data for 2009-1 growth in Japan and the Euro area, with lower lokelihood of an early and strong recovery Low inflation (and deflation) projected for the main OECD regions in 2009, with very low inflation throughout 2010

12. Partial but sustained recovery of World Stock Markets since March 2009 Source: Datastream. Last obs.: May 4, 2009.

13. Recent Projections for Growth and Inflation Source: Consensus Forecast / EIU, May 15, 2009.

14. 2. Financial Crisis and Private Pension Funds in Europe and beyond

15. Financial Crisis and Pension Funds • The crisis and the recession have caused the largest stock market losses recorded in many decades … • … implying major financial stress for both defined-contribution and defined-benefit pensions funds. • While sustained recovery in world stock markets seems to take hold since March 2009, it is still partial and fragile … • … and hence the double-digit pension wealth losses recorded in 2008 represent a major challenge to risk taking and risk sharing in funded pension systems.

16. Outstanding Pension Fund Assets in OECD Countries, 2007-2008 (% of GDP)

17. Nominal Investment Return of Pension Funds in OECD and non-OECD Countries, 2008 (%)

18. Real Investment Return of Pension Funds in OECD Countries, 2008 (%)

19. Real Investment Return and Exposure to Equities of Pension Funds in OECD Countries, 2008 (%)

20. 3. Lessons from the Crisis for Funded Pension Systems

21. Lessons from the Crisis • Pension fund losses from the ongoing crisis-cum-recession implies the large blow to the financial strength and political reputation of funded pension systems worldwide • Therefore funded pensions systems face major challenges to address their management and design shortcomings, as well as to repair their political reputations. • This is valid for FF-DC (fully-funded defined-contributions), FF-DB (fully-funded defined benefits) and PF-PAYG (partly-funded pay-as-you-go) systems.

22. Negative Lessons for FF-DC systems • Do NOT rescue individual pension system contributors from wealth losses (as opposed to rescues of bank depositors), because: • pension funds are not subject to systemic runs • too expensive for governments • raises future moral hazard of pensions funds • Better: let work government minimum guarantees • Do NOT relax conditions for early retirement or invalidity pensions (bad European experience in 70s and 80s)

23. Positive Lessons for all Systems During the crisis: • FF-DC: relax mandatory annuitization at retirement for some years in systems where it is the only option, allowing temporary phased withdrawals until asset prices recover partly • FF-DB (analogous to above): extend solvency recovery periods • Do NOT downsize privately-managed FF-DC pillars by enlarging government-managed PAYG-DB pillars (like in the Slovak Republic) – and certainly do NOT nationalize privately-managed pillars (like in Argentina)

24. Lessons for all Funded Systems (1) After the crisis, evaluate and implement: • alternative ways to limit or disincentive excessive risk taking for the poor and/or those nearing retirement: • impose default shift to lower-risk investment portfolios • possibly limited to finance a minimum threshold pension • or impose mandatory acquisition of a deferred annuity at a threshold age • at date of retirement, force pensioners that choose phased withdrawals to complement them with a deferred annuity • improve insurance (subsidies) for low-income contributors and for reducing non-contributory spells • extend programs of financial information for contributors in systems with investment choices.

25. Lessons for all Funded Systems (2) After the crisis, evaluate and implement (continued): • strengthen supervisory oversight of pension funds by: • stricter stress testing • more frequent on-site visits • increased reporting • adoption of risk-based supervision • coordinate more closely with other financial supervisors • adopt counter-cyclical provisioning and solvency rules for FF-DB systems • analogous to counter-cyclical macro-prudential regulation of Spanish banks (pro-cyclical bank provisions) • good for pensions funds and for the aggregate economy • lower disincentives to work longer, providing more flexibility to recover from financial losses.

26. 4. Reform Challenge for Europe’s (and other Industrial Countries’) Mandatory Pension Systems

27. Systemic Transition Europe is (and other industrial-country regions are) very heterogeneous in pension systems and plans Yet industrial countries are in a gradual and multi-dimensional systemic pension transition: • from DB to DC pension plans • from occupational to personal plans • from PAYG to FF systems • from book reserves to funded plans • from public to private plans (funds) • from voluntary to mandatory systems (and back)

28. Potential replacement ratios at normal retirement age in OECD countries: public pension, mandatory private pensions, and typical occupational plans Source: OECD.

29. Private pension assets compared with the public pension system's gross replacement rate in OECD countries, 2007 Source: OECD.

30. Trends in total OECD pension funds assets, 2001-2007 (US$ b.) Source: OECD.

31. Pension funds assets in OECD countries, 2007 (% of GDP) Source: OECD.

32. Pension fund assets in selected non-OECD countries, 2007 (% of GDP) Source: OECD.

33. Systemic Transition is too slow Europe’s (and other OECD regions’) systemic heterogeneity is unacceptably large and its systemic pension transition is unacceptably low Why “unacceptable”? Because of: • financial/fiscal unsustainability of state-managed PAYG-DB systems • efficiency (labor-market, capital-market, and growth) costs of PAYG and occupational pension systems • intra and inter-generational equity costs of PAYG and occupational pension systems

34. The Reform Challenge Europe’s (and other OECD regions’) pension system transition should be accelerated toward multi-pillar systems where the mandatory contributory (second) pillar should be dominantly (or exclusively) FF, based on personal plans and DC that are internationally portable, as well as privately-managed and well-regulated World-wide experience collected during the last three decades (and the last 9 months) shows that regulatory design and supervision of the latter pillars should tackle their main weaknesses – and this can be done: • Low(er) coverage • Weaknesses of redistribution/social insurance of first pillar • Competition failures • Excessive risk taking • Lack of consumer information.

35. 5. Conclusion

36. Conclusion “Policies to further develop private pension systems are urgently needed in (some) OECD countries” OECD: “OECD Private Pensions Outlook 2008”, 2009, p. 43.

37. Mandatory Pension Funds in Europe: ¿What is their Future? Klaus Schmidt-Hebbel Former Chief Economist, OECD Catholic University of Chile FIAP Seminar on Investments and Payouts in Funded Pensions Systems Warsaw, 28-29 May 2009