Contents:
For pension funds, this set-up is attractive. In the final section of this article we advocate a discount rate that replaces the inefficient financial market outcome by a connection with the economic circulation in defining the rate as structural nominal GDP growth. Pension funds then have the advantage that an integral part of their income is not influenced by financial market volatility 4.
Both pension funds and the government will benefit. In a recent publication, the Bank of England states that this is a way of risk-sharing between government and private sector which secures the long-term durability of government financing. In the present situation, with rock-bottom rates, is it attractive for the government to enter such a swap?
Nominal GDP growth is also low and gyrates along long-term government rates plus spreads for credit risk and illiquidity risk.
So, even in these extraordinary times, this swap seems attractive for the government, and that is without taking into account the advantages of the overall proposal. This leaves intact the possibility to demand a return on investment equal to nominal GDP growth as the pay-off of many infrastructure projects have a positive correlation with that growth. Finally, it is easy to see that it would be advantageous when more countries simultaneously join in these efforts.
In a collective pension system with intergenerational transfers, the discount rate plays an important role. Current rules in most countries are based on the fictitious scenario of a short-term liquidation of the fund, using a second fictitious scenario in which financial markets are able to value accrued pension liabilities.
Moreover, in countries like the Netherlands, it is assumed that these liabilities are nominal and risk free.
"This book consists of a collection of papers that deal with the effect the assumption of endogenous growth has on the functioning of public-pension plans. pension system and economic growth in an overlapping generation model, . income, public pensions are bad for growth in an economy with.
This risk assumption is unrealistic and is not in accordance with pension practice. It is a political assumption, interfering with intergenerational distribution 5. Whatever the reason and whatever the specific assumptions with regard to the appropriate risk-free rate, the choice of discount rate for valuation of liabilities makes the fund vulnerable to volatility in the financial markets.
It is ironic that the design of the collective pension system, covering financial risks for old age has become the opposite because of this choice. Participants are confronted with volatility and periodic derailments of financial markets and, moreover, the framework contributes to pro-cyclical movements in contributions and pension payments.
A second objection is its overriding influence on investment policy. The right-hand side is dominated by its exposure to interest rate risk. For this risk, extra buffers need to be created, unless this risk is mitigated one way or the other, for instance by compensating rate exposure on the left side of the balance sheet. As their buffers are depleted by the regulation itself and low interest rates boosting liabilities, pension funds have to hedge, leading to a concentrated investment portfolio of long-dated government bonds.
In recent years, with continually declining rates, this was beneficial for funds, but in the future these bonds will be a disaster.
Balance sheet risks are hedged at the present nominal pension level, so inflation will kill the purchasing power of this nominal amount and, with a reviving economy, pensions will lag behind. In fact, pension funds without sufficient buffers to take extra risks find themselves in a poverty trap. The real issue is whether or not there is another system for determining the discount rate that will include a fair treatment of generations. This rate must be prudent, that is, not higher than future returns to be expected from a well-diversified investment portfolio.
Next to that, the rate should follow changes in the economic environment. Taking into consideration these properties and following our preference for an economic approach on pensions, our proposal is to fix the discount rate at the nominal growth of GDP.
This has clear advantages. Changes in economic growth lead to changes in the calculated financial positions of pension funds and will induce changes in pension payments along this road. Pension ambitions follow general welfare, be it exact or at a certain distance. The choice for nominal GDP growth is prudent.
The average long-term interest rate is, over the long run, more or less equal to this growth, a bit lower in the Netherlands, and somewhat higher in the US. Equity returns, on average, are higher than this growth figure. Structural GDP growth does not show the random walk of financial markets and, therefore, can serve as an stability anchor. We have attempted to assess the relation between pensions and economic growth from an economic perspective instead of using financial market paradigms.
Direct investments by pension funds in the real economy are beneficial. As pensions eventually need to be paid from economic output, it is a logical consequence to base the discount rate directly on the central economic factor — GDP growth. That fits the macroeconomic function of pension funds as a provider of risk capital for economic growth, which contributes directly to the real component of GDP. The so-called security sought-after in the present regulatory framework is only obtained by investing in AA or higher-rated government bonds, which is disastrous for future pensions.
Replacement by more real investments will strengthen the economic structure, which is the real securitisation of future pension payments.
In its World Economic Outlook, , the IMF passionately advocates increasing infrastructure investments to stimulate economic growth. Governments in both developed and emerging countries should lead the way because massive external effects are to be expected and, almost by definition, these effects do not provide sufficient stimulus for private investments, focused as they are on micro profits. These investments create a short-term demand-pull effect and a longer-term capacity effect.
The problem is broader than just insufficient infrastructure; scientific developments in IT, nanotechnology, robotisation, fuel technology and so on need more seed and development capital. In the longer run, better infrastructure benefits growth, which in turn crowds in private investments as indicated empirically. Brookings Papers on Economic Activity , Fall That fits the macroeconomic function of pension funds as a provider of risk capital for economic growth, which contributes directly to the real component of GDP. Change pension regulation and enhance economic growth. More has to be done. We have attempted to assess the relation between pensions and economic growth from an economic perspective instead of using financial market paradigms.
The first is more than necessary as monetary impulses can only influence growth to a limited extent and effective demand should be stimulated more directly, especially when present overcapacity goes along with low interest rate levels. In the longer run, better infrastructure benefits growth, which in turn crowds in private investments as indicated empirically.
Moreover, proof is delivered that debt ratios decline as a consequence of induced higher growth. Theo van der Klundert is an academic at Tilburg University and Anton van Nunen is a former director of strategic pension management at Syntrus Achmea. The Entrepreneurial State, New York. Of course, this initiative could easily be connected to the so-called Juncker plan proposed by the EU.
The size of an infrastructure fund, geared towards the Dutch economy, depends on the degree to which a rise in the public investments ratio and a parallel shift to this fund can be realised. The present investment ratio is 3. Opposite, in the present regulatory framework there is a strong tendency to increase the exposure to long-term market interest rates. They state that the choice for the risk-free rate as discount factor is both arbitrary and economically unsound.
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