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Aging and
Financial Markets |
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As populations age, the relative size
of pension fund liabilities grows, but the total theoretical level
potentially dwarfs levels recognized thus far. |
The
implications of population aging for financial markets, and for macroeconomic
and financial stability, are getting greater attention as the baby-boom
generation approaches retirement. For governments, threats to fiscal
sustainability have been brought to the fore in recent years, and pension and
health care reforms are increasingly high on the policy agenda. Similarly, the
weak financial position of many pension funds has highlighted the need to
secure financial resources and improve risk management practices to meet
retirement needs, triggering a variety of reform efforts.
Financial markets can play an important
role in the management of aging-related risks. For this reason, governments
should seek to encourage and influence market developments in this area, and
policymakers may need to reconsider the appropriate sharing of risk between
the public, private and household sectors. In some cases, governments may
simply provide a framework or otherwise influence market participants to
address incomplete markets. In other cases, governments may need to intervene
directly to provide some minimum level of insurance coverage. Some risks may
be best managed by the household sector, although shifting more risk to
households will likely require additional measures to ensure they have some
ability to manage such risks. The selection of any combination of these
alternatives will be influenced by the sophistication and depth of domestic or
regional financial markets and institutions, as well as by cultural and social
considerations.
Governments should also act as long-term
risk managers, pursuing proactive and comprehensive risk management
strategies. In doing so, they would likely benefit from greater market inputs
and risk management instruments. So far, few governments have approached
aging-related challenges in this manner. However, given the focus that, for
example, rating agencies are increasingly applying to sovereign long-term
fiscal issues and related risks, and the potential for rating downgrades if
such risks are not addressed, greater action may soon be required. Indeed,
although the typically shorter-term focus of politicians and much of society
may often inhibit more immediate efforts to address these long-term
challenges, greater scrutiny from public auditors and legislators, the
financial media, and international financial institutions and investors, and
possibly even domestic households, is likely to increase the policy emphasis
on aging-related challenges.
This article looks at the nature and
size of the financial challenges facing aging societies today, the potential
role of financial markets in addressing these challenges, and the role of
governments as managers of key long-term risks related to aging, drawing on
policy work we have done for the IMF’s Global Financial Stability Report,
the Group of Ten, and a Group of Twenty workshop on demography and financial
markets.
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The shift from defined-benefit to
defined-contribution pension plans effectively transfers risks to
households from governments and pension funds. |
Growing
long-term risks:
As populations age, the
relative size of pension fund liabilities grows, but the total theoretical
level potentially dwarfs levels recognized thus far. The adverse impact of
aging on defined-benefit pension plans has been compounded since 2000 by lower
equity market returns and (even more important) low interest rates. As a
result, many such plans have become significantly underfunded, although
funding ratios appear to have stabilized somewhat in the past two years. This
growing pressure on defined-benefit pension plans may lead to lower
replacement rates for retirement income, and has accelerated the trend toward
defined-contribution and hybrid pension plans in the United States, Europe and
Japan. However, contribution rates in defined-contribution plans tend to be
lower; and where participation in such plans is voluntary, many countries have
found that participation rates also tend to be low. Both of these factors
adversely affect retirement saving.
Households in some countries may not be
adjusting their saving levels to achieve expected replacement rates. In the
United Kingdom, the 2006 Pensions Commission Report warned that many
households are significantly undersaving. In the United States, a newly
developed national retirement risk index shows that almost 45 percent of
working-age households are at risk of ending up with inadequate retirement
income. Of particular concern may be the impact on those in the middle-income
and middle-age bracket, who tend to rely disproportionately on traditional
private and public benefit schemes, which are in decline.
The shift from defined-benefit to
defined-contribution pension plans effectively transfers risks to households
from governments and pension funds. Such risks include market risks (for
example, interest rate, equity and credit), inflation risk (as indexation is
reduced or removed), investment planning and longevity risk (outliving
retirement resources). Aging also exposes households, insurers and governments
to substantial health care risks. In recent years, health care costs have
risen well in excess of household incomes and general inflation in many
countries, largely reflecting advances in medical technology.
From the government’s perspective, the
increasing financial pressures on pension and health care plans pose
substantial long-term challenges. Aging-related costs represent latent but
certain liabilities of the state, associated with its role as employer and
provider of public social services. Furthermore, the responsibilities of the
state may go beyond explicit commitments and encompass a role of "insurer of
last resort." This is a source of additional and possibly significant implicit
and contingent liabilities.
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A variety of financial instruments
are required to raise long-term saving and investment, as well as manage
long-term risks and obligations. |
Over the coming decades, the share of
public expenditure related to population aging (pensions, health care and
long-term care) is likely to increase dramatically relative to GDP. Absent
further reforms, spending reductions elsewhere, or changes in the distribution
of risks, the financial costs of aging and related government liabilities have
the potential to generate intense pressure on public finances and sovereign
ratings. Moreover, there is considerable uncertainty regarding the estimates
and extent of these aging-related liabilities.
How can
financial markets help?:
A variety of financial
instruments are required to raise long-term saving and investment, as well as
manage long-term risks and obligations. However, many of these instruments and
markets remain underdeveloped or will need to be created.
Pension fund managers routinely stress
that new instruments, and a greater supply of certain existing securities, are
needed to help them better manage duration, longevity and inflation risks. The
availability of such instruments would complement the introduction of more
market-oriented or risk-based regulatory frameworks. These instruments include
long-dated (30 years and longer) and inflation-linked bonds. In many
countries, authorities have sought to further develop the markets for such
bonds but they remain small relative to the potential demand of pension funds
and insurance companies.
For households, a crucial element of
retirement planning is the ability to convert long-term savings into a
dependable income stream during retirement through annuitization.
Increasingly, academics and policymakers conclude that an individual’s
greatest retirement risk may be that of outliving retirement assets. However,
annuity markets are generally underdeveloped, or at least underutilized,
particularly for individuals. Given the generally large share of housing
assets in household net worth, the availability of home equity release
products, such as reverse mortgages, may help households realize this form of
long-term saving and obtain an annuity-like income stream.
In countries where capital markets are
less developed, the range of saving and investment instruments available to
households and institutional investors may be limited. The further development
of capital markets in these countries—including credit markets—would introduce
opportunities for greater portfolio diversification while improving the
risk-return profile of households and institutional investors.
Even in more advanced economies, new
products and markets, including risk-transfer markets, may need to be
developed to expand the range of long-term saving/investment and risk
management instruments available to institutions and households. These
include, among others, markets to manage longevity, health care costs, and
house price risks, all of which are important in the context of aging
populations.
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Households, as the "shareholders"
of the system, have always been the ultimate bearers of financial and
other risks. |
Longevity risk:
Annuities provide a longevity risk hedge for consumers and longevity bonds
could do the same for insurance companies and pension providers. However, the
development of the annuities market has been hindered in part by the limited
availability of suitable long-term hedges for annuity providers, including
against inflation risk, and by lackluster consumer demand.
Health care
coverage and costs:
Reinsurance is used to a very limited extent to manage health care coverage
and costs, and there is no capital market activity for health care–related
risks. Private insurers and the government manage these risks largely by
shifting them to households and/or health plan sponsors, primarily through
repricing mechanisms or, in the case of the government, increases in taxation
and/or reductions in benefits.
House price
risk: Housing
wealth is an increasingly important source of retirement income in the United
States and Europe. Declines in house prices could therefore significantly
affect retirees’ consumption, making the ability to hedge price movements
increasingly relevant. In May 2006, indices of house prices in 10 U.S. cities
started trading on the Chicago Mercantile Exchange. Some countries also have
developed, or are looking to develop, broader real estate products, including
more conventional real estate investment trusts. However, except in the United
States, the market to hedge house price risk is nascent or nonexistent.
Overall,
regulation, technology, data quality and availability are very important
influences on market development and innovation. In particular, market
participants and academics emphasize the need for more consistent supervisory
frameworks. For example, the Basel regulations since the late 1980s have
encouraged banks to sell credit risk and create more liquid balance sheets,
and technology advances allow banks to better evaluate credit risks. The
forthcoming Solvency II principles regarding insurance supervision in Europe
may similarly be used to promote new risk management practices in the
insurance industry, including greater risk-transfer activity.
Government as
risk manager:
Ongoing reforms of pension and
other benefit systems have increased public awareness of these issues in some
countries, but that is only a first step. Particularly because many of the
risks associated with aging are long term and systemic, governments should
increasingly view themselves as risk managers. To do this, they may consider
three broad, possibly complementary, approaches:
using
various policy levers to encourage the private sector to address incomplete
markets for the management of aging-related risks;
acting as
the "insurer of last resort" and directly assuming, perhaps temporarily, some
of these risks; and
determining whether households are best positioned to bear and manage these
risks.
Using policy
levers:
Governments can influence the
flow of risks in the financial system and encourage the development of new
products and risk-transfer markets by using the policy levers described below.
Regulatory
frameworks:
Some countries, most notably the Netherlands, have recently made significant
strides in strengthening pension fund regulation, particularly through more
risk-based supervision. Such efforts should improve the risk and
asset-liability management focus of pension fund and insurance company
managers, and encourage product and market developments to meet related
demand.
Accounting
standards:
While fair value accounting may bring more discipline to pension reporting,
the volatility associated with it may not accurately reflect a pension fund’s
risk profile or properly focus risk management on long-term pension
obligations. Indeed, an important question is whether such reforms may not
diminish pension funds and insurers’ long-term orientation, which has
typically enhanced financial stability.
Tax policy:
Taxation is often the determining factor in setting annual pension
contributions. Tax regimes for pensions should encourage prudent, possibly
continuous, funding policies and, ideally, seek to build reasonable funding
cushions (two or three years of normal contributions, for example).
Data
availability:
The availability, reliability and timeliness of data required to decompose,
price, and trade individual risks are broadly cited as crucial for the
improved management of certain aging-related risks—but are often missing.
Governments may have a comparative advantage and interest in improving the
availability of data, which may be seen as a relatively lower cost method to
support market-based solutions.
Compulsion:
The need to pool diversified risks is an important feature of insurance,
including annuities and health care coverage. For example, to reduce adverse
selection and bias, governments may impose a degree of compulsory
annuitization, possibly as a proportion of tax-privileged pension savings.
Mandatory annuitization may also encourage the emergence of more "vanilla"
annuity products and potentially improve households’ understanding and
acceptance of such products.
Government as
insurer of last resort:
By assuming certain
types of risk (such as extreme longevity), governments may increase the
capacity of market participants to provide more products and thereby
facilitate the development of broader markets. For aging-related risks, an
important consideration is the extent of state health care and pension
provision, since where such provision is low or being reduced, some capacity
may be freed up for governments to take on aging-related risks, ideally in a
way that may also attract private capital and capacity.
In all cases,
government interventions should be part of a comprehensive strategy, taking
into account expected costs and benefits (that is, the impact on the public
sector balance sheet), the time horizon and the existence of potential
financial market solutions. Government interventions may thus be tailored to
very specific risks or those of limited duration and removed as private
financial services develop.
Letting
households bear the risk:
Households, as the
"shareholders" of the system, have always been the ultimate bearers of
financial and other risks. However, they are increasingly facing additional
risks more directly as public and private benefits are reduced or
restructured. Policy considerations regarding the desirable risk profile of
the household sector involve important cultural, social, and political issues,
which may be addressed differently across countries or regions. Nevertheless,
a greater transfer of risks to households raises the question of how well
equipped households are to bear such risks.
Depending on policy considerations,
various ways of encouraging savings or achieving a desired level of risk
sharing are possible. With regard to savings, the workplace may be the most
efficient location to organize and accumulate retirement savings. Through
occupational pension schemes, employers can most effectively organize the
funding of employees’ retirement savings. Moreover, employees seem more
prepared to contribute wages at source to work-related pension schemes. More
generally, traditional defined-benefit schemes and principles should not be
uniformly discarded, and hybrid occupational pension plans may provide a
useful risk-sharing approach.
In considering the allocation or sharing
of risks, policymakers need to measure the impact of ongoing and proposed
changes in pension and welfare systems on households. In particular, they may
develop statistical tools to capture the distribution of risks across
population subgroups, especially age and income cohorts, and efforts to
improve the collection, timeliness, and comparability of household sector data
are needed. Policymakers may also look to develop broader, more
forward-looking measures of household wealth. In Sweden, for example, the
Sveriges Riksbank has sought to assess the financial margin of Swedish
households and their ability to service their obligations when faced with
potential benefit adjustments or economic shocks (a rise in interest costs,
for example, or a decline in income).
Building public
support:
Issues related to aging are
relevant to all countries and are not going to fade away. On the contrary,
risks tend to cumulate and, with time, may well exacerbate a number of related
social, economic and financial challenges. Moreover, governments, domestic
businesses, and financial markets compete globally for investment capital, and
the potential economic effects of aging may adversely influence their
competitive positions, as well as macroeconomic and financial stability.
These and other
factors should compel policymakers to build greater support for more immediate
policy initiatives to mitigate such adverse impacts. Given the
multigenerational nature of the challenges and most of the likely reforms, it
is important to start such efforts now. Delay in addressing these challenges
may only increase their ultimate economic cost and financial impact.
Source: Finance and Development
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