As Governments face funding challenges, how important are private pension plans to the society?
Private pension systems are facing pressing and broad challenges.
The economic crisis led to a reduction in government revenues to finance pay-as-you-go public pensions, leaving space for a growing role for private pensions in providing for old age.
However, population ageing and the current economic environment are introducing challenges to the ability of private pensions to deliver adequate retirement income.
Population ageing is leading not only to an increase in the number of people in retirement relative to the size of the working age population, but also most importantly to an increase in the number of years that people spending in retirement, at least when the retirement age is not increased adequately.
This may affect the solvency of defined benefit (DB) pension plans and the adequacy of income derived from defined contribution (DC) pension plans.
DB pension funds are exposed to the longevity risk owing to uncertainty about future improvements in mortality and life expectancy. If pension promises are calculated based on a life expectancy which is underestimated, the actual pension payments will be larger than expected and DB pension funds may lack sufficient assets to cover their future liabilities.
For DC pension funds, higher life expectancy means that accumulated assets must fund longer retirement periods if people do not adjust their retirement age, potentially rendering the resulting pension amount inadequate to maintain the desired standard of living in retirement.
The performance of pension funds measured over the last five years remains positive. Over the period December 2008 to December 2013, 24 OECD countries had a real annual rate of return higher than two per cent, while 22 OECD countries had a nominal average annual rate of return higher than four per cent.
The current economic environment characterised by low returns on investments, low interest rates and low growth is compounding these problems.
These factors may lead to lower resources than expected to finance retirement promises or simply to lower retirement income.
Low returns on investments reduce the expected future value of benefits, as assets accumulated will grow at a lower rate than expected.
Low interest rates may reduce the amount of pension income that a given amount of accumulated assets may be able to deliver, especially in DC pensions. In DB pensions, low interest rates may increase future liabilities and lead to solvency problems. Additionally, low economic growth may reduce the overall resources (employer and employee contributions) available to finance retirement.
Pension systems are facing crucial and far-reaching challenges. The present economic environment, characterised by low returns on investment, low growth and low interest rates is compounding the problems posed by population ageing by creating sustainability problems for pay-as-you-go financed public pensions, solvency for defined benefit plans and adequacy challenges for defined contribution pensions.
Pension funds and annuity providers need to effectively manage the longevity risk they are exposed to. Individuals receiving a lifetime income may live longer than expected or accounted for in the actuarial calculations to provision for these liabilities. Mismanaged longevity risk can deteriorate finances, cause bankruptcy and expose individuals to the risk of losing their retirement income.
To safeguard against this risk, pension funds and annuity providers must make provision for future improvements in mortality and life expectancy. The regulatory framework can support the effective management of longevity risk.
