29 January 2002

European Pensions Analysis

Bond Boom Tames the ‘Time Bomb’?
Demographics are forcing pensions on to the EU’s political agenda; economic reform could contain rising public spending, but increased funding of pensions looks likely Encouraging second-pillar pension schemes may cause a five-fold rise in Eurozone pension assets — to ㈊ trillion; regulatory influences could shape the asset allocation towards a major bond component So a ‘bond boom’ would result — especially in longer maturity, non-government bonds — to match the age profile of the retired lives; but where will the supply come from? An implication — governments may need to lengthen their debt maturity, perhaps even giving an ‘interest rate subsidy’; but such steps would need substantial political cooperation within the Eurozone

Summary Economic reform in the EU is essential to help solve the pension time bomb. But the corresponding growth in ‘second pillar’ pensions may produce an exceptional demand for assets. The regulatory framework will influence asset allocations but the potential demand for bonds strains credulity. As a first step, governments may need to lengthen their debt maturities.
The Pension Time Bomb can be contained Implementing aggressive economic reform in the EU and meeting the targets of the ‘Lisbon process’ could nearly halve the upswing in pension spending. That is important to financial markets as it would reduce the nagging fear that governments might allow deficits to mushroom and then finally resolve the problem by inflating away the real value of the debts. However, the structural commitment to low inflation — via the independence of the ECB — would be buttressed by the sheer voting power of the pensioners.

‘Second Pillar’ pension assets could rise five-fold Encouraging second pillar pensions could well see relevant Eurozone financial assets rise from Ԃ trillion today to ԇ trillion. Allowing for real growth and some inflation over the next decade points to a figure nearer ㈊ trillion. A serious move to reduce the generosity of public pensions by a quarter — implicit in the scenarios for stabilising public finances — might raise that amount.
Regulation may influence the asset allocation profoundly The EU is in the process of setting up two fundamental regulatory measures for pensions: The public measure of the ‘Pensions Directive’ and the public authorisation of private regulation via the IAS on Employee Benefits. That regulatory framework may influence the choice of the type of pension fund — with broader implications for financial markets.

The expansion of non-government bonds strains credulity With a bond allocation of 50%, perhaps Ԅ trillion of additional fixed income assets will be required. The non-central government sector of the Salomon Smith Barney Index only amounts to ԁ.2 trillion and needs to increase by Ԅ trillion. ‘Demand creates its own supply’, but . . .

So should governments give an interest rate subsidy to their long bonds?
The maturity profile of public debt may have to change to provide the appropriate assets for retirement savings. This may even involve an ‘interest rate subsidy’ — rather than a tax incentive — to maintain the attractions of funded pensions at all. But that would need a coordination of debt management policy that would require substantial political cooperation within the Eurozone.

Contents<>
Executive Summary Introduction The Demographic Challenge to European Policy-Makers Economic Policy Analysis The Implications for the Scale of Pension Assets The Pension Policy Response The Pensions Directive Accounting Standards – IAS 19 The Consistency of Accounting Standards: The UK’s FRS 17 versus IAS 19 The Implication of the Pension Policy Choices Can the Bond Market meet the Challenge? The Required Scale of the Bond Market Bond Issuance since EMU Sizing the Markets Impact on the Yield Curve Appendix

Figures
Figure 1. Key Labour Market Comparisons — EU versus US.
Figure 2. Male Life Expectancy, Years
Figure 3. Projected Size of the EU Working-Age and Elderly Population (Millions).
Figure 4. A Comparison of Demographic and Economic Dependency Ratios
Figure 5. Public Pension Expenditures (including Most Public Replacement Revenues) to People aged 55 or Over, Before Taxes, as % of GDP
Figure 6. Sensitivity Tests for Pensions Projections: Difference from the ‘Current Policy’ Scenario
Figure 7. Pension Assets in Europe, 2000 (Euros in Billions)
Figure 8. Asset Allocation of European Pension Funds, in % of Total Assets, 2000
Figure 9. Asset Allocation of US Pension Funds, in % of Total Assets, 2000
Figure 10. Issuance of All Euro-Denominated Bonds, 1999-01 (Euros in Billions)
Figure 11. Growth in Euro Area Bond Markets 1998–01, (Euros in Billions) (Minimum Issue Size 🗴 million)
Figure 12. Yield Curve versus Market Capitalisation of Euro and UK Markets, December 2001
Figure 13. Maturity Distribution of All Euro Bond Issue 1999-01, in % of Total
Figure 14. Issue Size of ‘All’ Euro Bond Issues, 1999-01, in % of Total
Figure 15. Credit Rating Distribution of ‘All’ Euro Bond Issues, 1999-01, in % of Total

© Graham Bishop