29 January 2002

European Pensions: Bond Boom Tames the 'Time Bomb'?

-
Graham Bishop has published his recent study on European pensions. He concludes that 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 main findings are:

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 10 trillion euro; 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

The main conclusions beeing driven from the findings above are:

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 2 trillion euro today to 7 trillion euro. Allowing for real growth and some inflation over the next decade points to a figure nearer 10 trillion euro. 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 4 trillion euro of additional fixed income assets will be required. The non-central government sector of the Salomon Smith Barney Index only amounts to 1.2 trillion euro and needs to increase by 4 trillion euro. '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.

(The full report is available for clients of Schroder Salomon Smith Barney)

© Graham Bishop