Governmental pension funds and reform: What is all the fuss about?

Governmental pension schemes are facing a financial crisis. The current measures governments are taking are not sufficient to close the financing gap. Alternative Risk Transfer can offer a solution to bridge the financing gap.
January 17, 2020
retirement, pension, alternative risk transfer
Governmental pension funds need to find a solution to their financing problems. Alternative Risk Transfer can offer the solution.

Governments around the world have been under increased pressure to overhaul their public pension systems and introduce reforms that will ease the financial burden and liabilities associated with the pension schemes they currently have in place, while still maintaining adequate retirement conditions for pensioners. Despite the general public generally accepting the necessity of pension reforms, these are usually very unpopular plans, as demonstrated by the last wave of protests in France against President Macron’s pension reform plan. But why do governments need to reform existing plans? And are the reforms sufficient?

Pension schemes are facing increasing challenges on various fronts

In the countries of the OECD, the percentage of the population over 65 has more than doubled since the 1960s, while the average life expectancy is nearing 80. In addition to living longer, fertility rates are going down. The population of 65-and-older is set to reach 20% of the population in the US in 2030 and will more than double from 2010–2050. With medical technology, diagnostics and treatment making leaps and bounds along with people leading healthier lifestyles, these numbers are only expected to rise.

life expectancy, elderly population, liabilities, pension
Life expectancy is going up, along with the population above 65

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This puts immense financial pressure on public pension systems and governments responsible for paying out pension benefits, and raises pension-related liabilities and longevity risk. Governments spend a large part of their national GDP on pension payouts, and the older the population gets, the larger the part dedicated to pensions will need to be. But with a shrinking working-age population, governments are scrambling to fund their pension obligations. In addition, market volatility in uncertain economic and political times contribute to the pressure governmental pension systems are experiencing.

According to a Citibank report from 2016, the 20 largest countries in the OECD alone are missing $78 Trillion USD to be able to fund all of their pension obligations - which is almost twice the national debt of these countries combined.

So what is being done about it?

As a result of the global financial crisis of 2009, many countries aimed to improve the sustainability of their pension systems while maintaining or improving the adequacy of their plans. Retirement age has been raised in a few countries (a very unpopular measure), employer contributions have been increased along with auto-enrollment into pension plans, encouraging private savings and benefits for those who decide to begin withdrawals at a later stage in life.

GDP, Pension spending, OECD countries
Pension spending per country as % of GDP

The measures governments are taking to improve their pension systems are currently not enough. Plans to raise the retirement age only account for half of the increase in life expectancy, and other measures are equally insufficient. Unfortunately, the momentum of the financial crisis has subsided and many previously announced reforms have not come to fruition due to their unpopularity among the population who isn’t so keen on retiring at a later stage in life.

What else can be done?

The Mercer Global Pension Index recently examined pension systems around the world and measured them for sustainability, adequacy and integrity. The report also included recommendations on how to improve current systems. Their recommendations included:

  • Increasing workforce participation among older workers and incentives to delay retirement
  • Increasing retirement age further
  • Encouraging household savings and reducing household debt
  • Limiting access to funds before retirement
  • Encouraging retirement benefits as income streams as opposed to lump sums
  • Adjust levels of mandatory contribution
  • Lowering of governmental debt

Alternative Risk Transfer can be the answer

Governments will most likely be hesitant to fully implement Mercer’s recommendations due to their mentioned unpopularity. Alternative Risk Transfer could potentially help governments hedge their pension plan liabilities and provide an alternative for pension reforms’ most controversial issues. Private insurance providers and pension funds have been using Alternative Risk Transfer for over a decade to provide solvency relief and hedge their ever-increasing liabilities, with demand only growing.

In the ART process, an insurance company or pension fund (or potentially a government, in this case) sells assets or liabilities to third parties through tradable securities. ART solutions come in the form of mortality catastrophe bonds, mortality forwards, mortality/longevity swaps and longevity bonds.

ART transfers risk and liabilities to the capital markets, which have the capacity to hedge the liabilities governments are exposed to or provide the capital they need to fund their pension plans and future retirement obligations. ART solutions are un-correlated and less exposed to the volatility of the markets, providing greatly needed stability. In addition, ART solutions are cheap and cost effective, simple to structure and have low counterparty and basis risks.

This could very possibly be the solution to the looming pension crisis that governments are facing worldwide. We look forward to seeing governments looking into alternative risk transfer solutions that can help them keep their seat and popularity among voters while providing an efficient solution to the pension problem.

Vesttoo has developed advanced technologies for data-driven risk management, transferring actuarial risk to financial risk through the capital markets. Vesttoo specializes in risk modeling and alternative risk transfer for the Life and P&C insurance markets, providing insurers with a low-cost strategic risk management solution for immediate capital relief, value enhancement and liability hedging.

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