Pension investment
The first part of the collection brings together a number of papers that essentially build the case for the pension improving benefits of global asset diversification. The benefits of portfolio diversification are particularly present in the case of fully funded pensions. Ageing industrial countries can escape part of the demographic problem by investing in emerging markets, while poor countries can diversify away some of their idiosyncratic risks stemming from higher exposure to country specific shocks by investing some of their pension assets in industrial countries. Such diversification benefits notwithstanding, pension funds are still heavily invested into home assets, in particular in the non- Organization for Economic Co-operation and Development area. The gradual erosion of that home bias that are now already observing for Organization for Economic Co-operation and Development assets will have tremendous implications for global capital flows .
In the absence of foreign pension investment into younger economies, what should we expect to happen to the capital returns on funded pensions once the Organization for Economic Co-operation and Development baby boomers have started to retire. As the labor force declines, the existing capital stock becomes oversized relative to the labor force. The change in relative factor proportions reduces the rental return on capital relative to wages; this effect is reinforced if fully funded pensions indeed stimulate savings. Simultaneously, the prior phase of asset accumulation would give way to a long period of asset de-cumulation, as the baby boomers; start to draw on their pension assets to finance their retirement. Clearly, therefore, a fully funded pension scheme is bound to get under stress by population ageing, very much like an unfunded scheme. But the funded pensions, unlike the unfunded schemes, can partly beat demography in an open economy. The asset decumulation during the retirement period will not be confined to home assets, but to emerging market assets that still will be benefiting from net pension contributions of the underlying younger population. And capital returns, unlike in a closed economy, will not be lowered by a declining labor force, but by the world capital market and the demand for capital by the younger non- Organization for Economic Co-operation and Development area .
PENSION FUNDS, CAPITAL CONTROLS AND MACROECONOMIC STABIliTY .
It is well known that high capital mobility introduces an important constraint on macroeconomic policy. The question therefore arises as to whether free international investment by pension funds might have a macroeconomic cost that needs to be weighed against its presumed microeconomic advantages in terms of permitting retirees to enjoy the benefits of international diversification. If so, the further question arises of whether a novel form of exchange control, example, and a requirement that foreign investment by foreign funds be allowed only when there is equal inward investment by foreign pension funds might help to overcome the macroeconomic costs without losing the micro gains .
This paper starts with an analysis of the impact of a small country opening up its stock market for investment from abroad, focusing on the question of the extent to which this will constrain microeconomic policy. It then proceeds to examine the investment strategies of and the restrictions imposed upon, privately managed pension funds in the Organization for Economic Co-operation and Development area.
PENSION FUND INVESTMENT .
The rich worlds ageing population will inevitably intensify pressures that can be expected to stimulate strong growth in private funded pensions, both inside and outside the Organization for Economic Co-operation and Development area. Unfunded, earnings related pension schemes could be reasonably well sustained under the demographic conditions of the immediate post war decades. Increasingly, though, as the baby boom generation starts to retire, a dwindling cohort of tax payers will have to support an increasingly old population .
The demographic time-bomb imposes some most unpleasant arithmetic on unfunded state social security systems: .
Public finances will come under ever growing pressure from the scale and financing requirements of public pension schemes. Public debt in almost every country is much larger than is generally documented when pledged state pension benefits and future pension contributions are factored in. Recent stimulations have estimated the gap between the present value of contributions and pension payments.
Employment creation will be strongly discouraged under the scenario presented above. Unemployment on the Organization for Economic Co-operation and Development area is concentrated among those with low skills and low potential earnings. The Organization for Economic Co-operation and Development Jobs Study finds that rising social security contributions, both by employers and employees, have significantly contributed to low skilled unemployment. Because of ceilings on social security contributions and due to real wage resistance resulting from minimum wages, rising employers contributions depress labor demand especially for low income jobs. It goes without saying that the required rise in contribution ratios would rather dampen the prospects for job creation. The rise would also reduce labor supply as it further stimulates the desire to work tax free in the black economy or alternately, discourages entry or return to the workforce. Finally, the policy option to raise the pensionable age is also clearly at odds with the current need to lower the high incidence of unemployment on young labor market entrants .
Economic performance of those countries will be badly damaged where contribution ratios are raised further to balance net public pension liabilities. Little has been put aside into funded pensions, rising social security taxes will cut more and deeply into profits.
THE MUTUAL BENEFITS OF GLOBAL PENSION INVESTMENT .
Benefits for Ageing Organization for Economic Co-operation and Development Counties .
It is little understood that even fully funded pension schemes will not escape demographic pressures if their assets remain invested in ageing economies alone. Funded pension schemes, unlike earnings related schemes, can beat demography, however, by serious asset diversification into younger economies. Pay-as-you-go schemes, by contract, are locked into the ageing economy. The mean return of portfolios is likely to be raised through investment in emerging markets as long as Gross Domestic Product growth in the Organization for Economic Co-operation and Development remains substantially below that of many non- Organization for Economic Co-operation and Development countries. Stock market capital gains cannot outpace Gross Domestic Product growth in the longer run: share prices cannot rise faster than the profits from which they are paid. Profits in turn can scarcely rise faster than the economy, as that would mean shareholders winning consistently at the expense of someone else. Investment in high-growth developing countries thus promises higher returns than in slow-growth Organization for Economic Co-operation and Development countries, as long as the market is less than perfectly efficient at arbitrating away such differences .
For any portfolio currently under invested in foreign assets there is the prospect of a free lunch : international diversification can lower risk by eliminating non-systematic volatility without sacrificing expected return; alternatively, it will raise the expected return for a given level of risk. Risk is reduced by investing in markets which are relatively uncorrelated with the investors domestic market. International diversification reduces risk faster than does domestic diversification because domestic securities exhibit stronger correlation as a result of their joint exposure to country specific shocks. An international portfolio provides some insurance against losses originating, say, from a domestic wage push or a decline in the countrys terms of trade.
From the perspective of the globally diversified pension fund, investment into the emerging markets promises a much improved risk return profile. Emerging stock markets are defined by the International Finance Corporation as those markets with potential for growth in size and sophistication .
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