The efforts to develop any pension system are very much path-dependent. The starting point is the current state of the system, which determines the options available for developing it. However, it makes sense to examine the big picture of collective pension systems in more detail and ponder what a perfect pension system would be like. It may give some pointers as to what we should strive for. Here, I will look at it as a whole from a single point of view: the amount of pension assets and how they should be invested.
A wide range of diversity internationally
The pension systems of individual countries differ greatly from one another. Usually, pre-funded systems in which the money is collected in advance are considered the best. A strong trend in many countries is a gradual shift towards a defined contribution approach, in which risk is partly or fully shifted to the individual or in which the risk of the success of investments is borne collectively by the pensioners.
Internationally, there are a number of criteria for ranking pension systems. Mercer, a global consultancy, uses three criteria: adequacy, sustainability and integrity. The number one country in these comparisons is Iceland, followed by the Netherlands and Denmark. Finland is ranked just behind them, with a high score for system integrity.
How to invest?
As a rule, pension investors can be roughly divided into two camps. The determining factor is the ratio of pension assets to the current value of pension liabilities and how fixed a connection and target is set between the two. When it comes to investing pension assets, the rules governing the system are also of great importance.
There are systems in which the funding ratio is the determining factor and those in which the key is the return earned on the investments. The Netherlands, Denmark and the UK are prime examples of countries where pension investors focus on achieving, growing and maintaining an adequate level of funding. Enough pension contributions are accumulated to cover the current value of pension entitlements. Countries with fully pre-funded systems aim at a 100% funding ratio as a minimum.
The Dutch system aims at full pre-funding in the short term. Under the current system, if the funding ratio falls below 100%, the pension fund must prepare a plan to restore the funding ratio to above 100%. If the funding ratio is sufficient, the pension fund will, as a rule, pursue a relatively risk-free investment policy, i.e. seek to match the behaviour of the investment portfolio with that of the pension liabilities. This is done by investing a large part of the assets in bonds whose maturity and interest rate match the behaviour of the discount rate on the pension liability. This maintains the adequacy of pension assets relative to the current value of pension liabilities as interest rates change, ensuring that the system remains in equilibrium.
The British system is highly complicated. Over the years, liability-driven investments became an increasingly complex mix of consultants, asset managers, leverage and derivatives. Although the system looks soundly funded on paper, it faced a serious crisis in September 2022 due to a lack of collateral for derivatives. However, the system emerged from the 2022 turmoil surprisingly intact.
In the United States, a public pension fund is underfunded if its assets fall below 100%. The discount factor used to discount pension rights is the expected rate of return on investments. Investment portfolios are surprisingly return-seeking, which can be partly explained by the need to keep the expected rate of return and discount factor high and the pension liability low. Another reason for holding a high-risk portfolio is that returns are hoped to help achieve the target funding ratio in the long run.
In Finland (TyEL, Keva, VER, etc.) and Sweden (AP Funds), the system is in many respects partially pre-funded. The underlying thinking is that investment returns will contain pressures to increase pension contributions or cut down on pension rights or even make up for any underfunding. The Canadian system falls into the same category. In many countries, however, pensions are not pre-funded at all and are paid hand-to-mouth in a pay-as-you-go system.
Norway’s global pension fund’s investment horizon is long, if not perpetual. The fund does not have any actual allocated liabilities. Hence, its investment policy should not be compared to that of pension investors, as pension investors' assets are nothing "extra" like Norwegian assets could be thought to be.
In conclusion
Basically, a well-funded pension system usually ensures the adequacy of its assets by pursuing a risk-free investment policy. Underfunded systems seek to keep investment returns high, thus allowing a relatively high level of risk. The root cause of underfunding is not low investment returns, but the historically low level of pension contributions relative to the pension promise.
Systems evolve at a low pace, and the gap due to underfunding cannot be easily closed. Moreover, it may involve substantial risks. If the investment risks assumed by the systems are significantly increased, it is only natural that the focus shifts to returns rather than short-term solvency or funding ratios, while some of the risk (good and bad) will also be passed on to pensioners. The Swedish system is a prime example of this, as part of the state pension risk is transferred to pensioners and the main focus is on investment returns.
From the pensioner's point of view, a perfect system is secure. The best system is probably one in which all the accumulated pension liabilities are collected and invested securely and pensions are paid out without fail. All other systems are only second best, although they can also work well, as we have seen in practice.
The writer is VER's CEO Timo Löyttyniemi.
