Collective pension funds deliver welfare gains; at least for the time being

23 January 2015

Risk sharing of adverse shocks between generations within pension funds deliver welfare gains, according to studies. Researcher Ward Romp gives such funds the benefit of the doubt for the time being, but notes that the welfare gains are subject to increasing restrictions.

Ward Romp is in the faculty of Economics and Business at the UvA fully engaged in scientific research that touches closely on current events. A recent article he wrote with professor Roel Beetsma for the Royal Netherlands Economic Association (KVS) examines whether there are benefits to be gained in the sharing of risks between generations within pension funds. The ‘struggle between young and old’ within pension funds in recent years sparked fierce debate??, as both parties believe that they contribute disproportionately to the other.

Romp, who also is affiliated with the Tinbergen Institute and pension think tank Netspar, is also working on a study of the impact of removing the compulsory participation of workers in a pension scheme. He is also the supervisor of several researchers. Romp spends half of his time to teaching and supervising PhD students, the other half he is engaged in research. 

Intergenerational risk sharing

The controversial issue of the so-called ‘Intergenerational risk sharing’ (IGR) within pension funds attracts Romp’s full attention. The concept provides a good basis to determine both what constitutes a good pension system, and especially what does not. 

‘Our current system where our pension assets are primarily within funds in which investment and longevity risks are distributed between generations, seems to be of benefit to us’, says Romp. ‘Studies show that such pension funds can afford to take more investment risk on average. The extra return achieved thus provides results of between 0.1% and about 1% of additional consumption.’ 

The operation of risk sharing within such funds is simple. A negative impact on the financial markets is not immediately or only partially passed on to pension rights and benefits of the elderly within the funds. The blows are temporarily captured by eating into the buffers and increasing premiums for workers. Conversely, the pension rights and benefits of the elderly will be subject to limited increases during periods of prosperity, but premiums will be reduced and the buffers will rise. This benefits younger workers within the funds, who will later be secured of a relatively stable pension. 

Adverse effects

It is only since ten years that there have been studies that give hard figures that indicate the abovementioned welfare gain of intergenerational risk sharing within pension funds. ‘There is still much more research needed’, says Romp, who is questioning the results. ‘It turns out that these studies do not reflect the limits there are to intergenerational risk sharing.’ 

An adverse effect of intergenerational risk sharing is, according to Romp, the disruption of the market, because risk-sharing leads to pro-cyclical macroeconomic effects. ‘Take the situation of 2008, when the benefits of the pension funds were reduced or at least not increased, while premiums were strongly increased. As the outcome of intergenerational risk sharing is that the economy as a whole suffers damage, this then diminishes the supposed welfare gains.’ 

Another factor that applies pressure to the supposed benefits is the behaviour of the government. ‘The government is doing weird things when the economy is in a poor state’, says Romp. ‘In recent years the government has made a series of interventions in the pension system. The supplementary pension becomes more and more a political issue, and the previously supposed gains can thus turn out quite different afterwards.’ 

Stepping out

Another danger for the positive effects of intergenerational risk sharing is that involvement of employees in their pension fund is under pressure due to increasing mobility of labour. ‘An employee who starts as an independent at an age of 45 seems to benefit from the risk-sharing within his pension initially, but afterwards the costs are high’, says Romp, who thinks that a lifelong connection with a pension fund in a given sector is past tense. According to Romp it is conceivable that due to the large shocks of recent years, current and future employees will turn their backs on the pension funds. 

According to Romp it is essential  to keep the degree of risk sharing within limits ‘to prevent a complete collapse of the system’. The recently modified pension rules of the government are, Romp feels, a step in the right direction. ‘On balance, the rules indicate a positive effect on the buffers while the premiums are more stable. In macroeconomic terms that is positive.’ 

When it appears that there are no beneficial effects to be achieved with intergenerational risk sharing, or when they will disappear like snow in summer, maintaining risk-sharing within pension funds is pointless, according to Romp. ‘We must certainly have compulsory saving for our retirement, but that could just as well be done individually. What we do not want is that the government sets up one national pension fund, as is sometimes advocated. That will lead to disaster.’

Bendert Zevenbergen

Published by  Economics and Business