The persistent low interest rates might lead governments to become pension provider of last resort…

As governments push their central banks to lower policy rates (Trump succeeds as well), they should know most economics decisions imply trade-offs. The luring prospect of trying to remain in power by all means could lead to disastrous consequences.

Lars Rhode, Governor of Denmark central bank in this speech points to some of the risks. It is interesting to note that the entire yield curve in Denmark is negative! He says the big impact of low/negative interest rates are pension markets:

Monetary policy makers are not the only ones facing challenges from the low level of interest rates. High savings rates, few profitable investment opportunities and negative interest rates are also imposing challenging times on investors. This includes pension funds and commercial banks. This is not least the case in Denmark where a large part of the pension system is funded. A consequence in Denmark has been that pension funds have turned their attention away from bonds and towards equities and so-called alternative investments such as infrastructure, forests, energy supply etc. It remains to be seen wh ether the risks associated with these investments are correctly estimated and priced. The lack of market prices and the lack of liquidity in many of these investments clearly pose a risk which can only be expected to materialise fully during an economic downturn.

By reducing the stock of defined benefit pension plans, pension funds have managed to transfer a large share of the risk stemming from the low yield environment to the pensioners. In general, pensions are a way to allocate society’s aggregate income across generations – in a closed economy this would mean domestic production. Choosing a funded system relative to for example a pay-as-you-go system is basically a question of creating the right incentives for the financing of pensions. That is, paying pension contributions rather than taxes. Funded pensions tend to be better at tackling demographic changes, and pay-as-you-go systems tend to be better at coping with large transitory shocks, e.g. large changes in inflation rates.

A mixed system like the Danish one therefore seems to be a good solution to secure a decent consumption level at retirement. If yields on the alternative investments of pension funds turn out to disappoint, an open question remains: who will actually pick up the bill for the retirement of our young generations? It is not certain that future pensioners will accept lower benefits, even though they currently take on more risk when moving towards funded pensions. The government might end up as a “pension provider of last resort”.

Another question is whether the low yields are affecting pension contributions to the pension funds? On the one hand, low interest rates might make it less beneficial to transfer income into pension savings. This is referred to as the substitution effect. On the other hand, pensioners will need to save more to receive the same amount of benefits at retirement age – the so-called income effect. Empirical studies have shown that an increase in the after-tax yield on pension savings tends to incentivise people to transfer income from other savings accounts to their pensions, while keeping the total amount of savings unchanged. This experience points to a potential decline in pension contributions due to the low interest rates. However, the prospects of a long period with very low interest rates, the so-called “new normal”, create an unprecedented situation. So pension savers may choose to increase pension contributions to compensate for the lost yield.

Time will tell.

These three words are as dangerous as the four words: “This time is Different”. For all you know, time is already telling and governments could soon be pushed into becoming pension provider of last resort.

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