Pension funds are among key institutional investors in the capital market. The emergence of pension funds boosts aggregate savings in society. Although people making retirement provisions through pension funds save less by means of other financial instruments, this decrease is not adequate, therefore the level of aggregate saving increases. Evidence from the U.S. indicates that each dollar contributed to an occupational pension saving plan reduces individual savings by a mere 60 cents, so total private savings increase by 40 cents.
In the absence of pension funds, part of their participants would either fail to save adequately for retirement or would save in other ways, outside the capital market. It is estimated that if institutionalised pension saving were unavailable, discretionary personal saving would constitute a mere 30 percent of the assets contributed to pension funds. Pension saving plans receive preferred tax treatment and thus are at an advantage as compared to other forms of saving.
In terms of the number of pension funds, the U.S. is in the lead with close to one million funds. They hold roughly 70 percent of the world’s pension fund assets. It is anticipated that Europe’s 1.5 trillion ecus ($2 trillion) of fund assets will have quadrupled by the year 2020.
The advantages of institutionalised investment
Assets accumulated in pension funds are channelled, via the capital market, to their most productive uses. They can efficiently be diversified through international allocations. Pension fund investment choices are professional and therefore more effective than those of individual investors. Empirical evidence suggests that, given low operating costs of pension funds, saving through them is cheaper than discretionary personal saving through banks or insurance companies.
Administering enormous amounts of assets during a long accumulation phase, pension funds can afford significant portfolio diversification. Even though ownership of equities involves a high level of risk, pension funds invest in them more than other financial institutions. As said earlier, pension fund assets are invested over the long term, so the risks level out, spreading over “good” and “bad” times and making pension funds not as susceptible to market fluctuations. In addition, investments in equities provide higher returns over the long run and a good safeguard against inflation.
Table 1. Pension Fund Investment Portfolios in Selected Countries
|Asset Structure of Pension Funds (as of the end of 1994)
Source: European Federation for Retirement Provision (EFRP)
Why investment portfolios differ
Investment portfolios differ considerably from pension fund to pension fund. It is notable though that these differences stem back to regulations applied to investment activity and the investment culture rather than pension fund liabilities.
Investment requirements in Anglo-Saxon countries are predicated on the “prudent person” rule. No restrictions are placed on investment activity except for one-there is a limit on employer-sponsored pension funds to reinvest in the sponsor’s company. This limit is 10 percent of a pension fund’s assets in the U.S. and up to 5 percent in the U.K. For this reason, American, British and Irish pension funds place significant funds in equities, which also provide reasonable assurance of a high return.
Equity markets in these countries are highly developed, for enterprises are used to raising capital via open securities market rather than banks. In continental Europe the prevailing form of corporate financing is still by way of bank loans, though the current trend is towards the Anglo-Saxon tradition. It is notable that pension funds in the countries imposing no investment restrictions offer the prospects of the highest investment returns.
Despite this fact, portfolio restrictions are traditionally widespread. It is a common belief that such policies reduce financial risks and further the growth of national economies. Yet, restrictions on pension funds to invest internationally are being lifted, and the trend is towards significant international diversification. In 1993, 300 of the world’s largest funds invested seven percent of their two-trillion-dollar of assets abroad. Today this figure must be as high as 12 percent. Internationally diversified portfolios may assume bigger risks and generate higher returns, while domestic markets may be too small for pension fund assets to be invested efficiently.
Table 2. Real Annual Investment Returns for the Average Pension Fund in 1984 through 1993, %
Ireland – 10.25
Great Britain – 10.23
USA – 9.67
Belgium – 8.82
Sweden – 8.07
Netherlands – 7.65
Germany – 7.15
Spain – 6.95
Japan – 6.48
Denmark – 6.33
Switzerland – 4.40
Pension funds boost campaigns to improve corporate governance
An increase in pension fund investments in equities leads to a more profound influence of pension funds on corporate governance. In the U.K. about half of all equity capital is in possession of pension funds. In the U.S. economy pension funds own a quarter of all corporate equities and half of all corporate bonds.
Pension funds tend to get increasingly involved in corporate governance as their ownership stakes boost. Traditionally the usual response of a fund manager to inadequate management of a firm has been to sell the firm’s shares. Such practices, however, are fairly expensive, for the price of shares falls as they are sold in large packages. Under such circumstances, pension funds are more likely to replace the administration rather than sell the shares. Undoubtedly, individual shareholders cannot exert such an influence on corporate governance.
When pension funds have a big stake in corporate equities, the form of raising equity capital changes. Presently companies rely heavily on bank financing. The growth of private pension funds, however, ousts bank loans as a form of corporate financing and encourages companies to raise more equity instead. It is notable though that pension funds are more inclined to place funds in large, well-known companies, therefore small-scale and starting businesses find it rather difficult to raise equity via securities market.
Impact on capital markets
International investments significantly transform capital markets. This should encourage Lithuania to enhance operational transparency of the capital market, to improve the regulatory framework for market operations and to impose a stricter control on trade.
These changes are likely to have a marked impact on the fund management industry. Most fund managers in continental Europe sell mainly in their home markets, whereas the capital markets in the U.S. and U.K. employ an army of professional fund managers with a long experience of investing internationally. The removal of restrictions should create a golden opportunity for them. Wells Fargo Nikko, a joint venture involving an American firm, is the second-largest fund manager in Holland; Schroders, a British bank, is the third-largest manager in Denmark; and America’s State Street Global Advisors ranks sixth in Switzerland.
The institutionalisation of retirement saving became the main force behind financial innovations. Pension funds assume long-term obligations, which are usually required to be adjusted for inflation and smooth down market fluctuations. Thus, they create a demand for new financial products, such as index-linked treasury bills, futures and options, guaranteed income contracts, etc.
The amount of pension fund assets is directly linked with market capitalisation. Countries with large pension funds have, as a rule, better developed equity markets. The correlation ratio is roughly 0.72.
As pension funds begin to spring up, the liquidity of the capital market improves. Increased supply of capital makes it grow cheaper, and the form of enterprise financing changes considerably. A well-developed capital market, in turn, facilitates enterprise privatisation.