Government as risk manager
THE IMPLICATIONS of population aging for financial markets, and for macroeconomic and financial stability, are getting greater attention as the baby-boom generation approaches retirement. For governments, threats to fiscal sustainability have been brought to the fore in recent years, and pension and health care reforms are increasingly high on the policy agenda. Similarly, the weak financial position of many pension funds has highlighted the need to secure financial resources and improve risk management practices to meet retirement needs, triggering a variety of reform efforts.
Financial markets can play an important role in the management of aging-related risks. For this reason, governments should seek to encourage and influence market developments in this area, and policymakers may need to reconsider the appropriate sharing of risk between the public, private, and household sectors. In some cases, governments may simply provide a framework or otherwise influence market participants to address incomplete markets. In other cases, governments may need to intervene directly to provide some minimum level of insurance coverage. Some risks may be best managed by the household sector, although shifting more risk to households will likely require additional measures to ensure they have some ability to manage such risks. The selection of any combination of these alternatives will be influenced by the sophistication and depth of domestic or regional financial markets and institutions, as well as by cultural and social considerations.
Governments should also act as long-term risk managers, pursuing proactive and comprehensive risk management strategies. In doing so, they would likely benefit from greater market inputs and risk management instruments. So far, few governments have approached aging-related challenges in this manner. However, given the focus that, for example, rating agencies are increasingly applying to sovereign long-term fiscal issues and related risks, and the potential for rating downgrades if such risks are not addressed, greater action may soon be required. Indeed, although the typically shorter-term focus of politicians and much of society may often inhibit more immediate efforts to address these long-term challenges, greater scrutiny from public auditors and legislators, the financial media, and international financial institutions and investors, and possibly even domestic households, is likely to increase the policy emphasis on aging-related challenges.
This article looks at the nature and size of the financial challenges facing aging societies today, the potential role of financial markets in addressing these challenges, and the role of governments as managers of key long-term risks related to aging, drawing on policy work we have done for the IMF’s Global Financial Stability Report, the Group of Ten, and a Group of Twenty workshop on demography and financial markets.
Growing long-term risks
As populations age, the relative size of pension fund liabilities grows, but the total theoretical level potentially dwarfs levels recognized thus far (see Chart 1). The adverse impact of aging on defined-benefit pension plans has been compounded since 2000 by lower equity market returns and (even more important) low interest rates. As a result, many such plans have become significantly underfunded, although funding ratios appear to have stabilized somewhat in the past two years. This growing pressure on defined-benefit pension plans may lead to lower replacement rates for retirement income, and has accelerated the trend toward defined-contribution and hybrid pension plans in the United States, Europe, and Japan. However, contribution rates in defined-contribution plans tend to be lower; and where participation in such plans is voluntary, many countries have found that participation rates also tend to be low. Both of these factors adversely affect retirement saving.
Chart 1Growing liability
Sources: OECD, World Bank, and IMF staff estimates.
1Total liability based on total annual wages in G-10 countries adjusted to reflect target replacement rates (x axis) and life expectancy after age 65 (y axis).
2Based on estimates of (i) total public pension liabilities (see Holzmann, Palacios and Zviniene, 2004) and (ii) private pension benefit obligations (see OECD, Global Pension Statistics).
3Replacement rate = retirement income as percent of previous salary.
80 (a) = liability based on 80 percent of previous salary, no one working beyond retirement.
80 (b) = 80 percent + ⅓ of population over age 65 working full-time.
80 (c) = 80 percent + ⅓ of population working over age 65 full-time and ⅕ of population over age 65 working part-time.
70 = liability based on 70 percent of previous salary, no one working beyond retirement.
Households in some countries may not be adjusting their saving levels to achieve expected replacement rates. In the United Kingdom, the 2006 Pensions Commission Report warned that many households are significantly undersaving. In the United States, a newly developed national retirement risk index shows that almost 45 percent of working-age households are at risk of ending up with inadequate retirement income. Of particular concern may be the impact on those in the middle-income and middle-age bracket, who tend to rely disproportionately on traditional private and public benefit schemes, which are in decline.
The shift from defined-benefit to defined-contribution pension plans effectively transfers risks to households from governments and pension funds. Such risks include market risks (for example, interest rate, equity, and credit), inflation risk (as indexation is reduced or removed), investment planning, and longevity risk (outliving retirement resources). Aging also exposes households, insurers, and governments to substantial health care risks. In recent years, health care costs have risen well in excess of household incomes and general inflation in many countries, largely reflecting advances in medical technology.
From the government’s perspective, the increasing financial pressures on pension and health care plans pose substantial long-term challenges. Aging-related costs represent latent but certain liabilities of the state, associated with its role as employer and provider of public social services. Furthermore, the responsibilities of the state may go beyond explicit commitments and encompass a role of “insurer of last resort.” This is a source of additional and possibly significant implicit and contingent liabilities.
Over the coming decades, the share of public expenditure related to population aging (pensions, health care, and long-term care) is likely to increase dramatically relative to GDP. Absent further reforms, spending reductions elsewhere, or changes in the distribution of risks, the financial costs of aging and related government liabilities have the potential to generate intense pressure on public finances and sovereign ratings (see table, next page). Moreover, there is considerable uncertainty regarding the estimates and extent of these aging-related liabilities.
How can financial markets help?
A variety of financial instruments are required to raise long-term saving and investment, as well as manage long-term risks and obligations. However, many of these instruments and markets remain underdeveloped or will need to be created.
Pension fund managers routinely stress that new instruments, and a greater supply of certain existing securities, are needed to help them better manage duration, longevity, and inflation risks. The availability of such instruments would complement the introduction of more market-oriented or risk-based regulatory frameworks. These instruments include long-dated (30 years and longer) and inflation-linked bonds. In many countries, authorities have sought to further develop the markets for such bonds but they remain small relative to the potential demand of pension funds and insurance companies (see Chart 2).
Chart 2Unsatisfied demand
Sources: Merrill Lynch; Watson Wyatt; Organization for Economic Cooperation and Development; International Financial Services, London; and IMF staff estimates.
For households, a crucial element of retirement planning is the ability to convert long-term savings into a dependable income stream during retirement through annuitization. Increasingly, academics and policymakers conclude that an individual’s greatest retirement risk may be that of outliving retirement assets. However, annuity markets are generally underdeveloped, or at least underutilized, particularly for individuals. Given the generally large share of housing assets in household net worth (see Chart 3), the availability of home equity release products, such as reverse mortgages, may help households realize this form of long-term saving and obtain an annuity-like income stream.
Chart 3Tapping home equity
Housing wealth, which constitutes a large part of total household wealth, could be tapped better.
(real estate and mortgage debt in percent of total household assets, 2004)1
Sources: U.S. Board of Governors of the Federal Reserve System; U.K., National Statistics Office; Japan, Bank of Japan, Economic and Social Research Institute; and Netherlands, Statistics Netherlands, DNB, European Mortgage Federation; OECD Economic Outlook; and Australian Bureau of Statistics.
1Total assets are the sum of financial assets and nonfinancial assets. For the United States and Canada, data refer to 2005.
In countries where capital markets are less developed, the range of saving and investment instruments available to households and institutional investors may be limited. The further development of capital markets in these countries—including credit markets—would introduce opportunities for greater portfolio diversification while improving the risk-return profile of households and institutional investors.
Even in more advanced economies, new products and markets, including risk-transfer markets, may need to be developed to expand the range of long-term saving/investment and risk management instruments available to institutions and households. These include, among others, markets to manage longevity, health care costs, and house price risks, all of which are important in the context of aging populations.
Longevity risk Annuities provide a longevity risk hedge for consumers, and longevity bonds could do the same for insurance companies and pension providers. However, the development of the annuities market has been hindered in part by the limited availability of suitable long-term hedges for annuity providers, including against inflation risk, and by lackluster consumer demand.
Health care coverage and costs. Reinsurance is used to a very limited extent to manage health care coverage and costs, and there is no capital market activity for health care—related risks. Private insurers and the government manage these risks largely by shifting them to households and/or health plan sponsors, primarily through repricing mechanisms or, in the case of the government, increases in taxation and/or reductions in benefits.
House price risk. Housing wealth is an increasingly important source of retirement income in the United States and Europe. Declines in house prices could therefore significantly affect retirees’ consumption, making the ability to hedge price movements increasingly relevant. In May 2006, indices of house prices in 10 U.S. cities started trading on the Chicago Mercantile Exchange. Some countries also have developed, or are looking to develop, broader real estate products, including more conventional real estate investment trusts. However, except in the United States, the market to hedge house price risk is nascent or nonexistent.
Overall, regulation, technology, and data quality and availability are very important influences on market development and innovation. In particular, market participants and academics emphasize the need for more consistent supervisory frameworks. For example, the Basel regulations since the late 1980s have encouraged banks to sell credit risk and create more liquid balance sheets, and technology advances allow banks to better evaluate credit risks. The forthcoming Solvency II principles regarding insurance supervision in Europe may similarly be used to promote new risk management practices in the insurance industry, including greater risk-transfer activity.
Government as risk manager
Ongoing reforms of pension and other benefit systems have increased public awareness of these issues in some countries, but that is only a first step. Particularly because many of the risks associated with aging are long term and systemic, governments should increasingly view themselves as risk managers. To do this, they may consider three broad, possibly complementary, approaches:
- using various policy levers to encourage the private sector to address incomplete markets for the management of aging-related risks;
- acting as the “insurer of last resort” and directly assuming, perhaps temporarily, some of these risks; and
- determining whether households are best positioned to bear and manage these risks.
Using policy levers
Governments can influence the flow of risks in the financial system and encourage the development of new products and risk-transfer markets by using the policy levers described below.
Regulatory frameworks. Some countries, most notably the Netherlands, have recently made significant strides in strengthening pension fund regulation, particularly through more risk-based supervision. Such efforts should improve the risk and asset-liability management focus of pension fund and insurance company managers, and encourage product and market developments to meet related demand.
Accounting standards. While fair value accounting may bring more discipline to pension reporting, the volatility associated with it may not accurately reflect a pension fund’s risk profile or properly focus risk management on long-term pension obligations. Indeed, an important question is whether such reforms may not diminish pension funds and insurers’ long-term orientation, which has typically enhanced financial stability.
Tax policy. Taxation is often the determining factor in setting annual pension contributions. Tax regimes for pensions should encourage prudent, possibly continuous, funding policies and, ideally, seek to build reasonable funding cushions (two or three years of normal contributions, for example).
Data availability. The availability, reliability, and timeliness of data required to decompose, price, and trade individual risks are broadly cited as crucial for the improved management of certain aging-related risks—but are often missing. Governments may have a comparative advantage and interest in improving the availability of data, which may be seen as a relatively lower cost method to support market-based solutions.
Compulsion. The need to pool diversified risks is an important feature of insurance, including annuities and health care coverage. For example, to reduce adverse selection and bias, governments may impose a degree of compulsory annuitization, possibly as a proportion of tax-privileged pension savings. Mandatory annuitization may also encourage the emergence of more “vanilla” annuity products and potentially improve households’ understanding and acceptance of such products.
Government as insurer of last resort
By assuming certain types of risk (such as extreme longevity), governments may increase the capacity of market participants to provide more products and thereby facilitate the development of broader markets. For aging-related risks, an important consideration is the extent of state health care and pension provision, since where such provision is low or being reduced, some capacity may be freed up for governments to take on aging-related risks, ideally in a way that may also attract private capital and capacity.
In all cases, government interventions should be part of a comprehensive strategy, taking into account expected costs and benefits (that is, the impact on the public sector balance sheet), the time horizon, and the existence of potential financial market solutions. Government interventions may thus be tailored to very specific risks or those of limited duration and removed as private financial services develop.
Letting households bear the risk
Households, as the “shareholders” of the system, have always been the ultimate bearers of financial and other risks. However, they are increasingly facing additional risks more directly as public and private benefits are reduced or restructured. Policy considerations regarding the desirable risk profile of the household sector involve important cultural, social, and political issues, which may be addressed differently across countries or regions. Nevertheless, a greater transfer of risks to households raises the question of how well equipped households are to bear such risks.
Depending on policy considerations, various ways of encouraging savings or achieving a desired level of risk sharing are possible. With regard to savings, the workplace may be the most efficient location to organize and accumulate retirement savings. Through occupational pension schemes, employers can most effectively organize the funding of employees’ retirement savings. Moreover, employees seem more prepared to contribute wages at source to work-related pension schemes. More generally, traditional defined-benefit schemes and principles should not be uniformly discarded, and hybrid occupational pension plans may provide a useful risk-sharing approach.
In considering the allocation or sharing of risks, policymakers need to measure the impact of ongoing and proposed changes in pension and welfare systems on households. In particular, they may develop statistical tools to capture the distribution of risks across population subgroups, especially age and income cohorts, and efforts to improve the collection, timeliness, and comparability of household sector data are needed. Policymakers may also look to develop broader, more forward-looking measures of household wealth. In Sweden, for example, the Sveriges Riksbank has sought to assess the financial margin of Swedish households and their ability to service their obligations when faced with potential benefit adjustments or economic shocks (a rise in interest costs, for example, or a decline in income).
Building public support
Issues related to aging are relevant to all countries and are not going to fade away. On the contrary, risks tend to cumulate and, with time, may well exacerbate a number of related social, economic, and financial challenges. Moreover, governments, domestic businesses, and financial markets compete globally for investment capital, and the potential economic effects of aging may adversely influence their competitive positions, as well as macroeconomic and financial stability.
These and other factors should compel policymakers to build greater support for more immediate policy initiatives to mitigate such adverse impacts. Given the multigenerational nature of the challenges and most of the likely reforms, it is important to start such efforts now. Delay in addressing these challenges may only increase their ultimate economic cost and financial impact.
W. Todd Groome is a Division Chief, Nicolas Blancher a Senior Economist, and Parmeshwar Ramlogan a Special Projects Officer in the IMF’s International Capital Markets Department. Oksana Khadarina, a Senior Research Assistant, helped in the preparation of this article.
Holzmann, Robert, RobertPalacios, and AstaZviniene, 2004, “Implicit Pension Debt: Issues, Measurement and Scope in International Perspective,”Social Protection Discussion Paper 0403 (Washington, World Bank).
International Monetary Fund, 2006, “The Influence of Credit Derivatives and Structured Credit Markets on Financial Stability,” in Global Financial Stability Report, April (Washington).
International Monetary Fund, 2005, “Aspects of Global Asset Allocation,” in Global Financial Stability Report, September (Washington).
International Monetary Fund, 2005, “Household Balance Sheets,” in Global Financial Stability Report, April (Washington).
International Monetary Fund, 2004, “Risk Management and the Pension Fund Industry,” in Global Financial Stability Report, September (Washington).
International Monetary Fund, 2004, “Risk Transfer and the Insurance Industry,” in Global Financial Stability Report, April (Washington).