Pension Funds, Financialization, and Lacklustre Investment

In recent debates over the reform of national pension systems, and especially the shift from pay-as-you-go (PAYGO) financing of public pensions to pre-funded arrangements, the labour movement has repeatedly stressed an important point. Regardless of whether pension costs are borne by contributors when benefits are paid or when they are accrued, future pension benefits are a claim on future production, and are ultimately paid out of future national income. That is, no matter how the pension scheme is financed today, future retirees’ consumption will be supported by allocating a portion of future output and income to pensioners.

So beyond the issue of financing design, an interesting question arises: to what extent do pay-as-you-go and pre-funded approaches contribute to the growth in future national income that will pay future pension obligations?

This question received relatively little consideration in the reform debates of the 1990s and 2000s. Among the advantages of PAYGO schemes, observers noted that pay-as-you-go arrangements can pay full benefits immediately, while pre-funded approaches require decades before accumulated contributions and investment returns can pay full pensions. It was also noted that PAYGO financing is relatively inexpensive with relatively young and growing populations. But once populations begin to age, required contribution levels in PAYGO schemes tend to rise, sparking concerns surrounding the “sustainability” of benefit levels.

Amidst a general trend toward lowering taxes, paying down debt, and reducing unfunded liabilities, the major debate in recent times between PAYGO and pre-funded systems was decided on the basis of “sustainability” and the need to control rising contributions amidst an ageing society. A distant secondary part of the debate was, what role could each approach play in ensuring growth in national income? Proponents of the pre-funded approach argued that the creation of a large pool of savings would raise the stock of capital and boost the level of investment. This begs much of the question of the investment process. But it is interesting nevertheless to look at the role pension funds might be playing amidst the current stagnant economic growth in many regions of the world economy, partly driven by lack of investment, despite historically low interest rates.

The OECD’s inaugural Business and Economic Outlook looked at this question. Published in June 2015, the OECD report examines the protracted low-interest rate environment, and the challenges it poses to (funded) pension systems’ solvency position and their ability to meet pension promises over the long-term. With adverse impacts for both the asset and liability side of the ledger, low interest rates are driving pension funds to invest a rising share of assets in “high-risk or potentially illiquid assets…such as leveraged hedge funds, high-yield corporate bonds, private equity and commodities.”

Empirically, the OECD finds clear evidence of a rising trend in the current value of investment in ‘other assets’ (including private equity, derivatives and structured products), and in countries like the UK, an increase in the share of the total investment portfolio invested in those assets classes. The OECD is concerned whether an excessive “hunt for yield” may begin to heighten insolvency risks.

But there is another way in which pension funds seek higher yield, dealt with elsewhere in the report. This has to do with the way in which equity investors can be observed to ‘punish’ companies that invest too much, and reward those that return cash to shareholders in the form of dividends and share buybacks.  The study reports “a clear investor preference against capital spending companies and in favour of short-termism.” Investing an experimental portfolio, the authors find that “selling high capital spending companies and buying low CAPEX and high buyback companies would have added 50% to portfolio values in the USA, 47% in Europe, 21% in emerging countries and even 12% in Japan” (p. 46).

The tendency of equity markets to punish companies that expand investment and reward companies that favour dividends and buybacks itself raises the hurdle rate (risk premium) for investment in an otherwise uncertain environment.

Reinforcing this logic, as Lazonick and Smithers have emphasized, is the fact that share buybacks and efforts to drive up the share price benefit executives personally, helping meet quarterly earnings per share targets on which their stock options and awards are based.

Anecdotally, there is evidence that in the hunt for yield, pension funds are encouraging this process. Low capital requirements are a leading attribute of high-quality companies sought out by pension funds, since high and stable income streams combined with low capital expenditure generate a high return on invested capital.

All of which suggests a new twist on the older debate. If the trend toward pre-funding PAYGO systems, the dominant trend in the OECD over the recent period, played an important role in driving financialization, which today is partly responsible for depressed investment and stagnant growth, perhaps pre-funding didn’t lead to appreciably more secure future benefits after all.

As an addendum, it might be argued that institutional investors like the CPP Investment Board are increasingly emphasizing long-term investment and value creation, not short-term yield at the expense of real investment.  It’s probably important to note, however, that public pension reserve funds like the one managed by the CPPIB are currently accumulating contributions, and investment income will only be drawn upon to pay benefits beginning in about 2023.

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