‘Ticking Time Bomb: The Hidden Pension Deficit’ – Critical Study of Post Crisis Reforms and Financial Viability of Current Pension System

Abstract

Management of pension schemes has always been a difficult task for governments and the challenges that governments are facing today are growing faster than many countries anticipated. Pension plans have evolved overtime as public and private sector schemes slowly switching to PAYG system of funding and the uncertainty over current contributors’ future is growing. However, the recent financial crisis turned attention towards this hidden deficit of the countries where pension funds around the world lost significant amount of their value and the mounting pressure forced the policy makers to take actions to address this issue which they did by suspending and scaling down pension privatisation which once was proposed by World Bank and supported by countries around the world specially in Eastern Europe to answer the funding problems of pension plans. Recent studies such as Drahokoupil and Domonkos (2013) and Orenstein (2014) among others have analysed the impact of financial crisis on pension funds and the role played by private pensions during that period but were unable to find any significant differences between public and private pensions in terms of returns and risks. These studies raise questions on the rationale behind the recent reforms that not only significantly reduced the funding through private pension plans but the initiatives such as UK government allowing pensioners to take their pension savings as single cash payment instead of buying annuity does not seem like a insightful step that can minimize the pension deficit but will result in extra cash burden on treasury (Flood, 2014). Many European countries such as Hungary, Latvia and Poland completely abolished private pensions as a response to resolve the problem of pension deficit. However, on comparing the portfolios of public and private pensions during the period of financial crash, analysts found that both were holding risky assets and due to the market turmoil, the fund lost their value but question of why only private pension funds were penalized is still far from answered that can make economic and financial reasoning. Resulting reforms imposes constraints and stringent requirement for pension funds where regulators in US and Europe have made attempts to prevent the use of financial derivatives to hedge the portfolio risk. The case for these regulations in reducing risk is debatable while some supported, other criticised as it leads to increased costs and impedes fund growth. These also resulting in misalignment of interests as assets managers are forced to focus on short-term volatility rather than sustainable returns (Randle and Rudolph, 2014). There are many reasons that have created this enormous pension deficit such as political, social, demographical, economic and financial. But some risk can be managed easily than others, as most of the literature focuses on the impact of political and social policies on pension plans, the discussion in this paper is on financial aspect of the problem and attempts to find solutions to manage the pension risks through financial markets. While many governments such as Detroit city sunk down the pension deficit abyss and defaulted on their obligations, Norwegian pension fund and Australian superannuation fund have emerged as ideal models that can be followed by countries facing pension crisis as the longer they take to react the deeper they sunk in to the deficit hole. The aim of this discussion is to: 1) gain insights into the underfunding problem of pension funds and the impact of financial crisis on pension liabilities and how it has amplified the pension risks and liabilities, with underfunding and risk mitigation as focal point. 2) Critically discuss post crisis pension reforms and how they are likely to resolve the problems. The focus will be on risks associated with private and public pension plans. 3) While regulatory law is not the main focus of this discussion but there are some regulations that directly impact the financial performance of the pension funds such as imposing constraints on investment of funds. Therefore the discussion follows the extent to which fed should intervene, and attention will also be drawn on inconsistent and biased regulations. 4) For sustainable pension plans strategies, Australian superannuation and Norway’s pension funds have been discussed in detail including their investment strategies, risk management techniques and supervision in order to find solutions that can be used by other countries such as US and UK.