PENSIONS AND THE EUROPEAN DEBT CRISIS       Jacob Vijverberg, Multi-Asset Investment Group, AEGON Asset Management        ...
A brief history of the European Debt Crisis1.   Oct 2008: Banking crisis in Iceland.2.   Oct 2008: IMF supported Hungary a...
Portugal was the next in line for a bailout, in April 2011. Portugal’s unit labour costs had risen quicklyfollowing the ad...
countries, including France and Italy, are now trying to balance their budgets sooner than previously       planned.      ...
Stability and Growth Pact to allow them a five-year breathing space proved inadequate. The reforms         were also dogge...
Finding a durable European solutionIn addition to the actions that individual countries need to take, it is clear that the...
Figure 2: Resolving the European debt crisisAlternatively, the ECB could decide to monetise government debt, leading to hi...
rates if no structural reforms are undertaken, and interest rates would remain depressed, resulting in         an increase...
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Pensions and the European Debt Crisis


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  1. 1. PENSIONS AND THE EUROPEAN DEBT CRISIS Jacob Vijverberg, Multi-Asset Investment Group, AEGON Asset Management The present debt crisis in Europe requires not only actions by individual states but also a sustainable long-term European solution. One-off national and multinational solutions need to be embedded in a more transparent and disciplined approach to national debt in Europe; one that better takes into account the costs of ageing and the bold policy reforms undertaken by member states. In this article, we identify four scenarios for resolving the debt crisis and how these may affect pensions. Key points The debt crisis poses a substantial risk to both funded and unfunded pension systems Implicit liabilities like pension systems should also be taken into account European politicians need to take actions in order to restore confidence and contain the debt crisis Structural reforms are needed and budget deficits will have to be reduced. Sowing the seeds of crisis Like many financial crises, the seeds for the current debt crisis in Europe were sown years ago. There are two primary underlying causes for the current crisis. The first was the steady build-up of excessive national debts across Europe. Although the European Stability and Growth Pact was intended to keep this debt below a critical level within the euro zone, the limit on budget deficits was effectively ignored, as a number of countries, including Germany and France, were allowed to continue to breach the limits. The second underlying reason for the crisis was that labour costs rose much more quickly than productivity in many southern European countries. This resulted in unit labour costs that exceeded those in northern Europe, making it very difficult to compete. 1 Underlying the present crisis is an additional factor that will continue to present a structural challenge long after the present problems recede: the progressive ageing of European society. Not only is Europe faced with a mountain of debt but there will be fewer workers both to pay off the debt and to support ever more pensioners. Attempts at European level to reform the Stability and Growth Pact have therefore also tried to reveal the hidden costs of ageing and to move towards reforming policies in a way that will take account of future demographic changes. It is clear that the present debt crisis has and will have a significant impact on pensions – but it is also the case that pensions themselves are playing a significant but less visible role in the present debt crisis.1 High unit labour costs are not to be confused with stand-alone productivity. The popular press often mentions that thesecountries are much less productive than their counterparts in the North and that these therefore can’t coexist in one currencyunion. This is not necessarily the case. Countries can be less productive in the same currency union as long as their labourcosts are equally depressed. 1 June 2010
  2. 2. A brief history of the European Debt Crisis1. Oct 2008: Banking crisis in Iceland.2. Oct 2008: IMF supported Hungary as foreigners retreated en masse from government securities, prompting liquidity pressures. Foreign exchange household loans added to vulnerability.3. July 2009: Hungary raised €1 bn in Florint bonds which was sufficient to cover financing needs.4. Oct 2009: Greece revised its budget deficit to 12.5 percent of GDP from 3.7 percent. Financial markets lost confidence in Greece.5. May 2010: Euro zone finance ministers and the International Monetary Fund (IMF) agreed on aid package for Greece worth €110 billion over three years.6. May 2010: In a bid to prop up other financially ailing member states, the EU finance ministers and the IMF agreed a provisional safety net worth €750 billion to be in effect until 2013.7. November 2010: Ireland asked for EU assistance. Under the safety net, the EU finance ministers agreed a bailout package with the IMF worth more than €85 billion over three years.8. March 2011: The European Council gave the green light to a permanent stability mechanism (ESM). Designed to take effect as of mid-2013, the fund will be worth €700 billion.9. April 2011: Portugal asked the EU for financial assistance.10. June 2011: Greek parliament approved austerity measures despite large scale street protest.11. July 2011: EU decided to implement a package of measures to assist Greece and calm markets about contagion risks after Spain and Italy had come under pressure.12. August 2011: Spreads on Spanish and Italian bonds widened dramatically as the market lost confidence in debt sustainability. The ECB decided to buy Spanish and Italian bonds to prevent a new crisis.Turbulent timesThe first euro zone country to experience severe financial difficulty was Greece in October 2009,after it admitted reporting erroneous debt and deficit figures. Greece received a bailout packagefrom the IMF and the EU in the spring of 2010. Meanwhile, Ireland was experiencing a majorhousing bust. As Irish banks were forced to write off huge sums, several became insolvent. The Irishgovernment recapitalised the banks, which is estimated as having cost almost 60% of Irish GDP.Ireland’s debt-to-GDP ratio shot up, forcing Ireland to accept an emergency package from the IMFand the EU in November 2010. Irish pension funds also suffered, as the Irish government introducedan annual pension levy of 0.6% of assets. 2 September 2011
  3. 3. Portugal was the next in line for a bailout, in April 2011. Portugal’s unit labour costs had risen quicklyfollowing the adoption of the euro. Structural inefficiencies were not addressed and the country wasrunning large current account deficits. Following the bailout of Portugal, by the summer of 2011,markets shifted their attention to Spain and Italy – both in Southern Europe but with quite differentdebt dynamics (see also Figure 1).Italy has a higher debt to GDP ratio, but a lower budget deficit than Portugal. Spain has a higherbudget deficit, but a lower debt level. These two countries are also struggling with more specificproblems. Spain is in the process of reforming its local savings banks, the Cajas, which sufferedlarge losses in the housing crash of 2008. Italy on the other hand has structurally uncompetitivesouthern provinces and the current political landscape makes it difficult to implement reforms.Investors, however, are not only concerned about the debt figures, but also about the ability and willof politicians – and populations – to implement reforms. Figure 1: Debt statistics for a sample of European countriesEurope intervenesThe present debt crisis does not respect the niceties of the EU legislative timetable and Europe isimplementing a range of immediate measures to contain it. In July 2011, interest rates were loweredand maturities extended on loans from the European Financial Stability Facility (EFSF). This fund isnow also able to recapitalise struggling banks and to buy back debt on financial markets, providedthat this is ratified by all member parliaments. Financial markets initially reacted favourably, but inAugust spreads started to increase rapidly again. The US was downgraded by S&P in the sameweek, worsening the negative sentiment. The ECB began buying Spanish and Italian bonds in orderto prevent the crisis from spreading.Ideally, this action should have been taken by the EFSF, but the EFSF was not yet ratified by allmember parliaments. However, the bond purchases put the ECB in a vulnerable position, as itcannot exert political pressure to force countries to implement austerity measures. The ECB iscurrently trying to neutralise its purchases by issuing short term bills. If it were not do so, it wouldeffectively end up monetising government debt, which could be inflationary. Several European 3 September 2011
  4. 4. countries, including France and Italy, are now trying to balance their budgets sooner than previously planned. In August, Angela Merkel and Nicholas Sarkozy agreed that they would propose the formation of a European economic government. The exact details are still unclear (as is how it will affect the current package of reforms proposed last September.) However, both sets of proposals would involve an increase in multilateral authority over national budgets. They also agreed to include a clause in all constitutions obliging countries to balance their budgets. These actions were not well received by investors, who were hoping for a more immediate solution. Hidden debt – sustainable pensions and Europe’s Stability and Growth Pact Europe’s Stability and Growth Pact is a collection of different measures, only some of which are legally binding. Applying to both the euro and non-euro zones, these measures were intended to provide a macroeconomic framework to reinforce Europe’s internal market policies. Sovereignty – fiscal, social and otherwise – makes greater European coordination in this area extremely difficult. In addition a lack of transparency and the lack of a common European methodology for costing pension systems make it hard to account for the true costs of Europe’s ageing populations. The risk is that, as the current crisis recedes, problems with the sustainability and adequacy of Europe’s pension systems will not only continue to grow but may continue to do so largely unseen. Europe’s pensions systems are, in fact, a largely concealed component of the debt crisis, whose full scale and nature has yet to be made apparent. The European Commission has tried to draw attention to the fiscal sustainability of Europe’s pension systems in its Pensions Green Paper of 2010 and other initiatives, including the reform of the Stability and Growth Pact. The discussion covers not only issues around state pay-as-you-go systems but also the implicit costs of ageing that may arise if, for example, workplace or private pensions systems fail to deliver according to expectations. The Commission’s proposals to improve sustainability are likely to feature in its Pension White Paper later this year. Progress is not likely to be rapid, however, as this is an area where each Member State can exercise its national veto. Furthermore, revealing the true state of national pension systems may also provide difficult reading for a number of EU countries who are currently not bearing the brunt of the current debt crisis. The potential impact of pensions is highlighted by the experiences and actions of several of the Central and Eastern European countries (CEECs). Many CEECs formed a special case under the Stability and Growth Pact. When they joined the EU, their pension systems were undergoing profound reform, moving away from a primary dependence on pay-as-you-go systems towards privately managed, mandatory-funded defined contribution systems. The CEECs tried to build these systems up very quickly by diverting part of the payroll tax away from the pay-as-you-go systems to finance their new, funded systems. The premise behind this approach was that the resulting ‘double payment problem’ would be tolerable as long as there was sustained, significant economic growth.2 However, the crisis revealed this expectation to be over-optimistic and a special provision in the2 "The scale of fiscal deterioration following the crisis is equivalent to offsetting 20 years of fiscal consolidation, implying thatfiscal constraints will be very strong in the next decade. Estimates suggest that the crisis will put further pressure on publicpension spending over the long-term because economic growth is set to be considerably lower and there is great uncertaintyas to the timing of the full recovery.[...] In a number of Member States some social security contributions were diverted tonewly established mandatory funded pensions. The crisis has underscored this double payment problem and has caused afew governments to halt or lower contributions to private pensions to improve public pension finances." EuropeanCommission: "Green Paper - towards adequate, sustainable and safe European pension systems", COM(2010)365, 7July 2010. 4 September 2011
  5. 5. Stability and Growth Pact to allow them a five-year breathing space proved inadequate. The reforms were also dogged by other issues, varying across the CEECs from the existence of special privileged pension plans for certain economic sectors that enjoyed political influence, the misuse of disability schemes to facilitate early retirement, the behaviour of certain sector providers and a failure to collect the appropriate level of contributions. The European Commission’s proposals3 to reform the Stability and Growth Pact early in 2010 may have been little-noticed by the European public (and been overwhelmed by events), but its call to reinforce Europe’s system of economic governance seems now to have been taken up by some European politicians. In its call for reform, the Commission not only pointed to the need to cover the costs of bailing out the financial sector but for debt to better reflect ‘implicit liabilities, notably related to ageing’4 and it proposed a more qualitative, forward-looking approach to assessing debt that would also take into account the likely effects of policy reforms. This not only included the effects of systemic pension reform but also reversals of these reforms.5 The reform package launched in September 2010 is still working its way through the EU institutions and is not due to come into effect until 2013. Reducing the European debt burden To resolve the debt crisis, both short and long-term measures will need to be taken. In the long run, indebted countries simply have to reduce their burden of debt. In order to be able to do this, they will need to run primary budget surpluses6 and preferably also to expand their economies. Currently, several European countries are still a long way removed from a primary budget surplus. They will therefore have to reduce spending, increase taxes and implement reforms. These reforms can be summarised into three general categories. First, countries will need to reduce their unit labour costs in order to regain competitiveness. This can be achieved by increasing productivity or by decreasing labour costs. Secondly, many countries are struggling with an ageing population and rising healthcare costs. Increasing both the effective as well as the statutory retirement ages would extend the contributing lives of the workforce. Reducing statutory retirement benefits may greatly enhance debt sustainability but the political (and social) impact places limits on this. It is therefore necessary to ensure that people understand the need to save for their retirement and that appropriate and reliable information is available so that they will be able to put sufficient money aside. There is also a need for greater efficiency in addressing the costs of medical and long-term care as an ageing population will demand more and costlier treatments. Thirdly, corruption and tax evasion should be addressed. This differs greatly for the various countries. In the short term, countries will not be able to reduce their deficits immediately. They will thus have to continue to finance their current budget deficits and refinance maturing debt. The ability to do this depends on the trust of the markets, and countries need to win this trust by demonstrating that they are serious about reform.3 EU Commission: "Reinforcing economic policy coordination", COM(2010) 250, 12 May 2010.4 EU Commission: "Enhancing economic policy coordination for stability, growth and jobs – Tools for stronger EUeconomic governance", COM(2010) 367/2, 30 June 2010.5 European Commission: "Propoosal for a Council Directive on requirements for budgetary frameworks of theMember States", COM(2010) 523, 29 September 2010.6 A primary budget balance is the budget balance excluding interest payments on debt. 5 September 2011
  6. 6. Finding a durable European solutionIn addition to the actions that individual countries need to take, it is clear that there is a Europeandimension to the debt crisis which requires a durable European solution. One-off national solutionsor multinational solutions such as Euro-bonds need to rest on a more transparent and disciplinedapproach to national debt in Europe, one which better takes into account the costs of ageing andbold policy reforms undertaken by member states.With regard to pensions in particular, profound and extremely sensitive issues of fiscal and socialsovereignty also need to be addressed. The current reform of the Stability and Growth Pact seemsto have escaped wider public attention, with press reports focussing on political positioning aroundshort-term responses to the crisis. The upcoming Pensions White Paper may be an opportunity for awider European discussion of the steps needed but real discussion about ensuring the fiscalsustainability of our pension systems may demand thinking the unthinkable: a more Europeanapproach to social and labour policy, at least for the euro zone countries.The European Commission refers to introducing greater ‘conditionality’ in the award of Europeansupport to individual countries. For example, there are also pension reform clauses in bailoutagreements to individual countries. If this is already possible under current arrangements, canEuropean countries take the next step towards a more multilateral approach to how they pay for theirpension systems in order to avoid cross-border pension bailouts?European solutions need not only be about enforcing fiscal discipline and cutting back on benefits. Ifwe can realize an internal market in pension provision, we have the potential to increase efficiencyand to make pension contributions go further. This needs to consider workplace and non-workplacepension provision and, in our cross-border reflections, ultimately we need to think about increasinglymobile pensioners as well as mobile workers.Four scenarios for resolving the debt crisisThe resolution of the European debt crisis depends on two variables: first, market confidence needsto be regained in the short term and, second, structural reforms must be implemented in the longterm (see Figure 2). Without market confidence, countries will not be able to finance themselves.Without wide-ranging reforms, the debt crisis will resurface in the future when debt dynamics will beeven harder to fix.If we look at how the debt crisis may be resolved, we identify four different scenarios. Of the fourscenarios, the worst-case scenario would be if Spain and Italy were to default. This could happen ifeither of these countries is unable to implement reforms or if the EU is unable to restore confidence.Renewed market panic would damage consumer and business confidence. The Spanish and Italianeconomies would fall back into recession after which their debt burden could becomeunmanageable, as GDP would contract and deficits grow. Eventually this would lead to arestructuring of their debt. The result would be a major banking crisis as many European banks holdsignificant amounts of Spanish and Italian debt. This could spark a depression and a break-up of theeuro. 6 September 2011
  7. 7. Figure 2: Resolving the European debt crisisAlternatively, the ECB could decide to monetise government debt, leading to high inflation and adecline in the euro. This would also probably spark a recession. It is unclear whether this would bepreferable to the break-up and default scenario. Another potential scenario would be that politiciansimplement credible structural reforms, but investor confidence is not restored. This could happen ifthere were uncertainty about whether measures would be implemented or if the EFSF provedincapable of dealing with a short-term market panic. In this scenario, spreads would rapidly rise;consumer and business confidence would drop, triggering a new recession and making it moredifficult to implement structural reforms. A default of several indebted countries and a recession inEurope would be a real possibility.A more optimistic scenario would be if politicians were able to restore confidence, by expanding theEFSF, for example. However, if this isn’t accompanied by the implementation of longer-termstructural reforms, debt sustainability would be unlikely to improve. In the short run, spreads coulddecline as the immediate default risk recedes. In the longer term, however, debts would rise ascompetitiveness and government budgets failed to improve. Eventually the debt crisis wouldresurface, after which it would prove even harder to avoid sovereign defaults.The most positive scenario would be a rapid return to growth. For this, confidence needs to berestored and spreads to decline. Structural reforms will be required to increase GDP growth. Withincreasing tax revenues, all major European economies would be able to reduce their debt-to-GDP.The implication for public and private pensionsLooking at the outcomes of the four different scenarios above, the question is how these will affectpensions – not only the market impact on the value of pension assets, but also the impact onpension liabilities. In addition, how may possible government actions affect pension funds?Looking at the worst-case scenario, pension funds would be affected in every possible way.Declining markets would affect pension assets decline, and high inflation will affect pensionliabilities. There is also the danger that governments will move to tax or otherwise to use pensionassets to reduce their debts. In the two, sub-optimal scenarios, pension funds would also beaffected, although less severely. Pension assets would probably perform below long-term growth 7 September 2011
  8. 8. rates if no structural reforms are undertaken, and interest rates would remain depressed, resulting in an increase in the remaining high nominal liabilities. Inflation would remain low as the economies perform below their growth potential, meaning that real liabilities would also not increase. However, granting indexation (where this is optional) would be difficult. If we look at an average or base-case scenario, the impact on pensions would be lightly positive. In this case, politicians would implement austerity measures to reduce their deficits. Any indication that the measures are insufficient would be penalised by higher spreads. These would serve as the main mechanism to enforce budget disciple and would also trigger pressures on the respective government by the EU and the ECB. It would however remain a balancing act, as renewed panic on the financial markets might be self-fulfilling. A solution would need to be found for Greece, and further restructuring of their debt seems inevitable. Structural reforms would be a key driver for any future growth and the recovery would in any case be slow, as government expenditure would continue to decline. The main economies would be able to start reducing debt by 2014. For pension funds, this base-case scenario would restore long-term growth perspectives. Interest rates would probably remain low, keeping nominal liabilities high and leading to slowly improving funding ratios. Inflation might increase due to monetary financing but probably not strongly, as the European economy would still be operating in a low growth mode. This would mean that real liabilities would increase slowly, making it difficult for pension funds to grant indexation. However, the current crisis has made it clear that expectations about entitlements from our current pension systems, whether funded or unfunded, are unrealistic.7 The decline in interest rates has further reduced the funding levels of pension funds, which were already hit by losses on investments. Those that can may well be forced to consider reducing liabilities by forgoing indexation or reducing benefit payments directly. The positive scenario would clearly provide the best outcome for pension funds. Pension assets would grow and interest rates rise, resulting in lower nominal liabilities and improving funding ratios. This would enable pension funds to provide indexation, which would probably be required as inflation would also gradually increase. Enabling reforms – the importance of transparency Increased transparency about our pension systems is a precondition for meaningful public debate and public acceptance of reform. Although over-generous state pay-as-you-go systems may look to be the culprits from a fiscal perspective, private funded systems, whether occupational or individual, are by no means completely future-proof. Transparency in pensions includes making clear to people the differences between the different providers and the pension promises on offer. To do this, the solution at European level is to ensure that prudential frameworks are capable of revealing the similarities and differences between the variety of funded pensions on offer, as well as to encourage an economic, risk-based approach to delivering pensions. A reformed prudential framework for pension provision at European level should also support the efficiencies of scale associated with a real internal market in pensions. A more efficient internal market in pension provision could play an important role in addressing Europe’s ‘demographic time bomb.’ In any case, transparency will enable all parties to gain a clearer view of our pension entitlements for the future.7 The future of public debt: prospects and implications, BIS working paper. 8 September 2011