Establishing pension funds and expanding capital market

Have you been thinking about your life after retirement? Do you have a plan that keeps you as happy in your retired life as you are now? I haven't reached my retirement age yet, but I was wondering how someone working in the private sector is managing their retirement funding. What are the options for a retiree? Investing in bank deposit, government savings certificate, stock market or may be real estate.

Low interest rate on bank deposit, stagnant real estate market and the low confidence on stock market have left the retirees with very few options. Oh, government is planning to cut the interest rate on savings certificate as well!

Some of us might not face this scenario with prior retirement planning but I believe there are very few and the primary pressing need for retirees is to develop some sort of income.

Without a steady paycheque coming in each month, you'll be on your own to come up with the money you need to pay for housing, food, and medical bills.

My primary concern is the private sector may be because I belong to that workforce and there is a pension scheme for the government employees. The government provides a pension to government servants on their retirement from public service.

But the workers of the private sector are not allowed pension at the time of retirement except that only an amount of gratuity is provided to them. They are not allowed to receive other benefits at retirement. Government has introduced Old Age Allowance Programme which covers small fraction of elderly people in the country who are not covered by pension system.

Although limited in coverage, this is a healthy beginning of providing security to vast majority of the elderly people who are not covered by the existing pension system but generally this is for the people living below the line.

If we think about investing retirement money, conventional investment wisdom has always been to move from more aggressive investment assets when you're young to less aggressive assets as you age. Traditionally that has meant heavily investing in stocks to start out, with a lesser investment in bonds and cash.

As people age, their percentage of investments in stocks slowly is decreased while their bond and cash-equivalent investments increase.

The idea is to grow assets quickly early on, then maintain those assets while reducing risk as you grow older. According to this fundamental, retirees prefer to choose bonds and cash for investing but our capital market hardly offers any such investment options.

But what about income? Conventional strategies often assume that you'll use up your principal in retirement. That requires you to figure out how much money you'll spend per year, predict how long you'll live post-retirement, and reach a net present value of retirement funds that will allow you to use your calculated amount of principal each year of retirement.

I am not sure how many do this calculation before retiring, rather people think of generating income from their retirement money. Here a big role can be played by the pension funds managed by professionals who can forecast a retirement figure for a person based on their money and lifestyle.

BEST OPTION FOR INVESTING RETIREMENT MONEY: I am not saying the only way of solving the problem with investing retirement money is pension funds, but it is one of the best available options for sure. We already have some insurance companies providing annuity for retirees, but this is not very popular in our country. If we have a look at the developed countries, they have several pension or superannuation funds open for general people.

A pension fund, also known as a superannuation fund in some countries, is any plan, fund, or scheme which provides retirement income. A pension has common asset pool run by a financial intermediary on behalf of its members to generate stable growth over the long term and provide pensions for the members. The asset is managed by professional fund managers who have better access to information compared to general people. Also fund manager apply risk management methods to protect their asset pool.

Pension funds typically have large amounts of money to invest and are the major investors in listed and private companies. They are especially important to the stock market where large institutional investors dominate.

The largest 300 pension funds of the world collectively hold about $6.0 trillion in assets. Morgan Stanley estimates that pension funds worldwide hold over US$20 trillion in assets, the largest for any category of investor ahead of mutual funds, insurance companies, currency reserves, sovereign wealth funds, hedge funds, or private equity.

Now our capital market is very limited to stocks with a handful of government and corporate bonds to invest. Corporate borrowing is heavily dependent on banks and Bangladesh Bank indicates the need for bonds to reduce bank borrowing by the corporations. Institutional investors have become increasingly important for both asset management and the development of financial systems.

In fact, institutional investors are likely among the most important conduits of private and public savings, supplying capital for firms and countries to grow. Among institutional investors, privately-managed pension funds (henceforth pension funds) have played a crucial role across countries. They have gained popularity as countries decided to shift away from publicly administered defined-benefit (DB) pension systems towards systems that rely mainly on mandatory, privately administered, defined-contribution (DC) pension funds.

They have become popular even at the corporate level, where changes in the pension systems have entailed a shift away from defined-benefit towards defined-contribution schemes to transfer risk from corporations to individual. A recent study that encompasses mature and emerging markets finds that an increase in the share of total assets managed by pension funds and insurance companies has a positive impact on bond and stock market capitalisation. The effect on the depth of bond and stock markets is stronger when the financial system is market-based, when international transactions in securities are not too large, and when pension contributions are mandatory

One key motivation for countries to reform their pension systems has been the expectation that these pension funds would play a dynamic role in the development of capital markets, fostering private sector savings and reducing the cost of capital for corporations, in the context of a broader strategy to achieve more developed, market-oriented financial systems.

Since pensioners save for the long run, pension funds (unlike other institutional or retail investors) are expected to be able to provide long-term financing to domestic corporations, as well as governments. Moreover, pensioners contribute a steady flow of funds for many years to pension funds, enabling the latter to be a stable source of capital. Importantly, since pensioners are required to hold their investments in at least one pension fund until retirement, this gives stability to the system as a whole.

Furthermore, given their size and commission fees, pension funds should be able to professionally manage the asset allocation, diversify risk appropriately, and overcome problems of asymmetric information and transaction costs that pervade financial markets.

And given the large size of their capital, they are expected to invest in a broad range of domestic assets and diversify risk as much as possible within the country.

Therefore, relative to other institutional investors, pension funds are thought to be the ones which contribute the most to the development of domestic capital markets.

The growth of the pension fund industry has profound potential implications for the emerging market asset class. In terms of assets under management, pension fund assets in the developed world greatly exceed the market capitalisation of external and domestic emerging markets.

Thus, even a small permanent allocation by pension funds to the emerging market asset class may have a stabilising effect. In emerging market countries, the domestic pension fund industry is rapidly becoming a major source of domestic financing and has the potential to shape the future evolution of domestic markets. 

HOW RISKS ARE COVERED: Like any other participants in the financial system, pension funds are exposed to some risks. Pension supervisory authorities around the world have been following other financial sectors and moving towards a risk-based approach to pension supervision.

This can be recognised as a structured process aimed at identifying the most critical risks that face each pension fund and, through a focused review by the supervisor, assessing the pension fund's management of those risks and the pension fund's financial vulnerability to potential adverse experience.

The first of these is return risk. This refers to the fact that the value of the pension that can be purchased at the time of a person's retirement depends largely on the conditions that exist just at the point of retirement. This risk is handled in different ways by different types of pension plans.

For example, a defined-benefit pension plan mitigates this risk by pooling the assets of all contributors. This pooling helps to protect the ability of a sponsor of a defined-benefit plan to pay the pensions of all plan members, even those who retire one day after a stock market crash, or at a time when the return on long-term bonds is particularly low.

The other type of risk is longevity risk. In a defined-benefit pension plan, this risk is transferred to the sponsor of the plan who is responsible for making up any shortfall that could arise from pensioners living longer on average than expected.

By pooling these risks, pension funds generate important benefits in terms of economic efficiency. By transferring risk from individuals to collectives, pension funds help achieves a more efficient allocation of savings.

Pension funds-particularly the very large ones-tend to have sophisticated asset managers. These large funds have the incentive and the ability to invest pools of contributions across appropriately varied asset classes.

Further, they invest over very long-time horizons, so they can finance large investment projects at competitive rates of return. All of this contributes significantly to economic efficiency by transferring risk to those investors that are best able to bear it.

Finally, I believe there are many people out there who faced an issue with provident fund or gratuity contribution from the employer while switching jobs. I have worked in financial institutions and heard stories from colleagues how they lost some or part of the employer contribution.

This picture might exist in other sectors as well. Independent pension funds are a solution to this problem as well. I strongly feel a person should be given the option where to save and build his retirement benefits and it must be under his/her control.

Countries with strong financial systems have moved towards this track so it is high time for our policy makers to give it a thought.

The writer currently works for Commonwealth Bank of Australia.

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