It is reasonably well known that, like many other areas in the developed world, the eurozone populat...
It is reasonably well known that, like many other areas in the developed world, the eurozone population is aging. At present, there are around four workers to every pensioner in the Euroland, by 2040 there will only be two.
This demographic shift is likely to put massive pressure on public pensions in the future, particularly in those countries which have quite generous provisions. State pensions in Europe are presently financed on a "pay as you go" (PAYG) basis where current workers' contributions are used to fund the pension payments of retired people.
Clearly, this sort of system is vulnerable to shifts in the ratio of workers to retirees. Without any changes, pension expenditure in the eurozone inevitably looks set to rise substantially in the years to come as the population ages. This additional expenditure must be met by either an increase in government borrowing and/or an increase in workers' corporations' taxes.
For Europe, neither option looks particularly viable given the rules of the Stability Pact and the general drive to reform the economies. It is very likely that a variety of methods will be employed to deal with the state pension problem in Europe. Raising retirement ages and cutting benefits is certainly one way to deal with the problem - but political implications suggest that it would be unwise to rely solely on these methods.
Another way to alleviate the problem is to allow and encourage the development of a market for supplementary (private) pensions in Europe. Although supplementary pensions can by no means be relied upon as a total solution to the problem, they can help to ease the pressure on governments in the future considerably by shifting some of the pension burden on to the private sector.
As trends in countries like the US and UK suggest, such a shift is possible but requires a framework which encourages both individuals and /or their employers to save in this manner. In an effort to achieve this, the EU Commission is in the midst of putting together a directive on the single market for supplementary pensions.
Once agreed upon, this directive should play a major role in encouraging the further development of a private pension market in Europe. These regulations will take some time to implement, but once in place, such changes could also have quite profound effect on financial markets in Europe as well with savings likely to be channelled into those investments which have the appropriate risk/return qualities for a fully funded pension fund.
We already have an idea of the framework which may result from the introduction of this directive after the publication of two key papers last year. What seems clear is that the directive is likely to allow pension funds in the EU to take quite a flexible approach towards their investments with no quantitative asset allocation restrictions likely to be applied.
It is also highly unlikely that the EU will adopt a minimum funding requirement (MFR) which is as strict as the UK's. Currency matching rules may change to allow non-EMU countries in the EU to match liabilities with euro denominated assets. A code of best practice rule will allow countries to continue to apply their own rules if they so wish. This framework will be an important factor determining the functioning of private pensions when implemented (this could be some time).
However, it is extremely important to understand that retirement savings are not just built up in pension funds alone. A good deal of savings which is expected to provide the same function as a pension occurs outside of these schemes. Consequently, we recommend looking at total household savings when contemplating the effects on markets. Whether savings occur inside or outside of private pension schemes, one thing seems inevitable, eurozone households' financial assets look likely to grow quite dramatically in the years to come.
The major point being that this development will be good news for all financial assets with higher demand for savings likely to depress nominal and real bond yields and earnings yields on equities. Some of the other, more specific conclusions for the markets are as follows:
l Financial markets as a whole. One way or another the demographic trend is likely to prompt increased pension fund savings in Europe.
The introduction of an EU Directive for Supplementary Pension, by itself is not necessary to prompt this move, but will help to facilitate it. The increased levels of savings generated by the shift in the demographic mix should be good for all financial assets in the next 10 to 15 years as it pulls down real bond yields and earnings/dividend yields on equities. Consequently, we maintain our structurally bullish stance on bond markets in the West and believe that the latest setback in bonds should not be viewed as a secular shift to a long term bear market. The shift also suggests that earnings and dividend yields on equities are not too low which, in turn, should help to underpin the bull market there.
l Equities versus Bonds. In terms of the performance of relative asset classes, European equities should benefit most from this build up in pension savings given the immaturity of the funds and the reasonably dramatic shift in existing weightings in the years to come (eurozone pension funds presently hold around 60% of their assets in bond versus 20% in equities - demographic trends indicate the need for a full reversal of these weightings).
As a result, we anticipate that equities will outperform versus bonds further in the years to come in the eurozone. At present, the 10 year government bond yield in the eurozone is around 1.5 times the earnings yield on equities - in the US, the ratio is much higher with bonds yielding over twice equities.
In our view, both the demographic patterns and likely asset allocation shifts in Europe indicate scope for these
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