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4.1. Business model, function in society and the capital markets
The provision of adequate retirement incomes for the aged is an obvious social welfare objective of most economies today.
Pension provision in most countries is a combination of public (unfunded) schemes, publicly-mandated contributory schemes and voluntary private retirement savings65. OECD, World Bank and ILO definition of pension schemes differ slightly66 but the principle followed by all schemes can be illustrated by the three pillar system used by the OECD.
| First pillar | Second pillar | Third pillar | |
|---|---|---|---|
| Pension provider | publicly managed pension schemes |
privately managed pension schemes, provided as part of an employment contract | personal pension plans provided by private pension and insuring companies |
| Product | defined benefit | defined benefit
defined contribution |
saving and annuity schemes |
| Funding scheme | pay-as-you-go finance usually based on a payroll tax | contribution by employer and employee | contribution by individual |
| Participation | complementary | Compulsory/Voluntary | Voluntary |
Table 12: Pension provision scheme following OECD taxonomy67
Being part of the second and the third pillar, the main objective of Pension Funds is the provision of adequate retirement incomes for the aged. While achieving this target Pension Funds act as intermediate that essentially transform terms and risk.
- Transforming terms (time period): transforming today’s available cash into available cash in the long term future68 (retirement)
- Transforming risk: the longevity risk of the individual is transformed to the longevity risk of many69 (and by the law of high numbers into lower risk)
Pension funds collect, pool and invest funds contributed by sponsors and beneficiaries to provide for the future pension entitlements of beneficiaries70. They thus provide means for individuals to accumulate savings over their working life to finance their consumption needs in retirement.
Pensions add to wealth of all populations, but especially are of importance to aging population as they prevent poverty during retirement. Consequence of failure is high social cost to the society.
Successful long term investment is important for the individual as it secures his living standard once he retires. But long term investment can also provide added value to the countries economy because it allows investors to demand a premium for illiquidity. It further lowers turnover of capital, what reduces cost, and makes pro-cyclical investment strategies obsolete. These effects improve financial stability. Long term investment can drive competiveness and support the development of the country’s infrastructure and new markets and thus leading to sustainable growth71.
| Function | Added value | Stakeholder |
|---|---|---|
| Transformation of terms | Converting today’s value into long term future value | Society, Individual, Sponsor |
| Transformation of risk | uncertainty of longevity
insurance risk Poverty prevention |
Society, Individual, Sponsor |
| Governance | active voting policies | Society, economy |
| Development | support infrastructure development, green growth initiatives | Society, economy |
Table 13: Added value of Pension Funds and the respective stakeholders
Forms of Pension Funds
Pension Funds are organized in two main forms that are72
- The trust/foundation: the pension plan members may have beneficial ownership rights over the pension fund or some other contractual claim against the pension entity, but the legal title (and often control) is vested on the trustee or the board of the foundation, who is expected to manage the fund in the best interest of the plan members.
- The corporate form: pension plan members have legal ownership rights over the pension fund via their ownership of a certain number of a shares in the pension entity that owns those assets.
Other forms are mainly autonomous pension funds: the pool of assets is deposited in a separate account managed by a financial company on behalf of the plan/fund members (Only certain financial institutions are authorised to offer such contracts)
Illustration 13: Scheme of stakeholders
65 Framework for Public Pension Fund Management, Paper presented to 2nd Public Pension Fund Management Conference World Bank, Washington DC, May 5 – 7, 2003
66 Yermo, Juan, REVISED TAXONOMY FOR PENSION PLANS, PENSION FUNDS AND PENSION ENTITIES, OECD 2002
67 Yermo, Juan, REVISED TAXONOMY FOR PENSION PLANS, PENSION FUNDS AND PENSION ENTITIES, OECD 2002
68 If a worker starts his contribution with the beginning of his working life in his early 20s his retirement is likely not starting before more than 40 years have past.
69 With the beginning of his retirement every worker knows the average age that his generation possibly lives. But for him personally the age with the highest probability does not matter much. His requirement for cash may be (hopefully) much longer than the average.
70 Davis (1995), Bodie and Davis (2000) in PORTFOLIO REGULATION OF LIFE INSURANCE COMPANIES AND PENSION FUNDS commissioned by the OECD, E Philip Davis, Brunel University London
71 Della Croce, R, Stewart F., Yermo J., Promoting longer term investment by institutional investors: selected issues and Policies, OECD Journal Volume 2011-1
72 Yermo, Juan, REVISED TAXONOMY FOR PENSION PLANS, PENSION FUNDS AND PENSION ENTITIES, OECD 2002