Investors should take account of pension liabilities when analysing solvability of European countries, says Edhec
While public and private pension systems in the EU are under tremendous pressure, a new study by Edhec-Risk Institute analyses the explicit and implicit pension liabilities that are weighing on the public finances, and the principal related risks.
As structural deficits become a target in the Eurozone and beyond, it is fundamental to evaluate the extent to which the increasing funding needs, and decreasing funding basis of public pensions, could add to public deficits.
Due to the variety of national systems, obtaining a clear view of pension liabilities is not straightforward. The recent 2012 Ageing Report (European Commission, 2012) goes a long way in providing comparable figures and projections of public pension expenditures. On the basis of these projections to the year 2060, EDHEC-Risk Institute has estimated the net present value of the corresponding liabilities for various discount rates.
The present value of pension liabilities is very sensitive to the discount rate chosen, but is not negligible in any event. For the highest discount rate of five per cent, we obtain accrued-to-date liabilities around or above 100 per cent of 2010 GDP in 18 countries out of 27; above 200 per cent in eight countries; and up to 483 per cent for Belgium. With the central hypothesis of a four per cent rate, 12 countries are above 200 per cent and seven countries above 400 per cent. Finally, for the lowest hypothesis of 3 per cent, 11 countries are above 400 per cent, six countries are above 800 per cent of GDP, and it is impossible to calculate a discount rate for three countries whose pension expenditure growth rates are above three per cent.
Ultimately, the values for public pension liabilities that Edhec-Risk Institute has calculated can lead to solvability analyses that are substantially different from those habitually taken into account by ratings agencies or investors.
As such, countries with virtuous public finances in the Maastricht sense, such as for example, Sweden, Luxembourg or Denmark, are much less virtuous if their public pension commitments are taken into account, while the situation of countries such as Spain, Italy, or even Portugal, is relatively better.
The risk factors that could erode these forecasts further are mainly demographic (increase in the old-age dependency ratio), economic (persistent unemployment, reduction in hours worked, stagnant potential GDP) and political (notably the difficulty in ensuring that previous commitments are applied).
The European Commission is currently considering an agenda for adequate, safe and sustainable pensions, through a white paper to which Edhec-Risk Institute recently responded. In this perspective, Edhec-Risk Institute is making three major recommendations:
1. Investors must be more vigilant on pensions risk when evaluating the solvency of sovereign issuers.
2. European institutions should continue to work towards more transparency and information in the area of public finances, notably with regard to the data available and the modelling of public and private pensions liabilities.
3. Ultimately, one should envisage the inclusion of explicit criteria on pension liabilities, in addition to the goals of the stability and growth pact and the budgetary pact. This inclusion would allow all stakeholders to better evaluate pensions risk and would favour the implementation of indispensable reforms.
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