How do Demographic Changes Affect Pension Funds?
The problem of demographic changes has been ignored by economic planners for a very long time. This is because economic planners rarely look beyond a period of five years. Demographic changes do not happen over a five-year period. Instead, these changes are glacial in nature. This means that they happen very slowly every year. However, over the years, the cumulative impact can be quite significant. This is what has happened as far as demographic changes in most parts of the western world are concerned.
Today, a significant number of pension funds across the world are underfunded because they have not taken changing demographics into account.
In this article, we will explain how changing demographics tend to affect pension funds.
Investment Philosophy of the Funds
Also, when pension funds have a large number of retirees, their asset allocation also undergoes a significant change. This is because it is a known fact that equity investments provide a larger return over a longer period of time. However, they are very volatile in the short run. Therefore, if a fund is investing over a short time horizon, it would be advised to steer clear of equity.
Funds with younger populations can afford to invest in riskier assets and generate higher yields. It is also common for pension funds with a lower average age to invest directly in many companies instead of buying their shares listed on the stock exchange. Since they can hold the investment for a longer duration of time, they are very likely to generate superior returns.
However, funds that have aging populations, they have to invest more in bonds and other short-term fixed-income securities. This brings down the overall yield of the fund.
Increase in International Investments: When economies age, the availability of economic opportunity also declines significantly. This is because the number of people not actively working goes up. The economy becomes more consumption-based. Hence, from an investors point of view, the number of available opportunities to invest in equity assets also goes down considerably. In such a situation, if the pension fund has a large amount of funds that it needs to invest, it is surely going to run out of investment opportunities.
Hence, in order to avail better investment opportunities, the pension funds start investing in foreign markets. Empirical data shows a clear correlation between an aging population and the percentage of funds that have been invested overseas.
The bottom line is that demographic factors are very important for pension funds. They can completely change the manner in which pension funds deploy and distribute their funds. Now since the dependency ratio has reached alarming levels, pension funds have no alternative but to pay attention to the same.
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.