"Global Capital-Market Diversification is the Silver Bullet for Pension System Problems"

Whilst life expectancy is on the rise in Germany, demographic change lags behind. Between these two trends yawns the pension gap: the difference between the net earned income a person is accustomed to and their pension benefits after retirement. Despite measures such as the Riester pension, it is clear that, for much of the current workforce, pension benefits won't be enough to maintain their customary standard of living in retirement. ZEW research associate Martin Weber makes the case for investing in the capital market as a supplement to statutory and company pensions to provide for old age.

Is the pension gap phenomenon a general symptom of the decrepitude of highly developed nations? How do other countries fare in comparison?

Sweden and Australia have created a mandatory third pillar in addition to statutory and company pensions, which – from the perspective of one particular attitude to risk – is better than what we have on offer here in Germany. In this case, “better” means that Sweden and Australia offers a pension fund in the form of an optimally diversified portfolio, into which the population pays a part of their social security contributions. Of course the old rule still applies to this sort of model: no risk, no return. But if the risk is optimally distributed – with globally diversified investments in different asset classes – then you can count on a good rate of return. Sweden and Australia have been successful with their model because they have high rates of return. The German Riester pension, which was modelled after the 401k system in the US, is a scheme along the same lines. However, it suffers from a number of design flaws.

So what is the problem with the Riester pension?

The Riester pension is a government-sponsored private pension plan that enables investment in a wide range of investment products.The catch is the excessively wide range of possible investment vehicles. There's also the fact that the Riester pension was originally drawn up without a capital guarantee, but public pressure mounted, leading to the introduction of the guarantee that all capital paid in must be available at the end of the saving period. This mechanism fails to take inflation into account. And finally, the Riester pension is a type of voluntary pension scheme for which sales representatives are very well paid, whilst the consumers themselves have to apply for the Riester subsidy, which is far too complex and expensive. Mistakes were also made with Riester pensions that were politically driven to a certain extent, because the population is afraid of the capital market.

How secure would a pension be as an investment in the capital market in the current low interest rate environment?

The present phase of low interest rates is not a permanent situation. At ZEW, we've carried out a series of studies looking at how high real interest rates were in Germany over the past 30 years, taking inflation into account. There were recurrent phases of zero interest rates as well as situations where the real interest rate hovered at around four per cent and inflation was 4.5 per cent or 3.5 per cent. This means that the current low interest rate environment wouldn't really have much of an effect at all on an investment in the capital market over the course of 30, 40 years. Investing in the capital market always inevitably carries a certain degree of risk; however this can be significantly reduced. Global diversification is the silver bullet here, because the global economy just doesn't come crashing down to rubble all at once.

How would you convince the working population and the political institutions to invest savings earmarked for retirement in the capital market?

First of all, investing in the capital market really just means investing in companies. Such investments may fluctuate in value, but can be expected to rise over the long term. If I have very broadly diversified investments – for example, some 1,700 companies are listed in the MSCI World Index – I own a small fraction of the world economy. The stock market is not a casino; it serves to assess the value of companies. That needs to be made clear to people. I'm less optimistic when it comes to political institutions. The Swedish or Australian models would of course have to be adapted for Germany, so that, for example, savings components are offered over graduated risk classes; that would then come down to individual preference. There would also need to be additional solutions for low-income earners. The state could provide instruments for that. And of course an institution like ZEW could contribute in the form of evidence-based recommendations.