The inaugural edition of the OECD Business and Finance Outlook says the main concern is that pension funds and life insurance companies might become involved in the “search for yield” in order to match the levels of returns promised to policyholders and beneficiaries when interest rate were higher. This poses risks including insolvency.
“Generating the resources needed to confront the challenge of ageing populations will require a better global allocation of resources to the most productive investments but without excessive risk-taking,” said OECD Secretary-General Angel Gurría launching the report in Paris.
“Above all, much remains to be done to strengthen the ability of the financial system to absorb shocks and avoid the bubbles and busts of recent decades” he added.
The report also cites a very real risk that the current trend for companies to return cash to shareholders via dividends and buybacks, in order to boost short-term returns, means that capital will not be reinvested in more productive activities. This will hurt innovative investment and productivity growth. There are also risks building up from greater leverage and riskier investment in higher-yield and complex products with poor liquidity.
Over the next five years, pension funds are expected to grow 26% from an estimated USD 28.4 trillion in 2014 to USD 35.8 trillion in 2019; insurance companies’ assets will grow 33% from USD 28.2 trillion in 2014 to USD 37.7 trillion in 2019; and mutual funds will expand by 38% from USD 33.4 trillion in 2014 to USD 46.1 trillion in 2019.
Pension funds and insurers could face issues as high-yielding bonds are replaced by low-yielding bonds in their portfolios. Lower interest rates will lead to lower returns for pension funds, which invest around 40% or more of their assets in fixed income securities, including lower yielding government bonds. If interest rates remain low into the future, funds and insurers may find their assets insufficient to meet their promises, unless they adjust their pension or payment promises.
To reduce insolvency risks, insurers may need to offer lower guaranteed returns on new contracts to reduce liabilities and, in extreme cases, renegotiate current terms. Pension plan sponsors could adjust or terminate existing plans and offer less attractive terms to new employees. Defined benefit pension plan sponsors could increase contributions to funds. Regulators and policy makers will need to remain vigilant to prevent excessive “search for yield”, says the report.
The OECD Business and Finance Outlook also analyses the rise of shadow banking and the impact of financial sector reforms since the crisis. It says there is still much to do to eliminate the current under-pricing of risk and to strengthen the ability of the system to absorb future shocks. These should involve ensuring strong capital bases and making key financial sector firms less interconnected by, for example, separating shadow banking from more traditional deposit banking and implementing policies to limit critical leverage.
Other chapters in the Outlook address bank and capital market financing of SMEs; MNEs in the shifting global business landscape; market-based financing of corporate investments; and pro-competitive policy reform for investment and growth.
Full press release
Full Business and Finance Outlook