We recently updated our comparative data representing the size of pension funds in different countries in relation to the country’s GDP. We included funds of both statutory (1st pillar) and occupational (2nd pillar) pension schemes. As a reader’s guide we would like to briefly explain some of the different funding mechanisms.
1. Liquidity funds
Every pension system needs a certain amount of liquidity; otherwise, exactly the same amount of contributions needs to flow into the system as is paid out as benefits to pensioners. That might work on paper but not in reality. The size of the liquidity buffer depends on the fund.
For statutory schemes, the liquidity amount required in a pension system is determined separately by each nation. For example, in Germany the liquidity fund of the private sector statutory scheme corresponds to the pension expenditure of 1.5 months.
2. Buffer funds
As a rule, buffer funds are set up at a certain point in time and consumed at a later point when the demographic ratio weakens. That means that a given generation pre-finances a part of its future pension expenditure. Many countries in Europe established buffer funds in times of demographic dividend as a mechanism to smoothen pension expenditure when society ages (as of the 2020s).
For example, Spain has this kind of funds in its statutory systems. However, due to a dire economic development, Spain started to deplete their buffer funds ahead of schedule. This also points to the weakness of this mechanism: a buffer fund is subject to political risk as no contract guarantees that the collected money is used at the intended time. In the end, these funds have ended up being cyclical buffers.
Often buffer funds are small in relative size. They could be viewed as extended liquidity funds. The buffer funds in Norway, Luxembourg and Sweden form notable exceptions to this rule: they cover several years of pension expenditure.
3. Partial funding
Partial funding can be described as a system that combines both pay-as-you-go and pre-funding within the same scheme. Depending on the level of funding, the pre-funded component can be noticeable or small. In the Finnish private sector earnings-related pension scheme, roughly one fifth of the pension accrued liabilities is funded and paid out as a pension later. In other words, accrued pension rights are partly funded on an individual basis. Similarly, the German liberal professions pension scheme ABV combines features of pay-as-you-go and funding (although the scheme likes to call its partial funding by the more emblematic term ‘open capitalization’).
The beauty in this mechanism is that it distributes the risk on both the development of the wage sum (paygo) and the financial markets (funding). In other words, it stands on two feet.
It must be pointed out, however, that as the liabilities are only partly funded, the funds are typically smaller than the liabilities of the system. On the other hand, under the current rules, they are never going to be totally depleted (as buffer funds may be) since it would mean that there are no existing liabilities.
4. Full funding
The archetype of private pension schemes is full funding. This means that the liabilities of the pension scheme need to be fully funded according to solvency regulations. Countries such as Denmark and the Netherlands have large occupational pension schemes based on full funding. That explains why these countries top the list in our figure.
Under the assumption that contribution rates are kept constant, pension benefits might need to be reduced in case of turmoil on the financial markets. On the other hand, when the financial markets produce large gains, benefits can be indexed at a higher rate.
In short, all the pension funds serve the same purpose of financing pensions but they differ significantly in terms of size, use and how they are accumulated.