How Do Pension Funds Influence Economic Growth?

Pension funds have witnessed a dramatic increase in the number of assets that they control. This increase has been the result of an ever-increasing workforce that has been diligently contributing to their financial future.

The funds being managed by pension funds have increased both in developed as well as developing nations. Many developing nations are witnessing the positive spillover effect of the increased investment in these pension funds.

In this article, we will look at the various ways in which pension funds lead to overall economic growth.

  1. Higher Savings Rates: The entire concept of pension funds is based on the premise that governments give a tax holiday to employees if they invest their money today. The end result is that the large middle class is incentivized towards allocating money towards saving and funding their own retirement.

    Many studies have proved that the countries in which pension funds are more prevalent are the ones that tend to have higher savings rates. Since savings rate is important for the overall capital formation in an economy. Hence, when pension funds increase the savings rate, they lead to an overall improvement in the economy.

  2. Longer Investment Horizons: Pension funds not only increase the savings rate of the economy but also provide funds for a longer duration. The amount which is invested in pension funds is locked in for decades. Hence, pension funds can afford to undertake investments that will yield better in the long term irrespective of the short-term pressures.

    Projects related to renewable energy and such other sustainable technologies generally follow this cash flow pattern. Since pension funds can afford to fund these sectors, they not only increase the savings rate but also invest in the desirable sectors of society.

  3. Deeper Capital Markets: Pension funds invest a large percentage of their corpus in capital markets. These include all kinds of markets such as stock markets, bond markets, and the markets for ultra-short-term funds. Since pension funds control large amounts of money and are always transacting in these markets, pension funds provide much-needed liquidity to all of these markets. Pension funds also transact in many segments of the market where there are relatively fewer players.

    Pension funds continue to transact even during periods of liquidity which makes them strategically important as far as market liquidity is concerned. This liquidity is very important for investor confidence. Hence, it can be said that pension funds help in improving investor confidence and therefore in improving the overall state of the economy.

  4. Improvement of Governance: Since pension funds invest large amounts of money in the market, they end up owning a significant percentage of the shares of some companies. Hence, under normal circumstances, pension funds end up being on the board of directors of several small and large companies. As a result, pension funds have the opportunity to improve the level of corporate governance which is followed at such companies. This helps create a benchmark for the standard of corporate governance that the market expects.

    The end result is that pension funds end up positively influencing the level of corporate governance in the markets. This in turn attracts more investors and improves the functioning of the overall economy.

  5. Higher Spending Power: Pension funds help investors appropriate their earnings throughout their life. A portion of the money earned during a person’s youth can be set aside to fund their retirement. The end result is that the money compounds over the period of years and creates a significant corpus that can be used during retirement. This means that the retirees i.e. the people without an active income also have a steady cash flow thanks to pension funds. This steady flow of income leads to steady demand in the economy. This positively impacts aggregate demand and many other macro-economic factors leading to overall growth for the economy.

  6. Increased Life Expectancy: As mentioned above, pension funds enable retirees to have a steady source of income even when they are not earning. This money available in the hands of the retirees is often used to fund medical expenses. The end result is that retirees are able to obtain timely medical care which ends up increasing their life expectancy. Hence, pension funds enable the increase of demand for medical facilities and they also increase the quality of life enjoyed by retirees during the final years of their lives.

  7. Lowers Government Expenses: Since pension funds enable retirees to generate cash flows during their retirement years, the government does not have to fund these expenses using taxpayer money.

    If more people are enrolled in pension schemes, fewer people will need welfare benefits. Hence, the government does not need to tax its people at a higher rate to fund these liabilities. This can have several benefits for the economy.

    The lower tax rate makes companies more competitive. Hence, in a way pension schemes enable private corporations to become more competitive in the international market. Also, the lower tax provides more disposable income in the hands of the country’s citizens. This additional income also creates upward pressure on aggregate demand which leads to overall growth and development of the economy.

The bottom line is that it would be fair to say that pension funds are the institutional pillars that strengthen the foundation of any economy. It is for this reason that governments encourage investments in pension funds. Developed countries are already known for encouraging such investments. It would be in the best interest of developing countries to also do so.

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Pension Funds