Pension reform, capital markets, and the rate of return

This paper discusses the consequences of population aging and a fundamental pension reform - that is, a shift towards more pre-funding – for capital markets in Germany. We use a stylized overlapping generations model to predict rates of return over a long horizon, taking demographic projections as given. Our simulations show that a transition to a partially funded system crowds out existing savings only partially. The capital stock increases initially, but decreases when the baby boom generations enter retirement. The corresponding decrease in the rate of return, which results from both population aging and pre-funded pensions, is only modest, less than one percentage point in the closed-economy, fixed-technology case. The return on capital can be improved by international diversification, that is, by investing pension funds in countries with a more favorable demographic transition path. Feedback effects from strengthened capital markets and improved corporate governance, which are unlikely to be achieved with capital market reforms alone, will raise capital performance further.