Academic journal article Journal of Economics & Management

Complexity in Risks Facing Pension Plans: Nonmarket Financial Risk in the United States and Poland

Academic journal article Journal of Economics & Management

Complexity in Risks Facing Pension Plans: Nonmarket Financial Risk in the United States and Poland

Article excerpt

Introduction

Financial markets in modern economies are complex systems. The ongoing international integration of financial markets intensifies this complexity. Knowledge about complex financial market systems and understanding the way such systems function, along with understanding interactions between components of those systems, is incomplete. Complexity of financial systems results in difficul - ties in anticipating directions of development in market segments. A situation in which a market segment functions or interacts with other segments in an unforeseen manner may result in other segments of financial markets behaving contrary to expectations. Such unforeseen behaviours of elements of the system may lead to the whole system behaving contrary to expectations [Hanseth 2007]. In the context of a financial system, complexity may be discussed either of financial instruments (and to be more exact financial innovations that are very complex products) or of the structure of the financial system that is based on mutual interdependencies in the group of actors and contractors. As a result of such mutual interdependencies, it is possible to observe emergence of mechanisms of transmitting economic shocks through networks whose structure is being transformed by financial innovations and regulatory arbitrage. As a result, numerous loops of feedbacks are created that amplify financial market effects [Landau 2009].

Growing complexity of the financial system results in its greater unpredictability. Financial phenomena that may be observed in such systems are increasingly difficult to control. It is even more difficult to manage them. Integration of financial markets has intensified their complexity, which results in an increase in the level of risks in the financial institution environment [Hanseth 2007]. This complexity makes financial institutions face totally new challenges. These challenges include, inter alia, ongoing innovations, complicated regulations and supervision of governmental institutions, overload of information, and market volatility. Because of the rapidly changing nature of the basic reasons for the complexity, new mechanisms that drive this complexity have emerged. This leads to emergence of new risks to be managed [ERM 2011].

Increasingly, pension funds face a number of nonmarket financial risks. In an attempt to expand diversification of their portfolios, pension plans have increased the range of assets in which they invest. At one time, they invested almost exclusively in assets traded on public exchanges. Now they also invest in infrastructure, real estate, real assets (such as timber) and private equity. Formerly, the primary financial risks they bore were those of financial markets. Now they are also exposed to agency and counterparty risks. In addition, they are exposed to regulatory capture risks, which is the risk that the regulations will be designed to favor the regulated industry. For example, the advisers to pension plans and participants may engage in regulatory capture so as to protect their ability to benefit from conflicts of interest and to provide advice that is not in the best interests of their clients. Also, they face political risks, particularly when funded pensions have replaced or partially replaced pay-as-you-go social security systems.

This paper discusses agency, regulatory capture, counterparty and political risks as aspects of financial risks that pension plans and their participants bear. We use as examples the United States and Poland. The intent of the paper is to expand beyond financial market risks the discussion of financial risks that pension plans and participants bear in funded pension systems. Thus, this paper fits into the broader discussion of the relative merits of funded and unfunded pensions. The paper also relates to analysis of the increasingly complex environment in which pension plans operate.

1. Agency risks

Agency relationships occur between principals and agents of the principals. …

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