The real obstacle to EU capital market integration is unreformed pension systems

A pension system crisis is looming in the European Union. As their populations age, EU countries must address their often alarmingly high levels of unfunded public pension liabilities, which typically vastly exceed countries’ gross public debt levels (Figure 1). These liabilities are calculated from current life expectancies, effective retirement ages and pension benefit levels. Many, if not all, EU governments will in the coming years have to change these pension system provisions and renege on earlier promises made to voters.

Figure 1: Accrued-to-date pension entitlements in social insurance, % of GDP 2021

Source: Eurostat and IMF.

How EU governments decide to reform pensions will in many cases determine their long-term national fiscal solvency, though it should not have financial market repercussions similar to defaulting on existing sovereign debt. Pensions reform will also either facilitate or sink the EU’s longstanding attempt at capital markets integration – what is now known as the Savings and Investment Union.

The European Commission, European Council, EU countries – not least Germany – and the European Parliament have been trying for years to agree greater harmonisation of rules on issues relevant to capital market functionality and infrastructure. These, generally governed at national level, include insolvency laws, securitisation rules and supervisory procedures for stock markets, clearing houses and crypto exchanges.

Yet, these rules are not the main reason for fragmented capital markets in the EU. The biggest issue remains the vast differences in people’s savings behaviour and the vehicles available to them. Here, pension systems can play a crucial role by channelling the savings of most workers into retirement products invested directly in stocks, bonds and other assets traded in national and global financial markets.

The far deeper and more liquid financial markets in the United States have benefitted greatly from the almost $40 trillion (about 140% of US GDP by 2023) in savings accumulated in and then invested from Americans’ pension vehicles. Of particular relevance to the EU, where financial markets are often desperately short of risk capital, is the role of pension funds as major investors in America’s venture capital and private equity markets, providing much of the resources that fund US entrepreneurs and start-ups.

US pension savings vehicles include 401(k) plans, 403(b) plans, employee stock ownership plans and profit-sharing plans. All benefit from preferential federal income tax treatment. The best known is the 401(k) plan. Employees can elect to defer a portion of their salary, which is instead contributed on their behalf, before taxes, to the 401(k) plan. Sometimes, employers match these contributions.

The US of course has the advantage that the federal government can offer preferential federal income tax treatment to these types of pension savings across the entire US economy. With no EU-level taxation, such preferential tax treatment cannot be offered to pension savings vehicles across the EU. 

The problems the EU faces in nurturing private pension savings go further than this, however. Major differences between national pension systems in the EU greatly complicate any integration attempts. This is particularly the case for pillars 2 (occupational pensions) and 3 (other private pensions) of pension systems, relevant for private pension savings. In many EU countries, such savings vehicles hardly exist, denying residents of those countries the option to put their savings to work in financial markets (Figure 2).

Figure 2: Total assets of private pension providers, % of GDP 2023

Source: OECD.

Only in Denmark and the Netherlands in the EU do private pension savings match the US level of roughly 140% of GDP. In all large EU countries, private pension savings remain a tiny fraction of GDP. Denmark alone has only slightly less in private pension savings than Germany, France and Italy combined, while the Netherlands has only slightly less than the entire rest of the euro area. This shows clearly that any meaningful integration of European pension savings vehicles will only be possible once more EU countries make such private savings possible.

Even if that happens, it will take time to build up national private pension savings to macroeconomically relevant levels. This will be particularly important in Germany, France, Italy, Spain and Poland, without which overall EU private pension savings will likely never be sufficient to promote better functioning of regional capital markets.

EU countries thus need to reform national pension systems to promote more private pension savings. This is underlined by the fact that the EU’s earlier attempt to create and promote a cross-border Pan-European Personal Pension Product has been an abject failure that has done next to nothing to increase EU private pension savings. If EU leaders want more private pension savings, and with them the possibility of larger and better-functioning capital markets to promote growth, they must reform their national pension systems first.