Pension funds clearly have a role to play in the life-cycle pattern of saving, with the function of ensuring that sufficient assets are available to provide income after retirement. Some would argue in favour of their development purely as a means to encourage saving at the macroeconomic level, but the evidence that they are a suitable means for this is not clear-cut, as discussed below.

An exposition of the life-cycle hypothesis and liquidity constraints is essential to a number of the arguments of the book; those already familiar should skip this section. The life-cycle hypothesis assumes that consumers derive utility from a smooth pattern of consumption over both working and non-working life. As regards the implications of retirement, this entails accumulation of assets during the working life, which will be decumulated after retirement. But there are also implications for borrowing. In a perfect capital market, where there are no restrictions on borrowing by individuals, the consumer carries out 'intertemporal optimization' by borrowing freely against the security of his human wealth (i.e. future wage income) or nonhuman wealth. Given a normal income profile, i.e. rising over time, with heavy expenditure on household formation in young adulthood, this is likely to mean heavy borrowing early in the life cycle and corresponding repayments later, overlaying the patterns of saving. A crucial assumption of the life cycle is that individuals are far-sighted enough to plan for retirement–in practice, the myopia 14 of certain individuals is one of the main arguments for institutionalized forms of retirement-income security. Note that the aggregation of individuals to give national saving in the context of the life cycle indicates that the demographic structure of the population will have an important influence on saving. In particular, the ageing of the population initially boosts private saving on a simple life-cycle basis, as there is likely to be a larger proportion of the population in the high-saving age group. Later, private saving may fall or become negative, depressing asset prices, as the large elderly generation seeks to realize its wealth.

Summary

Pension funds, as the major investors in equity, have a key role to play in corporate finance and corporate governance. Perhaps the most interesting recent development is increasing activism on the part of pension funds in directly influencing the management of the companies in which they invest.

• Where it is not restricted by regulations, international investment of pension funds has grown rapidly in recent years, thus reducing risk for a given return. International diversification has clear benefits for international capital markets, although concerns have been expressed about the possible destabilizing effect on securities markets and exchange rates of herding on the part of funds.

• Pension funds are either defined benefit or defined contribution. The individual bears more financial-market risk, with defined contribution, as the pension depends on asset returns. Particularly for those who remain with a single employer, defined-benefit funds may offer better 'retirement-income insurance'. Private defined-benefit pensions are generally only available through companies, which provide a form of guarantee. There are some disadvantages of defined-benefit funds (e.g. regarding labour mobility). But the case for defined contribution or defined benefit is much more subtle and complex than partisans of either side would suggest.

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