The risks of investor ignorance By Gerd Hausler Published: January 27 2005 19:58 | Last updated: January 27 2005 19:58

Over the past decade, we have witnessed a significant shift in how financial risk is borne in industrialised economies. It is essential for the long-term viability of the global financial system that we understand the nature and magnitude of the risks, identify those who ultimately bear them and carefully address the dramatic shifts. One change that has occurred with rather benign consequences so far is the transfer of risk from banks to non-bank financial institutions, such as insurance companies, mutual funds, pension funds and hedge funds. This development has been driven by, among other factors, differences in capital requirements and accounting rules across the sectors. We have every reason to believe that this trend will continue. A more complex shift is the transfer of financial risk from financial institutions to households, largely in response to fundamental demographic changes and the unavoidable evolution of pension systems. "Pay-as-you-go" systems as well as pension plans based solely on defined benefits are becoming financially unsustainable. Regardless of whether they are private or public, pension systems will increasingly be funded by and based on investments in capital markets. Therefore, the value of pensions will necessarily be correlated more and more with the price movements of financial assets. The changeover from a payas-you-go system to one where pension claims are contingent on economic and financial market variables will not be easy to accept. It represents a quantum leap rather than a mere transition. There is no point, however, in debating whether such a development is good or bad; in many countries, if not in most, it is just inevitable. But it could be politically devastating if the household sector did not understand the implications of this shift. It could discover one day that its risk profile is quite different from that previously assumed. What is the appropriate response to a shift of risk from professional investors to those whose only investment may be small financial holdings or a mortgage? It cannot rely solely on tougher regulation; financial risks will always exist, and they will need to be absorbed. Transparency is necessary, but it can provide only partial respite. What will be most critical is to educate households in the art of investing and to ensure the availability of high-quality and high-integrity financial advice. As a first step, households need to become aware that they bear risk when they participate in a pension scheme. They need to learn about the investing options of pension funds and what these may imply over the life of the investment. Furthermore, individuals need to become educated on managing their balance sheets - skills that may take decades or even generations to develop in the household sector

as a whole. Yet, just as the skill of safe driving is regarded as necessary and teachable, so too the financial industry needs to teach prudent investing. The second crucial element is for the financial industry to ensure that advice to households on financial decisions is free of any conflict of interest and that it is clear, understandable and follows fair practices. Obviously, financial advice should point out the real risks of an investment right from the start. Specifically, given the long-term nature of such investments, all investors need to understand the implications of longevity risk. This includes the impact on savings schemes and on paid-out annuities of a significant revision of mortality tables that may take place many years after a savings plan is introduced. Clearly, the two elements I refer to - education and high-quality advice - are intrinsically linked and need to go hand in hand if they are to be effective. It is also clear that implementing them would be costly for financial institutions and advisers alike, in fact for society as a whole. Yet not implementing them would be even costlier. Ignorance breeds irrational expectations or fear and, if not properly understood, the assumption of risk may create resentment in the household sector, which may in turn bring political pressure to bear on governments to cover future shortfalls. Yet again, governments may be forced to borrow against future generations, which is precisely what needs to change. The best way to avoid such a powerful political backlash is for financial institutions to act now to improve the way they operate in relation to households. Now that the latter are becoming the "shock absorber of last resort", it is high time to teach them how to manage such risks. It is in the self-interest of financial institutions and advisers to educate and provide sound advice when it comes to financial decisions and their implications. The alternative could be very unpleasant: sharply increased regulation as well as waves of litigation. The writer is counsellor and director of the International Monetary Fund's International Capital Markets Department. Find this article at: http://news.ft.com/cms/s/9280ff54-7098-11d9-b57200000e2511c8,ft_acl=_ftalert_ftarc_ftcol_ftfree_ftindsum_ftmywap_ftprem_ftspecial_ftsu rvey_ftworldsub_ftym_ftymarc_ic_ipadmintool_nbe_poapp_printedn_psapp_reg,s01=1.h tml