Monday, October 30, 2017

The coming pensions crisis

The decades long secular decline in real interest rates has been taking a toll on savers. The pay-as-you-go, defined benefit pension schemes of many local governments, other public entities, and older corporations have promised very high returns whose realization may be difficult in this environment. Hyper-aggressive wealth and asset managers have massive funds under management that promise long periods of high returns, even after excluding their exorbitant management fees. 

The business models in pension funds, insurance, and asset management look likely to be upended by the persistent and declining trend in interest rates. 

A McKinsey Global Institute report last year made alarming prognosis about investment returns in developed markets over the next two decades when compared to the past thirty years. 
Accordingly, the MGI report estimates that for US and Western Europe, annual return on equities and fixed-income securities could be respectively 150-400 and 300-500 basis points lower. Its implications include,
A two- percentage-point difference in average annual returns over an extended period would mean that a 30-year-old today would have to work seven years longer or almost double her savings to live as well in retirement.
And in the medium term and even including emerging markets, as the seven-year return predictions of Jeremy Grantham shows, the likely real returns are mostly in the negative territory.

The biggest victims of this low return environment are likely to be pension funds, especially the defined benefits plans offered by government agencies and legacy plans of the big private corporations. A world with low yields for the foreseeable future compounds the problems for pension funds across the world. In recent years, the dynamics of demographics – rising share of aging populations – has already been exerting pressure on these pension funds, many of which are grappling with massive underfunded liabilities. They now have to earn sufficient returns not only to prevent the funding gap from widening further , but also make incremental returns to bridge their deficits. But the low return environment leaves them without enough to meet even the first objective. Further, the older towns and cities have been facing the problem of stagnant or declining populations which put pressure on their tax and other revenue sources.  

A study published by AQR Capital Management finds that defined contribution (DC) pensioners have to double their current savings to achieve the same target retirement income replacement ratio (RR) of 75%. The historical real return of 7.5% from equities is expected to decline to 5%, and that from bonds from 2.5% to 1%, thereby generating a two percentage points lower annual return of 3.5% on a standard asset allocation of 60% US equities and 40% Treasury Bonds. This means that the worker now has to save 15% a year, not the current 8%, to reach the same RR. On a 2.5% real return assumption, the contributions would have to rise to 19% overall!  
California Public Employees’ Retirement System (CalPERS), the biggest US public pension fund with nearly $300 billion of assets, posted just 0.6% gains for the year ending June 2016 compared to the 7.5% return required to meet its payment obligations. This has also brought down its average investment returns over the past two decades to 7%, below its target. About 60% of US pension funds assume a return of 6-7.5%.

The Hoover Institution, a Stanford University think tank, estimates the under-funded US public pension liabilities to be $3.4 trillion. Wilshire Consulting, an investment advisory, estimates that the funding gap of public pension plans in US rose from 23% in 2014 to 27% by mid-2015. As yields stay very low and dependency ratio rises, these liabilities are likely to balloon. Mercer, the consulting firm, estimates that pension deficits of UK’s FTSE 350 companies rose by £21bn to £119bn in just June 2016, almost entirely due to the fall in gilt yields. 

In fact, estimates for the US S&P 1500 companies by Mercer reveals similar disturbing trends. As on August 31, 2016, the estimated aggregate deficit of $570 bn represented a worsening by $166 bn from the $404 bn deficit at the end of 2015. Aggregate funding level of pension plans supported by these companies stood at 77 per cent.

Or as Larry Fink, the Chairman of world’s largest asset manager BlackRock, in his annual letter to shareholders last year, said,
For example, a 35-year-old looking to generate $48,000 per year in retirement income beginning at age 65 would need to invest $178,000 today in a 5% interest rate environment. In a 2% interest rate environment, however, that individual would need to invest $563,000 (or 3.2 times as much) to achieve the same outcome in retirement.

John Authers has said that for “US public employee pension plans, the three percentage points could more than double their deficit, from $1 trillion to $2.5 trillion”. The corollary of this is that these people will now have to cut back on their consumption to save atleast enough to maintain the same level of post-retirement income.

John Mauldin has initiated a series of posts on the looming pensions crisis in the US. As he writes, most of the public pension plans are not fully funded. In fact, as the graphic below shows, the extraordinary monetary accommodation has had a devastating effect, quintupling the the total unfunded liabilities in state and local pensions over the decade. 
Mauldin has dire predictions about the pension plans of city governments in the US, with very bitter consequences for those societies.  
Pension plans cover over 15% of many city budgets, with some having more pensioners than workers. The pension costs of Los Angeles Police Department rose from just 5% of general fund budget in 2002 to 20% today, forcing the LAPD ranks to fall to below 10,000 in 2013 against the required 12500. Similarly, New York today spends more on pensions than it does on building and repairing schools, bridges, parks, and subways. 

The results are hiring freezes which lowers the quality of service delivery and cut backs on the coverage of a variety of services. All this in turn results in higher crime, poor student learning outcomes, declining quality of utility services and so on.

In a different context, India faces an altogether different problem with its pensions. A recent RBI report on household financial savings describes a "ticking pension time bomb". Unlike the US, here it is just that only 7.4% of the working age population is covered by a pension program compared to 65% for Germany and 31% for Brazil. Or unlike UK where private pension investments make up more than 95% of GDP, it is less than 1% in India. The report found that more than 50% of households plan to depend on children for support during old age and 77% do not expect to retire or have not actively planned for retirement.

For India, with its favourable demographic pyramid with rising youth population, this is the right time to encourage savings so as to beneficially smooth inter-temporal financial needs. A recent report by the World Economic Forum reports a global unfunded pension gap of $400 trillion by 2050 for eight countries including India. It estimates India's annual savings gap to grow by 10% and reach $85 trillion by 2050. 

No comments: