Sunday, October 11, 2009

The Squeeze on Pensions?


The BBC reports on the squeeze on pensions:

The Conservative Party has outlined plans to raise the state pension age for men to 66 from 2016 - eight years earlier than planned.

The pension age for women will also rise to 66 by 2020 under Tory proposals - something the party says is needed to help reduce the UK's national debt.

The Labour government has already committed to raising the pension age for men gradually from 65 to 68 between 2024 to 2046. For women it will rise from 60 to 65 over ten years from 2010.

So why do the two parties want the pension age to go up?

Currently, there are more than 12m pensioners in the UK - with many more women than men in retirement.

The move by politicians to raise the state pension age comes not only amid difficult financial conditions, but also as the UK population ages, putting increased pressure on government resources.

Graph showing the ageing UK population

However, the UK is not alone. The world's population is also growing older and many other countries are facing similar problems.

Graph shpwing the ageing global population

The ageing UK population means there will be many more pensioners to support. In 2001, the government's Actuary Department calculated there were 3.32 people of working age to support every state pensioner.

By 2060, it says the ratio will have fallen to 2.44 people of working age for every one state pensioner. In other words, there will be fewer working people contributing towards the system that finances the state pension.

Both the Conservatives and Labour have proposed raising the state pension age, taking into account people's longer lives.

This means the amount of time spent in retirement, as well as government expenditure, will be reduced.

Graph showing the amount of time spent in retirement

Meanwhile, the value of state pensions has declined since the link with average earnings was cut by Margaret Thatcher's Conservative government in 1980.

Graph showing value of pension

Although a top-up benefit or pension credit has been introduced to ensure no pensioner has to live on less than £130 a week, Labour has legislated to bring back the link with average earnings by 2015 at the latest - a plan supported by the Tories.

You can find out more about pension credit on the Directgov site.

There are concerns that the new measures to raise the retirement age in the U.K. will hit women harder. But longevity risk is a major concern of many governments and private firms grappling with mounting pension liabilities. Citing research from Hewitt Associates, Reuters reports that UK pension schemes are likely to insure over 5 billion pounds of liabilities linked to rising life expectancy in 2010:

Matt Wilmington, global risk management specialist at Hewitt Associates, told Reuters the higher costs associated with the risk of retirees living longer had become a key issue to both trustees and sponsoring companies.

"Hewitt believes the longevity swap market will see a minimum of six deals over the next year, with a total value of over 5 billion pounds," he said.

"Once the Babcock deal was announced, we saw quite a flurry on interest from clients," Wilmington said.

In May, pension consultants said a longevity swap deal struck by engineering group Babcock International's (BAB.L) pension schemes to hedge 500 million pounds would open the door to more such deals.

Through longevity swaps, trustees pay a bank or some other counterparty to take on some of the risk over a defined period.

Wilmington said some of the new longevity swaps were at an "advanced stage" and he expected the bulk to be announced in the first quarter of next year. Hewitt is advising on some of those deals.

Around a third of FTSE 100 companies have already raised the age at which they assume their retirees will die, a move that will increase their pension liabilities.

On September 30, the FTSE 100 pension liabilities stood at 444 billion pounds, against 366 billion pounds of assets.

I am not so sure that "longevity swaps" are going to be the answer to the world's pension deficits. In fact, if they become very popular, I am concerned that they will be the source of yet another systemic crisis.

Pension woes are not only a U.K. problem. David Cho of the Washington Post writes Steep Losses Pose Crisis for Pensions (hat tip to Diane Urquhart):

The financial crisis has blown a hole in the rosy forecasts of pension funds that cover teachers, police officers and other government employees, casting into doubt as never before whether these public systems will be able to keep their promises to future generations of retirees.

The upheaval on Wall Street has deluged public pension systems with losses that government officials and consultants increasingly say are insurmountable unless pension managers fundamentally rethink how they pay out benefits or make money or both.

Within 15 years, public systems on average will have less half the money they need to pay pension benefits, according to an analysis by Pricewaterhouse Coopers. Other analysts say funding levels could hit that low within a decade.

After losing about $1 trillion in the markets, state and local governments are facing a devil's choice: Either slash retirement benefits or pursue high-return investments that come with high risk.

The urgent need for outsize returns by these vast public pension funds, which must hit high investment targets year after year to keep pace with rising retirement costs, is in turn fueling a renewed appetite for risk on Wall Street.

Before the crisis, many public pension funds had experimented with risky trading techniques or committed more of their money to hedge funds and other nontraditional firms, which in turn invested some of it in complex mortgage securities. When these melted down, pension funds got burned.

Now, facing an even bigger funding gap, some systems are investing in the same securities, betting that a rebound in their value will generate huge returns.

"The amount that needs to be made up is enormous," said Peter Austin, executive director of BNY Mellon Pension Services. "Frankly, they are forced to continue their allocation in these high-return asset classes because that's their only hope."

Some pension experts say the funding gap has become so great that no investment strategy can close it and that taxpayers will have to cover the massive bill.

The problem isn't limited to public pension funds; many corporate pension funds have lost so much ground that they are also pursuing riskier investments. And they, too, could end up a taxpayer burden if they cannot meet their obligations and are taken over by the federal Pension Benefit Guarantee Corp.

Public systems still have enough to meet their current obligations. If governments take no action, retirees could keep drawing full benefits for the foreseeable future even under the most pessimistic projections.

But already, some funds are seeking to trim benefits to conserve money. Some governments have also proposed increasing the amount of public money paid each year into the funds. In practice, however, some political leaders have begun doing the opposite -- cutting annual contributions to pension funds -- as a way of balancing state and local budgets buffeted in the recession by falling tax revenue and rising costs.

Around the country, governments are struggling with the pact they've made with employees.

In New Mexico, lawmakers passed legislation this year requiring public employees to contribute about 1.5 percent of their salary to cover retirement benefits. Labor unions representing 57,000 of the workers sued the state in response.

In Philadelphia, officials delivered an ultimatum to state lawmakers: Allow the city to take a two-year break from contributing to its pension system or Philadelphia would lay off 3,000 workers and cut sanitation and public safety services. Last month, the lawmakers not only granted the request, but extended the funding holiday to thousands of cities and counties, despite severe pension deficits in many of these places.

In Montgomery County, officials last year committed to setting up an investment fund to finance about $3 billion in retiree health-care benefits promised to employees. But when it came time to put the first round of seed money into the fund this year, county officials balked, citing budget constraints.

"We know we've got a huge health-care liability," chief administrative officer Timothy L. Firestine said. "Our plan was to work gradually to fund that. And this year we abandoned that plan."

Swift Change of Fortunes

Just a few years ago, it seemed far-fetched that Virginia's pension system would hit hard times. In 2003, the state's primary pension funds either had more money than they needed or, at a minimum, were nearly fully funded. And like their counterparts across the country, state officials assumed they would earn around 8 percent a year from investing in financial markets for years to come given the outstanding performance of stocks in the 1980s and 1990s.

But officials in Virginia and elsewhere soon began to wonder whether those two decades were a fluke. As pension deficits began to rise, officials questioned whether the investment assumptions were too optimistic. In 2006, Virginia's pension officials suggested scaling back benefits or requiring current employees to begin paying into the pension fund. The state's lawmakers took no action.

Then the crisis hit. Virginia lost 21 percent of the value of its portfolio, or about $11.5 billion. Maryland and the District, meantime, suffered drops of 20 percent.

The losses were typical of what pension funds suffered around the country. State and local government officials had predicted before the crisis they would have $3.6 trillion in their accounts by now, according to the Center for Retirement Research at Boston College. Today, they are $1.2 trillion short of that mark.

Pension funds were not equally affected. Officials in Arlington County, for instance, say their funding levels remain above 90 percent. And even those that suffered huge losses say they have enough money to payout retirement benefits for years to come. Virginia, for instance, still has nearly $43 billion in its accounts.

But Virginia officials now estimate the funding level of its major pension funds will sink to about 60 percent by 2013.

From there, the deficit will grow even wider, according to Kim Nicholl, the national director of PricewaterhouseCoopers public sector retirement practice. Even if public pension funds were to hit their 8 percent investment targets every year, Nicholl calculated they would have less than half of what they need by 2025. This is because a greater share of the population will be retired and those who are will live longer, thus collecting benefits longer, she said.

"I don't think you can invest your way out of this. Plans are going to have to make changes," Nicholl said. "The scale of the losses was just so great and the liabilities are growing so fast, much faster than they can keep up."

For these reasons, billionaire investor Warren Buffett has called these pensions ticking "time bombs." The financial crisis, experts say, shortened the fuse.

Last month, Virginia Gov. Timothy M. Kaine signaled he would consider the politically sensitive step of requiring the state's 100,000 employees to contribute part of their 2011 salaries toward their pensions. But the two candidates running to replace him -- and who would have to carry out the proposal -- have said they oppose it.

More Risk or Lower Returns

This is the dilemma confounding pension funds as they emerge from the wreckage of the financial crisis: If they shy away from riskier investments, they would be settling for lower returns that leave future shortfalls unaddressed. But by aggressively pursuing the higher rates of return they need, pension funds increase the chances they will be burned again by investment bets gone bad.

"State pension fund directors face enormous pressure trying to recover their investment losses. It will be tempting for them to consider investments that promise a high rate of return," said Sue Urahn, managing director of the Pew Center on the States, which plans to release a report on pension losses within weeks.

Traditional investment strategies, which rely on stocks, haven't fared well in recent years. To meet their obligations to retirees, pension funds tend to assume they will earn an eight percent return on investments each year. The stock market, as measured by the Standard & Poor's 500-stock index, is actually down 32 percent this decade.

Like many states, Maryland had begun moving money from stocks into hedge funds and private equity before the financial crisis. The goal was not only to earn a higher return but to diversify the investment portfolio. Should stocks sink, the thinking went, less traditional investments might hold up.

The financial crisis offered a shocking retort. Nearly all investments, save for government bonds, tumbled at the same time.

Yet Maryland is now continuing its shift away from stocks and into nontraditional investments. Pension officials argue they have little choice.

"How do I act in the new environment? There aren't any ready answers for that," said Mansco Perry, chief investment officer for Maryland's pensions. "But I have difficulty throwing away 30 to 40 years worth of knowledge and practice and say that doesn't work anymore."

Some pension funds are also continuing to engage in other investment practices that got them in trouble during the crisis.

One such trading technique is called securities lending. In this transaction, a pension fund lends a stock it holds to a hedge fund and receives cash in return as collateral. The deal is meant to provide a twofold benefit: The pension fund can make money by investing the cash collateral and can continue to benefit from the stock through its dividends and any appreciation in its value.

Before the crisis, states committed billions of dollars to this practice. But when the credit markets seized up last year, pension funds got stuck. They could not access the investments they made with the cash collateral. Some had to sell off other investments at a loss to pay retiree benefits.

California's pension fund lost $634 million from securities lending as of March 31, but the total could reach $1 billion after a full accounting is done, according to a report from the system's consultant, Wilshire Associates. Still, the pension fund says it remains committed to the practice because it boosted returns in the two decades before the financial meltdown.

Pension funds have also been aggressively pushing into real estate and troubled mortgage securities that were crushed in the crisis. California's pension fund is putting $2 billion into buying these toxic bank assets. Financial analysts say the prices for these assets have fallen so far that they may be a better bet than in the past. But the crisis showed how unreliable these investments can be. And their prices may not yet have hit bottom.

In August, California's pension fund took a similar gamble by investing $463 million in shopping centers across 17 states and the District of Columbia, though many experts forecast a prolonged slump in commercial real estate.

Even if these strategies succeed, the shortfall may still be insurmountable.

In Ohio, for instance, the teachers pension system reported that it would take 41 years for its investments to catch up with the costs of meeting its obligations to retirees. That was before the worst of the financial crisis.

During the last fiscal year, Ohio's fund lost 31 percent. Its most recent annual report detailed how long it would now take for its investments to put the fund back on track. Officials simply said: "Infinity."

The global pension crisis is a major concern. The uptrend in equities in Q3 boosted pension returns in Canada and elsewhere, but this will do little to address long-term concerns on the sustainability of pensions.

Finally, many of you saw CNBC's recent interview with famous hedge fund manager Julian Robertson (see video below). Among his gloomy predictions, he sees U.S. interest rates soaring to 15%-20% if China and Japan stop buying U.S. bonds.

An astute bond trader shared a few comments with me:
1) The Fed is already looking to remove some excess liquidity via the repo markets (cost of repo borrowing will go up);

2) Flush with cash, banks continue to make a killing in their trading operations. They're unwinding their long 2-year positions and moving down the curve for extra yield. He thinks it's a great time to put on a curve-flatner, not steepner.

3) As for interests rates hitting 15% to 20%: "It will never happen. Pensions will lock in rates at their actuarial liabilities of 6.5% or 7% in a blink of an eye."
I agree. In the near term, the Fed does not need to raise rates to remove excess liquidity. All they have to do is raise the cost of repo borrowing. Banks will roll over into longer dated bonds and the curve will flatten, not steepen. And Mr. Robertson needs a course in liability-driven investments (LDI). He has no idea how many pension funds are looking to lock in rates at half the rates he's predicting. That will pretty much cap the upper end of the bond market for a very long time.

I wish all Canadians a Happy Thanksgiving and all Americans a Happy Columbus day.


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