Thursday, June 25, 2015

OECD's Dire Warning on Pensions?

Alistair Gray and Josephine Columbo of the Financial Times report, OECD warns over pension scheme solvency as low rates bite:
Retirement funds and life assurers are in danger of being unable to keep their promises to pensioners and policyholders because of rock-bottom interest rates, the Organisation for Economic Co-operation and Development has warned.

Ultraloose monetary policy poses “serious problems to the solvency” of pension schemes and insurers as they struggle to produce enough income to fund their obligations, the group of rich nations said on Wednesday.

The warning from the Paris-based body is among the starkest yet about how institutions from Germany to the US can generate sufficient returns to meet their obligations without taking on extra risks.

In its inaugural annual business and finance outlook, the OECD identified the impact of cheap money from central banks on insurers and pension schemes as one of the biggest challenges facing economic policy makers.

“The current low interest rate environment poses a significant risk for the long-term financial viability of pension funds and insurance companies,” said the report.

The OECD raised the prospect the funds could be forced to cut payouts to retirees, saying they may have to “renegotiate” their promises to remain sustainable.

The organisation joins a growing chorus of economists and regulators speaking out about problems caused by historically low interest rates, as central banks from the eurozone to China try to stimulate economic growth.

Its assessment comes just three months after a similar warning from the International Monetary Fund, which said the European life insurance sector was facing “severe challenges”.

The problem arises because such institutions have little choice but to allocate a big chunk of their investment portfolios to conservative, low-yielding assets, notably government and corporate bonds.

The nature of their commitments prevents them from investing in potentially higher-returning but more risky securities, such as equities. Yet the cautious investment strategy they pursue has become increasingly problematic as bond yields have tumbled.

The OECD said it was growing concerned that the funds were being tempted to turn to alternative assets, such as private equity.

Presenting the study in Paris on Wednesday, Angel Gurría, the OECD’s secretary-general, said: “Pension funds and life insurers are feeling the pressure to chase yield . . . and to pursue higher-risk investment strategies that could ultimately undermine their solvency.

“This not only poses financial sector risks but potentially jeopardises the secure retirement of our citizens.”

While the report itself acknowledged there was a lack of detailed data to provide evidence for such an asset allocation shift, it said figures available for the UK showed that pension funds “may already be engaging in a ‘search for yield’”.

In response to the report, the UK’s National Association of Pension Funds, which represents 1,300 workplace schemes, said the switch into new asset classes did not necessarily mean they were taking on extra risk.

“Some of the underlying assumptions of the report do not necessarily hold true on the ground with UK pension funds,” said Helen Forrest, defined benefits policy lead at the NAPF.

“It is not necessarily taking extra risk in the search for yield, but finding alternative ways of providing the inflation-proofing the funds require.”
You can view the OECD's new annual Business and Finance Outlook by clicking here. To view it in PDF format register and view it by clicking here.

What are my thoughts on all this? The OECD is right, ultraloose monetary policy is wreaking havoc on global pensions and life insurers looking for yield, forcing them to search for higher yielding alternative assets, but in my humble opinion, this report is missing something.

Importantly, why are central banks pumping so much money into the global financial system and why are ultra low yields here to stay, forcing pensions and insurers to take risks in illiquid asset classes and hedge funds?

Regular readers of my blog already know my answer. I've been warning you to prepare for global deflation for a very long time. Never mind what the reflationistas tell you. Forget about billionaire hedge fund managers warning you of the bigger short.

I'm warning all of you, in a world of rising inequality, structurally high long-term unemployment, pension poverty, and aging demographics, global deflation is virtually assured and it will decimate pension plans struggling with chronic underfunding.

Of course, fears of deflation seem to be fading in Europe but it is still too early to claim bond markets are signalling a decisive shift to a less worryingly-low inflation environment. Mark my words, this is only a temporary reprieve due to the lower euro. Deal or no deal for Greece, the structural problems plaguing the eurozone remain unaddressed, and deflation will come back to haunt the continent.

And it's the specter of deflation that still worries me, central bankers and most intelligent economists, bond managers and hedge fund managers warning the Fed not to make a monumental mistake and start hiking rates too fast and too aggressively.

My fear is that they will sign another bogus "extend and pretend" deal for Greece, that Europe will stabilize somewhat in the coming months and the Fed will interpret this as a green light to start hiking rates in September.

Such a move would be catastrophic for the bond market and other markets suffering from liquidity constraints. A shift in monetary policy without an appropriate and sustained shift in long-term inflation expectations can precipitate a liquidity time bomb, bringing about another more pronounced global financial crisis.

As far as the shift into alternative assets like private equity, go back to read Ron Mock's warning on alternatives as well as my recent comment on private equity stealing from clients. Private equity is an important asset class for pensions, one that has a fairly long-term focus and is a good fit in terms of asset-liability management but ultra low rates have pushed deal pricing to nosebleed valuations, which is why some think it's time to stick a fork in it.

There are other problems with private equity. Yves Smith of the Naked Capitalism blog published a comment, “A Bad Man’s Guide to Private Equity and Pensions”, discussing how the surge in dividend recapitalization is loading private companies up with debt and jeopardizing private pension plans.

I've covered why private equity is eying dividend recaps and think this is a similar trend to what is going on in public markets where ultra low rates are inflating the buyback bubble, allowing corporate CEOs to artificially inflate earnings-per-share so they justify their pay which is spinning out of control. Meanwhile, average wages for workers stagnate as corporate profits are being plowed back into buybacks instead of hiring people, increasing wages or investing in research and development.

So, ultraloose monetary policy is driving inequality as corporate CEOs jump on the buyback bandwagon. It's also making the top private equity and hedge fund managers obscenely wealthy as global pensions search for yield and "scalable alpha".

Of course, none of this is discussed in any OECD, IMF or central bank report. Finance capitalism has serious structural problems, and unless policymakers and global pensions start discussing how they're fueling extraordinary inequality, this trend will continue, decimating the middle class in all developed countries.

Again, rising inequality, aging demographics, high structural long-term unemployment and the global pension crisis are why I remain convinced that we are heading for an unprecedented and prolonged period of global deflation. Anyone who thinks we are on a path to global recovery is absolutely fooling themselves. The China bubble will only exacerbate this global deflationary trend.

Remember, the titanic battle of deflation versus inflation should be central to your investment approach and how you address market volatility. If you think deflation is dead, you're dead.

Below, York University political economist Jonathan Nitzan discusses a paper he co-authored with Shimshon Bichler, Capital Accumulation: Fiction and Reality. This is the type of stuff George Soros would devour in his younger years (he's now too busy spreading disinformation on the Ukraine crisis), but I urge all of you, especially the folks at the IMF, OECD and central banks, to take the time to read the paper and listen to Jonathan's comments below.

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