Friday, August 12, 2016

The Pension Titanic Is Sinking?

Mohamed El-Erian wrote a comment for Bloomberg, The Titanic Risks of the Retirement System:
Imagine an entire enterprise set on course for disaster, driven by the owner’s arrogant pursuit of profit. The members of the management team, from the CEO on down, know better but fail to resist or are ignored. The clients remain totally unaware of the risks until far too late, with catastrophic results -- particularly for the poorest among them.

This is the story line of the excellent "Titanic," a musical now playing at the Charing Cross Theatre in London. As I took in this powerful portrayal of the human failures that brought down a ship thought to be unsinkable, it occurred to me that if we're not careful, the tragic story could also end up describing the fate of the global retirement system.

With interest rates extremely low and the prices of stocks and bonds at historic highs, finding safe investments that can help guarantee a comfortable retirement has become increasingly difficult. This has put the managers of pension funds and other institutions that invest on behalf of future retirees in a difficult position, driving them to take ever greater risks in hopes of meeting their performance objectives -- targets that are unlikely to be met absent a major revamp of economic policies and corporate prospects. As a result, individuals are increasingly being exposed to the threat of losses that cannot be recouped quickly.

The degree of long-term financial security that can be assured depends on three elements: future returns, correlations among different asset classes and volatility. The outlook for all three is becoming more uncertain.

What returns can investors realistically expect? With the combination of central bank activism and less robust economic prospects pushing bond yields into negative territory (most recently in the U.K.), fixed income markets no longer generate any meaningful returns -- unless one takes on a lot more default risk by accumulating junk debt issued by corporations and emerging-market governments. In the stock market, high-quality dividend-yielding shares have reached unnerving valuations, leaving more volatile and risky options.

More sophisticated investors may be able to access investment vehicles that traffic in less crowded areas -- but selecting the right manager is not easy, especially in a “zero sum” world in which one manager’s positive “alpha” is another’s losses.

In principle, the right mix of investments can provide greater return for the same risk. But this works only if the investments don’t move in sync -- and correlations among asset classes have lately become unstable and less predictable. Sophisticated long-term investors realize that portfolio diversification, while still necessary, is no longer sufficient for proper risk mitigation. Yet the next operational step is not easy, and it typically involves giving up some potential return.

Then there's volatility, which increases the chances that an investment will fall in value precisely when a future retiree needs the money. In recent years, central banks have largely been willing and able to repress financial volatility. Now, though, this is changing. Some, such as the Bank of Japan, appear less able while others, such as the Federal Reserve, somewhat less willing.

The repercussions for investment managers depend on where they stand. Those who oversee severely underfunded corporate or public defined-benefit pension plans are in a particularly tough bind: They must achieve high returns to meet their targets, so they face the greatest pressure to take on risks that could be catastrophic if companies and the economy don’t perform well enough to justify existing asset prices. Even better-funded pension plans that have matched their assets to their liabilities will be challenged to maintain historical returns if they take on new entrants.

To avoid disaster, policy makers and investment managers should consider three fixes. First, be a lot more realistic about the returns that can be achieved within traditional risk tolerance parameters. Second, put in place policies to boost savings and income, so people -- particularly the most vulnerable -- will have more money available to put aside for retirement. Third, be transparent with retirees about the risks that are being taken on their behalf, also offering less risky options with explicitly lower expected returns.

Absent urgent change, the retirement system could end up following the example of the Titanic. Like the ship’s passengers, many individuals would face the risk of devastating consequences. And like the second- and third-class passengers who had a hard time getting on lifeboats, the middle- and low-income segments of the population would be most at risk.
I'm glad Mohamed El-Erian finally decided to get on board and start writing about the pension Titanic which is one financial crisis away from sinking deep into the abyss.

El-Erian follows his former Pimco colleague Bill Gross who recently admonished US public pensions for not facing reality and letting go of their assumed rate of return which can never be achieved without taking undue and dangerous risks.

My former colleague from my days at BCA Research, Gerard MacDonell, had this to say on El-Erian's titanic piece:
Deep thinker and clearly global guy Mohamed El-Erian probably needs to decide on the sense in which he wants to use the word titanic. Is it a large thing or an overrated thing?

He wrote this and Bloomberg published it:
This is the story line of the excellent “Titanic,” a musical now playing at the Charing Cross Theatre in London. As I took in this powerful portrayal of the human failures that brought down a ship thought to be unsinkable, it occurred to me that if we’re not careful, the tragic story could also end up describing the fate of the global retirement system.
The issue El-Erian chooses to use as a segue into his London theatre preferences and his favorite theme that uncertainty could rise is actually an important one. It would be great to see some reporting on it.

Financial market returns are going to be much lower than pension plans assume. This is an issue for companies offering defined benefit plans, as well as their beneficiaries. And even for defined contribution plans or just 401ks, beneficiaries broadly defined are probably in for a rude awakening.

It is darkly funny that this issue receives such little attention compared to the endless moaning, whining and gnashing of teeth around DA NATIONAL DEBT!!!!

At some risk of being self-referential too, I think this issue of pressure on pensions fits into the point that equities can be BOTH not significantly overvalued AND likely to generate very subpar returns. In slight contrast, bonds may be overvalued, but are now almost certain to deliver low returns, by definition if held to maturity.
Gerard is bright guy but when it comes to pensions, he should refer his readers to my blog because he never worked at one, nor does he really understand the bigger picture.

And what's the bigger picture I'm referring to? Well, I went over it a week ago when I discussed Chicago's pitchforks and torches:
There's an even bigger problem which I want policymakers to wrap their heads around: chronic public pension deficits are deflationary.

Let me repeat that: Chronic and out of control public pension deficits are DEFLATIONARY. Why? Because it forces governments to introduce more property taxes or utility rate increases (another tax) to address them, leaving less money in the hands of consumers to spend on goods and services.

The other problem with raising taxes and utility bills is they are regressive, hurting the poor and working poor a lot more than Chicago's ultra rich. 

Now I'm going to have some idiotic hedge fund manager tell me "The answer is to cut defined-benefit pensions and replace them with cheaper defined-contribution plans." NO!!! That is a dumb solution because the brutal truth on DC plans is they are failing millions of Americans, exposing them to pension poverty which is even MORE DEFLATIONARY!!

I want all of you to pay attention to what is going on in Chicago because it's a cancer which will spread throughout parts the United States where chronic pension deficits are threatening municipalities, cities and states. And this slow motion train wreck will have drastic economic consequences for the entire country.
You will recall that chronic pension deficits are part of the six structural factors I continuously refer to when making my case for global deflation. In fact, I referred to these six factors recently in my comment on the bond market's ominous warning:
[...] I remain highly skeptical that anything policymakers do now will be enough to resurrect global inflation. Readers of my blog know that rising inequality is just one of six structural themes as to why I'm worried of a global deflationary tsunami:

  • The global jobs crisis: Jobs are vanishing all around the world at an alarming rate. Worse still, full-time jobs with good wages and benefits are being replaced with part-time jobs with low wages and no benefits.
  • Demographics: The aging of the population isn't pro-growth. As people get older, they live on a fixed income, consume less, and are generally more careful with their meager savings. The fact that the unemployment rate is soaring for younger workers just adds more fuel to the fire. Without a decent job, young people cannot afford to get married, buy a house and have children.
  • The global pension crisis: A common theme of this blog is how pension poverty is wreaking havoc on our economy. It's not just the demographic shift, as people retire with little or no savings, they consume less, governments collect less sales taxes and they pay out more in social welfare costs. This is why I'm such a stickler for enhanced CPP and Social Security, a universal pension which covers everyone (provided governments get the governance and risk-sharing right).
  • Rising inequality: Rising inequality is threatening the global recovery. As Warren Buffett once noted, the marginal utility of an extra billion to the ultra wealthy isn't as useful as it can be to millions of others struggling under crushing poverty. But while Buffett and Gates talk up "The Giving Pledge", the truth is philanthropy won't make a dent in the trend of rising inequality which is extremely deflationary because it concentrates wealth in the hands of a few and does nothing to stimulate widespread consumption.
  • High and unsustainable debt in the developed world: Government and household debt levels are high and unsustainable in many developed nations. This too constrains government and personal spending and is very deflationary.
  • Technology: Everyone loves shopping on-line to hunt for bargains. Technology is great in terms of keeping productivity high and prices low, but viewed over a very long period, great shifts in technology are disinflationary and some say deflationary (think Amazon, Uber, etc.).
Why am I bringing this up? Because the stock market is acting as if reflationary policies will succeed while the bond market is preparing for a protracted deflationary episode.

And while some think negative yields outside the US are "distorting" the US bond market, I would be very careful here because the fact remains Asia and Europe remain mired in deflation which can easily spread to the United States via lower import prices. So maybe the bond market has it right.
This brings me to an important point, Gerard is right when he says that "bonds are now almost certain to deliver low returns, by definition, if held to maturity," but he's missing a crucial point, one that I keep hammering, in a deflationary environment, bonds are the ultimate diversifier.

Put simply, this means despite the fact that ultra low or negative yields are here to stay, you still need bonds in your portfolio to buffer the financial shocks or even the volatile markets that are the product of record low bond yields and everyone chasing yield by taking more risk.

Gerard is right that too many people are focused on the national debt without realizing how the United States of pension poverty is on the road to more debt if it doesn't fix its retirement system and make it more like the one we have in Canada where our politicians just agreed to enhance the CPP which was the smartest move in terms of bolstering our retirement system.

This brings me to El-Erian's solution to the pension crisis:
To avoid disaster, policy makers and investment managers should consider three fixes. First, be a lot more realistic about the returns that can be achieved within traditional risk tolerance parameters. Second, put in place policies to boost savings and income, so people -- particularly the most vulnerable -- will have more money available to put aside for retirement. Third, be transparent with retirees about the risks that are being taken on their behalf, also offering less risky options with explicitly lower expected returns.
Sure, delusional US public pensions need more realistic return targets, after all there's no big illusion in the bond market, it's sending a clear message to everyone to prepare for lower returns ahead.

But while low returns are taking a toll on all pensions, especially US public pensions, the most pernicious factor driving pension deficits is record low or negative bond yields.

Importantly, at a time when pretty much all asset classes are fairly valued or over-valued, if another financial crisis hits and deflation sets in for a prolonged period, it will decimate all pensions.

To understand why, you need to understand what pensions are all about, namely, matching assets with liabilities. The liabilities most pensions have in their books go out 75+ years, while the investment life of most of the assets they invest in is much shorter (this is why pensions are increasingly focusing on infrastructure).

This means that a drop in rates will disproportionately impact pension deficits, especially when rates are at record lows because the duration of pension liabilities is much bigger than the duration of pension assets.

So even if stocks and corporate bonds are soaring, who cares, as long as rates keep declining, pension deficits will keep soaring. And if another financial crisis hits, watch out, both assets and liabilities will get hit, the perfect storm which will sink the pension Titanic.

El-Erian is right, the US needs to put in place a system that promotes savings but saving for what, a 401(k) nightmare or something much better like an enhanced Social Security modeled after what the Canada Pension Plan Investment Board is doing?

All these Wall Street types peddling their retirement solution are only looking to gouge consumers with more fees and paltry returns. America definitely needs a revolutionary retirement plan, just not the one Tony James and Teresa Ghilarducci are pushing for.

Also, El-Erian is right, pensions need to be transparent about the risks they're taking on behalf of retirees but they also need to be transparent about the lack of proper governance at US pensions and the need to implement a risk-sharing model to avoid a Chicago-style solution to the looming pension disaster which is coming to many American cities and states.

Last but not least, policymakers and public pensions have to be transparent and expose the brutal truth on defined-contribution plans as well as explain the benefits of large, well governed defined-benefit plans.

Of course, Bill Gross, Mohamed El-Erian, Gerard MacDonell and many others don't discuss all this because they aren't as well informed on all these issues to the extent that I am. I'm not deriding them, just stating a fact, when it comes to the pension Titanic sinking, there's only one lone wolf who's been warning all of you about the problem since June 2008 when he first started a blog called Pension Pulse.

With deflation on our doorstep, all of a sudden these experts are warning us of a looming retirement disaster. Where were they over the last decade, sipping the Kool-Aid?

Speaking of sipping the Kool-Aid, J.P. Morgan Asset Management, overseeing $1.7 trillion, says U.S. inflation is picking up. “U.S. inflation has actually come back,” Benjamin Mandel, a strategist for the company in New York, said Thursday on Bloomberg Television. “This idea that U.S. inflation is low and is always going to be low is an anachronism.”

You can watch the interview below. All I have to say is the bond market isn't impressed as traders see a divergence between US inflation and the economy. Also, the latest Fed survey shows US inflation expectations are at their lowest since March, which doesn't augur well for all those inflationistas warning us of hyperinflation.

My advice to all pensions is forget what Wall Street is selling you and prepare for the deflation tsunami ahead. The pension Titanic is sinking and you need to prepare for a long bout of low returns, low growth, low inflation and possibly even deflation ahead.

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