The $16 Trillion Global Pension Crisis
The U.S., China and other leading economies confront a massive funding gap of $15.8 trillion in 2050 to ensure lifetime financial support for their aging populations.The full G-30 report, Fixing the Pensions Crisis: Ensuring Lifetime Financial Security, is available here.
That’s according to a report spearheaded by former U.K. Financial Services Authority Chairman Adair Turner for the prestigious Group of 30, comprised of current and former policy makers.
“If public policies and individual behaviors do not change, many countries’ pension systems will face a severe crisis, threatening either unaffordable public expenditure pressures or inadequate incomes for retirees,” Turner said in a statement.
The projected $15.8 trillion shortfall is adjusted for inflation so the actual nominal dollar amount in 2050 will be materially larger, equivalent to 23% of global gross domestic product that year, according to the 75-page report.
The G-30, which includes Bank of England Governor Mark Carney and former U.S. Treasury Secretaries Timothy Geithner and Lawrence Summers, mainly blamed antiquated pension and retirement systems for the yawning financing gap, which it pegged at $1.2 trillion in 2018. Smaller projected returns on savings -- in an era of low interest rates -- aggravate the problem.
The report – which covers 21 countries, including Japan, Germany, India and Mexico, accounting for 90% of global GDP – said the coming crisis is not just about pensions. Lifetime financial security also depends on the availability of public health, housing and transportation services, as well as on informal community and family support.
The G-30 advocated a mixture of policies to tackle the problem:
The report’s working group, which included UBS Group AG Chairman Axel Weber and BlackRock Vice Chairman Philipp Hildebrand, also called for action to reduce the administration and asset management costs borne by people saving for retirement. That might include establishing national utilities to provide bulk processing and purchasing of asset management services.
- Increasing the official retirement age by at least four-to-six years by 2050 while enabling people to work longer. A quarter of the funding gap could be closed if retirees on average worked 20% of the time of standard-aged workers.
- Promoting higher savings by individuals and increasing taxes to support public pensions. Such steps might include mandatory savings programs.
- Accepting that expected incomes in retirement may need to be lower. For middle and high-income retirees, that might mean living on 60% of average pre-retirement incomes, rather than 75%.
Reforms to minimize investment management costs must be a priority, according to the report.
The G-30 said that while the shift by corporations away from defined benefit to defined contribution retirement plans like 401(k)s for their workers had in some ways been inevitable, it has not worked out well for many individuals. The group suggested hybrid retirement programs as a possible solution, including guaranteeing minimum investment returns for defined contributions.
“Reforms to defined contribution should enable individuals to benefit from collective investment management, at low cost, and not have their retirement savings hostage to market cycles as much as they are today,” G-30 Chairman and Singapore senior minister Tharman Shanmugaratnam said in a statement.
The report acknowledges that confronting the coming crisis will be difficult because it will involve potentially politically unpopular decisions.
Making it “even more arduous is that it occurs at a time when governmental institutions are increasingly mistrusted, mainstream political parties are under strain," and voters are becoming more diverse as well as "susceptible to populist rhetoric and demagoguery,” the G-30 said.
I must say, this report is comprehensive and by no means a quick and easy read, but every large institutional investor in the world should have their senior analysts analyze and resume it because it's critically important.
In case you haven't noticed, there's a global pension crisis going on and it goes hand in hand with the demographic time bomb which is hitting many countries.
I started this blog in June 2008, right in the thick of the crisis. I saw the writing on the wall, knew full well back then that the global pension crisis was only going to get worse and some countries are a lot more vulnerable than others.
One of the most vulnerable countries is the richest, most powerful nation on earth, the United States where I see an ongoing retirement crisis and widespread misery as a result of mounting pension poverty.
In fact, The Economist just published an article on how America’s public-sector pension schemes are trillions of dollars short:
Perhaps it takes teachers to give politicians a lesson. Any official who wants to understand the terrible state of American public-sector pensions should read the financial report of the Illinois Teachers Pension Fund. Its funding ratio of 40.7% is one of the worst in America, according to the Centre for Retirement Research (CRR) in Boston (see table).Mark my words, most people reading this blog, including me, will never see the day Chicago Teachers is back to fully funded status.
Since it was established in 1939, Illinois officials have not once set aside enough money to fund the pension promises made. As a result, three-quarters of the money the state (or rather the taxpayer) now pays in each year merely covers shortfalls from previous years. The situation is getting worse. In 2009 the schemes’ actuaries requested $2.1bn, but only $1.6bn was paid. By 2018 the state paid in $4.2bn, still well short of the $7.1bn the actuaries asked for. The trustees have warned that the plan would be “unable to absorb any financial shocks created by a sustained downturn in the markets”.
Other schemes have attracted similarly stark warnings. Illinois is the class dunce, with six languishing schemes. Chicago Municipal is just 25% funded and the actuaries warn that “the risk of insolvency for the fund has increased”. The actuaries of the Chicago police scheme warn that “this is a severely underfunded plan” with a shortfall of $10bn; the funded ratio is not projected to reach 50% until 2043.
Offering workers a defined-benefit pension, where an income based on final salary is paid for the rest of their lives, is an expensive proposition, especially as life expectancies lengthen. Pension shortfalls are common across America, with the average public scheme monitored by the CRR just 72.4% funded. That adds up to a collective shortfall of more than $1.6trn.
When a scheme is underfunded, one of three things can happen. More contributions can be made, by employers or workers or both. Benefits can be cut. Or the scheme can earn a higher return on its investments to make up for the shortfall.
Cities and states are paying more, but still not enough. In 2001 public-sector employers contributed a further 5.3% of their payroll to meet pension promises; now that figure is around 16.5% on average (see chart). Even so, in no year since 2001 has the average employer contributed as much as demanded by actuaries. Last year’s shortfall was just under 1% of payroll.
This reluctance is understandable. Politicians dislike raising taxes—or cutting services to pay for higher contributions. Workers do not want to see their current pay reduced by higher deductions, or their future benefits cut. And in any case, in some states courts have ruled that pension benefits, once promised, cannot be taken away. Arizona attempted a reform in 2012 that would have increased contributions for anyone with less than 20 years’ service. Workers sued and the courts ruled in their favour in 2016, requiring the scheme to repay $220m. Since the failed reform plan was instituted, employers’ contributions as a share of payroll have almost doubled.
So states and cities have crossed their fingers and hoped that their investments will bail them out. America’s buoyant stock market has done its best to help. Returns on government bonds have also been good for much of the past three decades. Even so, the average public-sector scheme is less well funded now than it was in 2001.
And the markets are unlikely to keep being so helpful. In 1982 the government sold long-term Treasury bonds with a yield of 14.6%; now such bonds yield just 2.4%. Equity valuations are high by historic standards. That suggests future returns will be lower than normal.
Kentucky offers a sobering example of how states can spiral towards disaster. In 2001 its retirement system was 120% funded and employers were putting in just 1.9% of payroll. After the dotcom slump, the funding position deteriorated. By 2005 the scheme was less than 75% funded and the required contribution had gone up to 5.3%. But the state fell short of the target every year until 2015, by which point the contribution had leapt to nearly 33% of payroll. In 2018 the actuaries asked for 41%.
Kentucky’s scheme covering “non-hazardous” workers (those who are not employed by the emergency services) is just 12.8% funded. One of its beneficiaries is Larry Totten, who worked for Kentucky’s park service and retired in 2010 after a 36-year career. When he found out about the scheme’s parlous state, he joined Kentucky Public Retirees, a group that lobbies for pensioners. “There’s enough blame to go around,” he says. Though it was state governors (of various parties) who failed to pay the required amounts into the scheme, it was the state legislature that let them get away with it.
Such severely underfunded schemes risk entering two vicious circles. The first involves costs. Kentucky’s public pension scheme covers a wide range of state employers and some have to pay 85% of payroll to cover their pension obligations. Employing someone on $50,000 a year requires an extra $42,500 of contributions. They naturally seek to lay off workers to reduce this cost. But that leaves fewer people paying in without changing the number currently receiving retirement benefits. That increases the short-term squeeze.
The second concerns the accounting treatment of public-sector funds. Many assume nominal returns on their portfolios of 7% or more after fees. This optimism has a big impact. Calculating the cost of a pension promise requires many assumptions—how long people will live, how much wages will rise and so on. Future payouts must be discounted to calculate a cost in current terms, and thus contributions. The higher the discount rate, the lower the current cost and the less employers have to pay in. Public-sector schemes use the assumed rate of investment return as their discount rate—so a high rate lowers the apparent cost.
But if a scheme becomes severely underfunded, a plunge in the stock market could leave it unable to cover current payouts. So it must invest in safer, lower-yielding securities, such as government bonds. That reduces the discount rate and makes the pension hole even bigger. Kentucky’s non-hazardous scheme uses an expected return of 5.25%, much lower than most public-sector schemes.
These calculations look surreal by comparison with private-sector pension funds. Their accounting rules regard a pension promise as a debt like any other. After all, courts insist pensions have to be paid, whatever the investment returns. The discount rate must therefore be based on the cost of debt—for companies, the yield on AA-rated corporate bonds. Since that yield, now around 3%, is far lower than the return assumed by public-sector funds, private-sector pension liabilities are very expensive. Faced with a $22.4bn shortfall, General Electric recently froze pension benefits for 20,000 employees.
These different accounting approaches seem to imply that it is cheaper to fund a public-sector pension than a private-sector one. In reality, that cannot be the case. The public-sector pension deficit is therefore much larger than the $1.6trn estimated by the CRR. It is hard to be precise about how much larger, but the accounts of troubled schemes give some indication.
The Chicago Teachers scheme has a shortfall of $13.4bn, and a funding ratio of 47.9% on the basis of an assumed return of 6.8%. Its financial report reveals that a one-percentage-point fall in the discount rate would increase the deficit by $3bn. The private-sector accounting approach would lower the discount rate by around four percentage points.
This is a crisis no one wants to solve, at least not quickly. The Chicago Teachers scheme is aiming for 90% funding, but not until 2059—long after many retired members will have died. New Jersey’s teachers’ scheme is not scheduled to be fully funded until 2048. Such promises might as well be dated “the 12th of never”. The bill for taxpayers seems certain to rise substantially. For the states with the biggest pension holes, political conflict is in store.
The US public sector pension crisis is definitely a crisis no one wants to solve which is why it will only get worse.
Why? Because pensions are all about managing assets and liabilities and I foresee low to negative rates being with us for a very long time, which means liabilities will soar to unprecedented levels and assets will not deliver anywhere close to the requisite returns pensions need.
[Note: the duration of liabilities is A LOT bigger than the duration of assets which means when rates fall, pension liabilities mushroom, especially when rates are already at ultra low levels and asset inflation, if there is any, won't make up for the shortfall. See a comment Zero Hedge posted earlier this week, US Stock Markets Up 200%, Yet Illinois Pension Hole Deepens 75%, and more importantly, my comment from the end of August where I discussed why the pension world is reeling from the plunge in yields.]
There is plenty of blame to go around for this dire situation. Bankrupt state governments and corrupt public-sector unions not wanting to abandon their 8% pipe dreams in order to keep the contribution rate low is just one of many structural flaws.
In my opinion, the biggest problem of all with US public sector pensions is there are too many of them (need to be amalgamated at the state level) and more importantly, the governance is all wrong!
The G-30 report doesn't refer explicitly to the Canadian model, but one of the reasons why Canada's mighty public pensions are doing so well is they got the governance right, kept the government out of the day-to-day management of these pensions, allowing them to focus solely on maximizing returns without taking undue risks over the long run.
Canada's large pensions hire professional pension fund managers who are compensated properly to invest across public and private markets all over the world, mostly investing directly to lower the overall fees while achieving a realistic target rate-of-return.
The other thing Canada's mighty pension plans got right is risk-sharing. Importantly, unless you introduce joint governance and share the risks of the plan equally among retired and active members, then you will never be able to achieve and maintain a fully funded status.
So why is there no political will to introduce major structural reforms at US public pensions to bolster their governance and introduce meaningful risk-sharing typically in the form of conditional inflation protection?
Well, last week I critically examined Ray Dalio's thoughts on the 'broken' capitalist system. I stated flat out, the system isn't broken, far from it, it's working extremely well for capitalists like Dalio who are “still making off like bandits and rising inequality continues unabated as profits are increasingly being concentrated in fewer and fewer companies (and funds)."
I also shared with you my thoughts on the end game for many underfunded US public pensions:
[...] two years ago, I wrote about the Mother of all US pension bailouts and last year I discussed how Congress gave a multibillion Thanksgiving pension bailout to solve a retirement crisis that threatened more than 1 million Americans in “multiemployer” pensions.Now, what I neglected to mention last week is Congress will make it seem like they are bailing out US public pensions but in reality, they're bailing out Wall Street and large hedge funds and private equity funds.
Why is this important? Because it provides clues as to what will happen when many chronically underfunded state and local pensions hit the proverbial brick wall, they will be bailed out by Congress and the Fed and US Treasury will help them meet their obligations (by buying pension bonds or simply transferring money to them).
Of course, it won't be that simple. I suspect retired members of these underfunded US public pensions will take some haircut, either partial or full removal of indexation or a more pronounced cut in benefits.
This is where Dalio rightly warns there will be huge tensions because teachers and other public sector employees and retirees will fight tooth and nail against any cuts in benefits.
But mark my words, the Mother of all US public pension bailouts is coming and it will likely come after the next major financial crisis hits us, whenever that is.
This is why central banks are vigorously trying to reflate the bubble, they know the next crisis will lead to widespread pain and misery, mostly for the poor, working class and those a step away from pension poverty.
Let me repeat this so you all understand: Congress, the Fed and the US Treasury will eventually bail out all large underfunded US public pensions, effectively ensuring Wall Street, large hedge funds and private equity funds can keep milking the US public pension cow in perpetuity.
I’m dead serious about this, that’s what capitalism is all about and anyone who thinks otherwise is in for a rude awakening.
You see, while I enjoyed reading the first part of Ray Dalio's Principles (the part on markets was awesome, principles not so much for me even though some of them are priceless), there's a much more important book you should all read to understand how capitalism really works, an older book by C. Wright Mills called The Power Elite.
I'm not kidding, this brilliant book written back in the mid-50s is all you need to read to really understand how the world works. It's far more important to understand this book than understanding principles, programing in C++, macroeconomic/ finance theory, technical analysis, etc.
I'd even go as far as saying you will become a much better long-term investor if you understand how the power elite control the world.
On that cheery note, please note I will return on Monday, November 25th to resume blogging. I would like to thank all of you who have taken the time to contribute to this blog and who value the immense work that goes into providing you daily coverage on pensions and markets.
Anyone can contribute to the blog on the top left-hand side under my picture using the PayPal options. While I am taking a week off, I will try to post some articles on Twitter and LinkedIn but not making any promises.
Below, the Dow, S&P 500 and Nasdaq closed at record highs. Lindsey Bell, CFRA Research Investment Strategist, and Mariann Montagne, portfolio manager at Gradient Investments, join CNBC's "Closing Bell" to discuss markets.
Second, Just Capital and Forbes published their third annual list of "Just" 100 companies. The list ranks how the largest publicly traded companies perform on issues such as worker pay, board diversity and environmental impact. Paul Tudor Jones, co-founder and chairman of Just Capital, and Dan Schulman, CEO of PayPal, join "Squawk Box" to discuss the initiative as well as what they are watching in the markets.
Third, Taylor Swift's public feud with music industry executives Scott Borchetta and Scooter Braun continued Thursday when she claimed on social media they were "exercising tyrannical control" and blocking her from performing her old music at the American Music Awards, where she will be honored with the Artist of the Decade Award on Nov. 24. Erik Hirsch, vice chairman at Hamilton Lane, to discuss how private equity can become 2020's new punching bag.
Fourth, Mark Redman, global head of private equity at the Ontario Municipal Employees Retirement System (OMERS), talks with Bloomberg's Lisa Abramowicz on "Bloomberg Money Undercover" about direct investing, the potential bubble in private equity, the firm's "dry powder" and an opportunities in the late-cycle economy. Listen to why Redman thinks we are "at the top of the market."
Lastly, Marc Lasry, Avenue Capital Group chairman and CEO, joins 'Fast Money Halftime Report' to discuss how markets would react if Senator Elizabeth Warren (D-Mass.) is elected president. He also discusses the future of capitalism.
Just remember to read C. Wright Mills' The Power Elite, you'll understand the past, present and future of capitalism. I'll be back on Monday, November 25th.
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