Lose-Lose for Pensions as Deficit Swells?
This year's surge in equities and other risky assets has been a relief for investors under pressure to boost returns after a dire 2011, but pension funds seem trapped in a low-yield world, aggravating their battle with demographic trends.
Despite equities enjoying one of the best annual starts in 30 years, the giant $35 trillion pension funds industry has seen its chronic funding gap widen this year - reflecting portfolios still laden with the low-return bonds whose yields they use to calculate their future liabilities.
Pension funds are already struggling to meet ever-growing future payments as populations age. Life expectancy in the developed world has jumped by 10 years, to 76 for men and 82 for women, in the past 50 years.
This demographic time-bomb, which is most pronounced in Japan and other developed economies, is potentially so problematic it could make recent financial crises such as that in the euro zone pale in comparison.
New data from consultancy Mercer shows funding deficits of pension plans of FTSE350 top British companies rose 9 billion pounds in February alone to 92 billion pounds, their highest since at least 2008.
In the United States, funding deficits of the 100 largest defined benefit plans, promising pensioners an annual income equivalent to a percentage of their final salaries, stood at $413 billion in February, more than double the amount seen in mid-2011, according to the Milliman Pension Fund Index.
While stronger equities do benefit pension asset positions, it is the level of bond yields that counts when it comes to assessing liabilities, which are calculated using benchmark yields such as those on top-rated corporate bonds.
Low yields lead to bigger liabilities, hence more deficits, because pension funds will need more assets to pay sufficient income to pensioners in the future and companies may need to pay more into the pot.
Bond yields in general have remained low due to large-scale money printing by developed central banks and a growing shortage of the triple-A-rated paper craved by pension funds.
"The key problem of pension funds globally is they tend to target very low-risk type portfolios like fixed income. They haven't been quick enough to take advantage of a rally in equity markets," said Norbert Fullerton, director of consulting EMEA at Russell Investments.
"Even if some of the assets are rising, liabilities are rising faster because quantitative easing has driven down bond yields. Pension funds are running a very large deficit. So in order for assets to keep paying liabilities, they have to work at least twice as hard."
The general rule of thumb is that a 50-basis-point fall in the discount bond rate roughly results in a 10 percent increase in liabilities.
The benchmark U.S. discount rate used to calculate pension liabilities fell to 4.77 percent in February, down from 4.84 percent in January and from 5.79 percent a year ago, according to Mercer. In Britain, regulators use double-A-rated corporate bond yields as a benchmark, for which spreads over risk-free rates have fallen more than 30 basis points since January 1.
Japan, the world's most rapidly ageing society, expects two out of every five of its population will be 65 or older by 2060, reflecting low birthrates and long life expectancy, with nearly 35 million pensioners but just 8 million children aged 14 or under.
Demographic trends are similar in other major economies.
HSBC projects Germany's working population will shrivel by 29 percent by 2050 while the European Union warned in 2010 that without reforms, the number of people in work for every retired person in the bloc would drop from four to just two by 2060.
Against this backdrop, pension funds around the world are under pressure to boost returns, but their bond-heavy portfolios are making things difficult.
Japan's $1.3 trillion public pension fund - the world's largest, with a portfolio nearly as big as Spain's economy - lost 2.5 percent in the nine months to December 2011, although returns were positive in the final quarter.
The fund puts two-thirds of its assets in Japanese government bonds, for which the benchmark 10-year yield languishes below 1 percent. Within its portfolio, foreign equities generated the biggest investment return, of around 8.8 percent, in the final three months of last year.
The California Public Employees' Retirement System (Calpers) lost 2.7 percent in the same nine-month period, while the Canada Pension Plan Investment Board made a 2.2 percent return.
In Europe, pension funds slashed their weightings for equities to an average of 31.6 percent in 2011 from 43.8 percent in 2006, while fixed income holdings rose to 54 percent from 47.8 percent in the same period, according to Mercer.
"They need to start focusing more on how much juice they can get from their portfolio, by investing more in equities or a more diversified return-type portfolio, infrastructure, commodities, and alternative type assets," Fullerton said.
"They are trying to match assets and liabilities but given high government bond prices, it's not the way to do it because all of their bond portfolio will start to fall in value."
One solution to the persistent funding problem may be to tweak accounting standards.
The U.S. Congress is debating whether to allow companies to use a longer 10-year average of bond yields instead of the current 24-month average to determine the amount of annual contribution by firms. This would lead to higher benchmark yields used to estimate future payments, thus lower liabilities.
Another way, is simply to increase contributions by sponsoring companies, whose balance sheets in general have improved considerably after the financial crisis.
Ford Motor is pouring $3.8 billion into its global pension plan this year, more than double its 2011 contribution, to minimize pension risks.
Boeing and Alcoa also plan large cash payments to their pension plans this year.
"The majority of plans which are in deficit have a choice: either take investment risks or commit to pay additional contribution to close the gap. Most companies are trying to strike the balance," said Adrian Hartshorn, partner at Mercer's financial strategy group.
Great article, shows you the challenges pension plans around the world face in an environment of longer life spans and low bond yields.
As I stated in my earlier comment on Japan, they need to do a lot more, including following Malaysia's pension fund, the second-largest state-run pension system in the Asia-Pacific region, which plans to raise holdings of overseas investments to 30% by 2017 to boost returns.
Earlier this week, Tesco became the first British company to announce it will raise the retirement age for its staff to 67, paving the way for others across the country:
More than 170,000 employees face working an extra two years in order to qualify for the maximum entitlement on their pensions, as Britain's biggest supermarket considers raising its retirement age from 65 to 67.
The company has launched a consultation with employees on the subject, but unlike most other FTSE 100 firms will continue to allow new members to join its pension scheme.
The scheme already has more than 293,000 members including 172,000 active workers, and the company plans to create 20,000 more customer service jobs in the UK over the next two years in customer service as it refreshes existing stores and opens new ones.
Under the new plans, Tesco will also use the lower inflation measure - consumer prices index (CPI) - to calculate the annual increases in its contributions to employee pensions.
It currently uses the retail prices index (RPI) which was 3.9% in January compared to a CPI figure of 3.6%.
However, it has kept the maximum rise in any year at 5%, twice the level set by the Government.
Although the change in retirement age will not force workers to remain in employment until they are 67, deciding to stop working earlier would hit pension savings.
The supermarket hopes to introduce the changes from June 1, adding they were necessary to limit risks such as unexpected rises in life expectancy.
A Tesco spokesman said: "Because people are living much longer pensions cost much more to provide. These changes make our defined benefit scheme sustainable."
When Tesco launched its first pension scheme in 1973, it expected retirees to live to 77, but now the firm expects average 40-year-old employees to live into their nineties.
I think other companies will follow Tesco but also worth noting is unlike other FTSE 100 companies, they're still offering pensions to new employees (very smart move).
Unfortunately, the situation in Britain is dire. Sinead Cruise of Reuters reports, With no faith in pensions, Britons face old age poverty:
Erin Graham helps well-heeled 60-somethings decide whether to spend their pensions and savings on Christmas cruises in the Caribbean or summer voyages 'on the Med'.
But the 27-year-old travel consultant knows the chances of enjoying the same lifestyle in her twilight years are slim.
Graham is typical of future generations of British retirees who have little or no pension. Some say their budgets are so tight they have no spare cash to save while others are simply shunning a system they have come to mistrust.
"I am not taking any steps to save money for my retirement as I simply cannot afford it. What I earn is spent on rent, food, petrol, car insurance and necessities. I have no wages left to put into savings," says Graham.
"I would like to retire at about 65 years old but by the sounds of it I'll be working well into my seventies."
The pensions industry and the government says younger generations are setting themselves up for a retirement spent in poverty, a contrast to those retiring now flush from final salary pension schemes and the proceeds of a housing boom.
Official figures show less than half of all UK employees were saving into a workplace pension scheme in 2011, with young people seen among the most reluctant savers.
"This is storing up massive socio-economic problems for the future," said Malcolm McLean, a consultant at Barnett Waddingham, one of Britain's largest independent firms of actuaries, administrators and consultants.
"I don't want to get too apocalyptic but there is a very real problem here and I don't think anyone should be complacent about it."
He and others predict years of "inter-generational strife": a cycle of parents who come to rely on their offspring to provide for them in retirement, hurting that generation's capacity to save for their old age, and so forcing the next generation of children to support them in turn.
The state and the corporate sector are rapidly handing back responsibility to individuals for their own old-age finances as life expectancy grows, forcing young Britons to map out the end of their life long before they have lived much of it.
But as living costs and personal debts spiral, people of all ages claim hoarding cash that won't be seen again for decades is out of the question, with 22-29 year-olds living on the median 406.60 pounds ($640) gross weekly wage in strongest opposition.
Arguably, a bigger problem is that public confidence in pensions has fallen to an all-time low.
Headlines about missold or mismanaged products, gold plated schemes for public sector workers, financial market crises as well as large bonuses for those managing pension funds, have turned people off.
A survey for the National Association of Pension Funds (NAPF) found that 54 percent of all workers did not trust pensions and would prefer other ways of saving.
Joe Tanner, a 28-year-old software trainer from southeast London has argued with his father about his lack of retirement planning every year since he started work.
"So much of what you hear in the press - it's almost like all of your worst paranoid fears and concerns are being reported as truth," he said.
"If it isn't about bankers earning more money than most of us would earn in a lifetime, it's MPs buying all sorts with taxpayer money...the idea of me putting my money into those systems doesn't exactly fill me with confidence."
He is saving 10 to 15 percent of his monthly salary but he ultimately intends to buy property with the money.
Those who do pay into pensions are not much more optimistic.
According to NAPF, 70 percent of those saving into a scheme for retirement were doubtful that it would give them enough money to live on in old age.
Diligent pensions investment has also backfired badly for many parents and grandparents, many of whom were missold costly schemes or lost years of growth in panicked share trading.
Steve Pattenden, a 55-year old entrepreneur from the London commuter town of Luton, has all but given up on retiring after watching more than 35 years of pension contributions turn sour.
"I envisage a meagre existence now as none of my pensions are worth anything like what they were even four years ago. I'm seriously looking at stopping contributions and cutting my losses," he said.
In addition many company pension schemes have become less generous, with defined benefit programmes being replaced with defined contribution schemes.
A member of a defined benefit (DB) scheme who joined at age 20 and is retiring now at age 60 would expect to receive a pension of around 21,070 pounds a year, based on the average UK salary of 31,600 pounds, Barnett Waddingham calculations show.
But a member of a defined contribution (DC) scheme making minimum contributions over the same period would have produced a pension of just 13,330 pounds a year.
Worse still, Barnett Waddingham estimates the projected DC pension for a 20-year old starting a pension now and paying into it for the next 40 years is only 6,440 pounds in today's money.
Conscious of its growing pensions burden, the government has come up with a plan to cajole Britain's youth into saving for the future with the launch of a work-based pension scheme called the National Employment Savings Trust (NEST) this October.
Employers will be required to make contributions on behalf of all workers without access to a qualifying pension scheme. Staff will be enrolled automatically and their contributions will be deducted directly from their wages unless they opt out.
But with no plans at this stage to make the scheme compulsory, there are doubts it will be enough to reverse a broad sense of apathy about investment or prevent today's youngest citizens from slipping into poverty in retirement.
Jeff Molitor, Chief Investment Officer, Europe, at $1.8 trillion investment house Vanguard says fund managers and financial advisors must adopt a results-based approach to creating and marketing products, particularly for coaxing young nervous clients into investment.
"It is clear that Gen-Y (born after the mid-1970s) investors are more risk averse and don't have the appetite to go after equities that their parents or grandparents did," Molitor said.
Financial advisors also say better education is needed to persuade people to change their ways.
"A lot of people are making bold but wholly unfounded assumptions that the state will look after them financially in retirement," Simon Bonnett, head of financial planning at private bank Duncan Lawrie.
"You don't know what kind of government is going to be in power when you retire. Do you have a contract with them to provide for you when you stop working?"
I had lunch today with a senior VP at a pension fund who told me flat out: "DC plans are not pension plans. They are a way to divert savings into the financial services industry. There is no pension promise, no guarantee of a minimum payment."
He's absolutely right. Let me once again share with you insights from Jim Keohane, President and CEO of the Healthcare of Ontario Pension Plan (HOOPP):
Finally, if markets keep rallying and bond yields keep rising, it will ease some of the strain on pensions but it won't be enough. Without meaningful pension reforms, pension deficits will keep ballooning.
There seems to be an underlying myth behind these discussions that defined contribution plans are cheaper than defined benefit plans. Actually, facts show that the reverse is true.
The cost of operating defined benefit plans such as HOOPP is a fraction of the cost of operating the typical DC plan. And switching from a DB to a DC plan doesn’t save the employer any money if the contribution rates remain the same.
Switching from DB to DC plans is really about risk transference. By switching from a DB to a DC plan employers are shifting the risk of future underfunding from themselves to the employee and ultimately to the social welfare system. Savings to the employer are only achieved by lowering the employers contribution rates.
Government employers should view the decision to shift from DB to DC differently than corporate employers. You could say that corporate employers are acting rationally by shifting from DB to DC plans. This allows them to shift risk off of their balance sheet onto the employee and the social welfare system.
However, if you are the government, you are simply shifting the risk from one bucket to another – from you the government as employer to you the government as the administrator of the social welfare system.
In fact this shift makes the problem worse. Due to the higher cost of administering DC plans, for the same contribution levels they produce lower pension incomes (a UK study found that they produce pension incomes which were 50% lower for the same contribution rates!) creating a greater strain on the social welfare system.Front end contribution rates are a function of investment returns and the back end benefits. The front end costs can only be reduced by reducing the back end benefits. Who bears costs and risk are a function of plan design and these issues can be dealt with within a DB structure.
Below, Michael Cloherty, head of U.S. interest rate strategy at RBC Capital Markets, talks about the International Monetary Fund's 28 billion-euro ($36.6 billion) loan to Greece, the bond market and the U.S. economy. Cloherty speaks with Tom Keene on Bloomberg Television’s “Surveillance Midday.”
Also, Christopher Sheldon, chief investment officer at the Deyfus Corp., talks about the outlook for U.S. markets, investor sentiment and investment strategy. Sheldon speaks with Scarlet Fu, Stephanie Ruhle, Sara Eisen and Erik Schatzker on Bloomberg Television's "InsideTrack."
Finally, Lisa Shalett, Merrill Lynch Global Wealth Management, and Ben Pace, Deutsche Bank Private Wealth Management, appeared on CNBC discussing whether the S&P's key milestone means investors should buy into the market. I remain long risk assets and think financials, tech, energy, metals and mining will keep climbing higher.