The Global Pension Crunch?

Yawen Chen and Nicholas Heath of Reuters report, China's pension funds under pressure with rising payments:

Many Chinese pension funds are under renewed pressure to break even as local governments race to increase pension payments to meet central government requirements, state news agency Xinhua said in a commentary on Tuesday.

The central government has ordered pension payments for corporate retirees to be increased by around 6.5 percent in all provinces, Xinhua said.

China's northeastern region of Liaoning has implemented a 6.75 percent rise in pension payments, which is estimated to cost the fund around 11 billion yuan ($1.65 billion).

Liaoning's pension fund deficit was 10.5 billion yuan in 2015, Xinhua said, citing an annual report published by China's Ministry of Human Resources and Social Security.

Pension funds in six provinces, including all three rustbelt provinces Liaoning, Heilongjiang and Jilin, already struggled with deficits in 2015, according to the report.

Despite the pressure to balance rising costs, the article said "systematic fiscal stipends would ensure costs to be balanced and that all retired corporate employees would receive full pension payments on time".

China's State Council, or cabinet, said late last year that dividends and income from state enterprises would be used to fill in gaps at pension funds and other social security funds, as part of plans to reform its inefficient and heavily indebted state-owned sector.

Xinhua said the coastal province of Shandong has spearheaded this effort, with Shandong transferring a sum of 18 billion yuan ($2.7 billion) so far and Shanghai planning to put no less than 19 percent of state enterprise income to subsidize the fund.

The last time I discussed China's pension gamble was back in April when Beijing announced that it will allow state pension funds to invest in stocks, with the hope of lifting returns and aiding equity-market liquidity.

Now we see Beijing has much bigger problems to contend with in terms of funding its underfunded state pensions. Even in China, government bureaucrats know better than messing around with pension benefits.

But if you ask me, this is just the beginning of China's massive pension woes. Sure, the Chinese have money to patch up their pension deficits but until they reform their state pensions and introduce real governance in terms of investment decisions, their underfunded state pensions are only going to become even more underfunded and this will be a huge problem for them in the future as their population ages.

And let's not forget, China is at the center of Asia's deflation crisis:

Research from the Hong Kong Monetary Authority on regional deflation has concluded that China lies “at the heart of the region’s deflation challenge” – with ramifications that could ripple across Asia.

A new white paper published by the HKMA’s monetary research institute has taken a look at declining producer prices across Asian economies. Policy wonks can find the full paper here, but in short its authors suggest their model’s findings confirm that spillover effects from China are one of the key determinants of Asian producer price deflation.

They go on to argue that a trifecta of issues in China – declining corporate profits, overcapacity and heavy debts – could undo recent rises in factory gate prices across Asia’s biggest economy. These factors increase the risk of producer price deflation, which the paper notes could ultimately lead to consumer deflation, kicking off a vicious cycle of deterioration for all of the above indicators.

Since the three issues outlined are more severe at China’s state-owned enterprises, the authors’ proposed fix centres on said government-run outfits:

[Besides] fiscal and monetary policies, supply side reforms such as tightening the overall credit growth, converting corporate debt into equity, and closing down non-profitable zombie firms, or any combination of these measures to reduce overcapacity and debt level, and improve the efficiency and profitability of state-own enterprises are required to avert a deflationary spiral.

The authors stop well short of suggesting major deflationary pressures are on the cards in the near term. But they warn that comprehensive reforms to address overcapacity and supportive policy to bolster demand are needed to avert a hard landing that could result in serious deflation throughout Asia.

One of the major policy reforms that China and the rest of the world need to address is to make sure as more and more people retire, they don't succumb to pension poverty because that is extremely deflationary.

And China isn't the only country struggling with its pensions. In the United States, the pension Titanic is sinking and many public pensions are crumbling. But unlike China, there is no more money left to throw at the problem, which is why we are seeing pitchforks and torches come out in cities like Chicago.

Of course, the pension problem is global in nature, a function of historic low rates, longer lifespans and terrible investment decisions guided by lousy governance standards.

Interestingly, over the weekend, Andrés Velasco, a former presidential candidate and finance minister of Chile, and Professor of Professional Practice in International Development at Columbia University's School of International and Public Affairs, wrote a comment for Project Syndicate on Chile's Pension Crunch:

Defined-benefit pension plans are under pressure. Changing demographics spell trouble for so-called pay-as-you-go (PAYG) systems, in which contributions from current workers finance pensions. And record-low interest rates are putting pressure on funded systems, in which the return from earlier investments pays for retirement benefits. The Financial Times recently called this pensions crunch a “creeping social and political crisis.”

Defined-contribution, fully-funded systems are often lauded as the feasible alternative. Chile, which since 1981 has required citizens to save for retirement in individual accounts, managed by private administrators, is supposed to be the poster child in this regard. Yet hundreds of thousands of Chileans have taken to the streets to protest against low pensions. (The average monthly benefit paid by Chile’s private system is around $300, less than Chile’s minimum wage.)

Chile’s government, feeling the heat, has vowed to change the system that countries like Peru, Colombia, and Mexico have imitated, and that George W. Bush once described as a “great example” for Social Security reform in the United States. What is going on?

The blame lies partially with the labor market. Chile’s is more formal than that of its neighbors, but many people – especially women and the young – either have no job or work without a contract. High job rotation makes it difficult to contribute regularly. And it has proven difficult to enforce regulations requiring self-employed workers to put money aside in their own accounts.

Moreover, the legally mandated savings rate is only 10% of the monthly wage, and men and women can retire at 65 and 60, respectively – figures that are much lower than the OECD average. The result is that Chileans save too little for retirement. No wonder pensions are low.

But that is not the end of the story. Some of the same problems plaguing defined-benefit systems are also troubling defined-contribution, private-account systems like Chile’s. Take changes in life expectancy. A woman retiring at age 60 today can expect to reach 90. So a fund accumulated over 15 years of contributions (the average for Chilean women) must finance pensions for an expected 30 years. That combination could yield decent pensions only if the returns on savings were astronomical.

They are not. On the contrary, since the 2008-2009 global financial crisis, interest rates have been collapsing worldwide. Chile is no exception. This affects all funded pension systems, regardless of whether they are defined-benefit or defined-contribution schemes.

Lower returns mean lower pensions – or larger deficits. The shock and its effect are large. In the case of a worker who at retirement uses his fund to buy an annuity, a drop in the long interest rate from 4% to 2% cuts his pension by nearly 20%.

The rate-of-return problem is compounded in Chile by the high fees charged by fund managers, which are set as a percentage of the saver’s monthly wage. Until the government forced fund managers to participate in auctions, there was little market competition (surveys reveal that most people are not aware of the fees they pay). A government-appointed commission recently concluded that managers have generated high gross real returns on investments: from 1981 to 2013, the annual average was 8.6%; but high fees cut net returns to savers to around 3% per year over that period.

Those high fees have also meant hefty profits for fund managers. And it is precisely the disparity between scrawny pension checks and managers’ fat profits that fuels protest. So, more challenging than any technical problem with Chile’s pension system is its legitimacy deficit.

To address that problem, it helps to think of any pension system as a way of managing risks – of unemployment, illness, volatile interest rates, sudden death, or a very long life span. Different principles for organizing a pension system – defined-benefit versus defined-contribution, fully funded versus PAYG, plus all the points in between – allocate those risks differently across workers, taxpayers, retirees, and the government.

The key lesson from Chile is that a defined-contribution, funded system with individual accounts has some advantages: it can stimulate savings, provide a large and growing stock of investible funds (over $170 billion in Chile), and spur economic growth. But it also leaves individual citizens too exposed to too many risks. A successful reform must improve the labor market and devise better risk-sharing mechanisms, while preserving incentives to save. It is a tall order.

Chile’s system already shares risks between low-income workers and taxpayers, via a minimum non-contributory pension and a set of pension top-ups introduced in 2008 (as Minister of Finance, I helped design that reform). Subsequent experience suggests that those benefits should be enlarged and made available to more retirees. But the Chilean government has little money left, having committed the revenues from a sizeable tax increase two years ago to the ill-conceived policy of free university education, even for high-income students.

In response to the recent protests, the government has proposed an additional risk-sharing scheme: some (thus far undecided) part of a five-percentage-point increase in the mandatory retirement savings rate, to be paid by employers, will go to a “solidarity fund” that can finance transfers to people receiving low pensions.

The goal is correct, but, as usual, the devil is in the details. In the medium to long run, it seems likely that wages will adjust, so that the effective burden of the additional savings will be borne by employees, not employers. One study estimates that workers treat half of the compulsory savings as a tax on labor income, so too-large an increase (especially in the funds that do not go to the worker’s individual account) could cause a drop in labor-force participation, a shift from formal to informal employment, or both. Chile’s economy does not need that.

There are no easy answers to the pensions conundrum, whether in Chile or elsewhere. Chilean legislators will have to make difficult choices with hard-to-quantify tradeoffs. Whatever they decide, irate pensioners and pensioners-to-be will be watching closely.

Mr. Velasco raises many excellent points in his comment but the key point I want to hammer in is the brutal truth on defined-contributions plans is they are by and large a miserable failure from a policy perspective and will only ensure widespread pension poverty.

The only long term solution to the pension conundrum is to follow Canada's radical pensions and adopt the governance model that has allowed them to thrive over the very long run.

I know I sound like a broken record but mark my words, unless the world goes Canadian on pensions, the global pension crunch will only get worse.

Below, a Taiwanese protest against the government's pension reform plans. Just wait, this will happen in China, Chile, Greece, and many other countries where pensions will be slashed as the global pension crunch becomes more entrenched, wreaking havoc on countries struggling with deflation.