Are Millennials Prepared for Pension Shock?

Michael Katz of Chief Investment Officer reports, IMF Urges Millennials to Prepare for ‘Pension Shock’:

Young workers in advanced economies won’t be able to rely on pension funds like their parents or grandparents have, and will have to work longer and save more than previous generations, according to the International Monetary Fund (IMF).

The IMF said the so-called Millennial generation needs to take action now to make sure they will have enough money to make it through a retirement that could last as long as 30 years.

“Public pensions have played a crucial role in ensuring retirement income security over the past few decades,” said Mauricio Soto, a senior economist in the IMF’s Fiscal Affairs Department. “But for the millennial generation coming of working age now, the prospect is that public pensions won’t provide as large a safety net as they did to earlier generations,” he said, adding that “as a result, Millennials should take steps to supplement their retirement income.”

The IMF cited statistics from the Organization for Economic Co-operation and Development (OECD) showing that pensions, and other types of public transfers, have accounted for more than 60% of retirees’ income in OECD-member countries.

“Pensions also reduce poverty,” said Soto. “Without them, poverty rates among those over 65 also would be much higher in advanced economies.”

However, the IMF pointed out that despite the benefits pensions provide, they are also expensive to maintain. According to the IMF, government spending on pensions has been increasing in advanced economies, more than doubling from an average of 4% of GDP in 1970, to close to 9% in 2015.

“Population aging puts pressure on pension systems by increasing the ratio of elderly beneficiaries to younger workers, who typically contribute to funding these benefits,” said Soto. “The pressure on retirement systems is exacerbated by increasing longevity—life expectancy at age 65 is projected to increase by about one year a decade.”

To deal with the rising costs of maintaining pension funds, many countries and companies have initiated pension reforms, which the IMF said has been aimed primarily at limiting growth in the number of pensioners, while reducing the size of pensions. The number of pensioners is often kept in check by increasing qualifying retirement ages or tightening eligibility rules, and minimizing pension size is usually achieved by adjusting benefit formulas.

The IMF said that since the 1980s, public pension expenditure per elderly person as a percent of income per capita—the so-called economic replacement rate—has been about 35%. And that replacement rate is projected to decline to less than 20% by 2060, according to the IMF.

“This means that younger generations will have to work longer and save more for retirement to achieve replacement rates similar to those of today’s retirees,” said Soto.

To close this gap in the economic replacement rate, the IMF said one option for younger individuals is to lengthen their productive work lives. It said that for workers who will start to retire in 2055, increasing retirement ages by five years would close half of the gap relative to today’s retirees.

“The good news for younger workers is that retirement is some four decades away, allowing time to plan for longer careers and to put money aside for later,” said Soto. “But they must start now.”

The IMF put out a press release written by Mauricio Soto going over the Pension Shock:

Young adults in advanced economies must take steps to increase their retirement income security.

Public pensions have played a crucial role in ensuring retirement income security over the past few decades. But for the millennial generation coming of working age now, the prospect is that public pensions won’t provide as large a safety net as they did to earlier generations. As a result, Millennials should take steps to supplement their retirement income.

Pensions and other types of public transfers have long been an important source of income for the elderly, accounting for more than 60 percent of their income in countries that are members of the Organisation for Economic Co-operation and Development (OECD). Pensions also reduce poverty. Without them, poverty rates among those over 65 also would be much higher in advanced economies.

Pressure on pensions

But pensions are also costly to provide. Government spending on pensions has been increasing in advanced economies from an average of 4 percent of GDP in 1970 to close to 9 percent in 2015—largely reflecting population aging (see Chart 1, left panel).

Population aging puts pressure on pension systems by increasing the ratio of elderly beneficiaries to younger workers, who typically contribute to funding these benefits. The pressure on retirement systems is exacerbated by increasing longevity—life expectancy at age 65 is projected to increase by about one year a decade.

To deal with the costs of aging, many countries have initiated significant pension reforms, aiming largely at containing the growth in the number of pensioners—typically by increasing retirement ages or tightening eligibility rules—and reducing the size of pensions, usually by adjusting benefit formulas. Since the 1980s, public pension expenditure per elderly person as a percent of income per capita—the so-called economic replacement rate—has been about 35 percent. But that replacement rate is projected to decline to less than 20 percent by 2060 (see Chart 1, right panel).

This means that younger generations will have to work longer and save more for retirement to achieve replacement rates similar to those of today’s retirees (see Chart 2):

Working longer: To close the gap in the economic replacement rate relative to today’s retirees, one option for younger individuals is to lengthen their productive work lives. For those born between 1990 and 2009, who will start to retire in 2055, increasing retirement ages by five years—from today’s average of 63 to 68 in 2060—would close half of the gap relative to today’s retirees. A longer work life can be justified by increased longevity. But prolonging work lives also has many benefits. It enhances long-term economic growth and helps governments’ ability to sustain tax and spending policies. Working longer can also help people maintain their physical, mental, and cognitive health (Staudinger and others 2016). However, efforts to promote longer work lives should be accompanied by adequate provisions to protect the poor, whose life expectancy tends to be shorter than average (Chetty and others 2016).

Saving more: Simulations suggest that if those born between 1990 and 2009 put aside about 6 percent of their earnings each year, they would close half of the gap in economic replacement rate relative to today’s retirees. In practice, relying on people’s private savings for retirement requires a hard-to-achieve mix of fortune and savvy. First, individuals need continuous and stable earnings over their careers to be able to save sufficient amounts. Second, workers would have to be able to decide how much to put aside each year and how to invest their savings. Third, the risks from uncertain or low returns are borne by individuals. Finally, workers would have to decide how fast to consume their savings during retirement. These are all complex decisions, and people can make mistakes at each step along the way (Munnel and Sundén 2004).
Time to cope

For younger generations, acting early is crucial to ensure retirement income security, especially because longevity gains are projected to continue. As millennials start to enter the workforce, retirement might be the last thing on their mind. But with many governments retrenching their role in providing retirement income, younger workers need to work longer and step up their retirement savings.

Governments can make it easier for individuals to remain in the workforce at older ages by reviewing taxes and benefits that might favor early retirement. Nudges to encourage workers to save can also help, for example by automatically enrolling them in private retirement saving plans. For example, starting in 2018, the United Kingdom will require employers to automatically enroll workers in a pension program. Boosting financial literacy and making the workplace more friendly to older workers can also be part of the solution.

The good news for younger workers is that retirement is some four decades away, allowing time to plan for longer careers and to put money aside for later. But they must start now.

Younger workers have a lot to contend with, especially those working in the private sector where defined-benefit plans have all but disappeared.

I'm not worried about young Canadian teachers, nurses, and other public-sector workers who have access to defined-benefit plans managed by great Canadian pensions. They too should save more and prepare for a potential 'pension shock' but at least their retirement money is well-managed by the likes of Ontario Teachers', HOOPP, the Caisse, and other top Canadian pensions.

Another good thing is the federal government and provincial governments have agreed to move ahead and enhance the Canada Pension Plan for all Canadian workers, which will also help future pensioners. This is 'forced saving' but the money is managed by CPPIB which is doing a great job investing across public and private markets all over the world.

What else are tech savvy, asset poor Millennials doing to save for retirement? More and more of them are embracing digital advisors (aka robo-advisors) as a low-cost way to safely save for retirement.

The attractiveness of digital platforms is that they offer instant diversification into low-cost exchange-traded funds (ETFs) and the platforms rebalance these ETFs on an annual basis or more frequently depending on the risk tolerance of the individuals.

Admittedly, I am simplifying things as there are important differences between digital platforms and it's important to note that all generations -- young and old -- are increasingly embracing these platforms.

It is beyond the scope of this comment to go over the pros and mostly cons of robo-advisors. I would caution anyone to do intense research to understand the advantages, disadvantages and differences between them.

What I can tell you with near certainty is that digital advisors are not the solution to defuse the world's $400 trillion pension time bomb. I am increasingly worried that this $3 $4 trillion beta bubble is on its last legs and more importantly, no robo-advisor or mutual fund can compete with a large, well-governed defined-benefit plan when it comes to retirement security and real low-cost diversification across public and private markets over the long run.

How certain am I making these claims? Just look at the long-term results CPPIB recently posted using its long-term strategy of diversifying into global private markets. And it's not just CPPIB, other large Canadian pensions have posted equally outstanding long-term results.

All this to say, yes, Millennials need to prepare for a 'pension shock' but so do many other people getting ready to retire. The pension storm cometh and far too many people are ill-prepared to confront the challenges they will face in retirement.

In my humble opinion, global policymakers need to rethink pension policy and incorporate many of the ideas that I discussed in a recent comment on the pension prescription.

Importantly, it's high time we realize the benefits of large, well-governed defined-benefit plans, bolster them and introduce some important changes to ensure our pensions are sustainable over the long run.

These changes include gradually raising the retirement age over many years, but more importantly, we need to introduce world class governance at public pensions, unions and governments need to be realistic on return expectations, and we need to introduce risk-sharing in all pensions, public and private.

And the big fat cats on Wall Street -- ie. the top hedge funds and private equity funds of this world -- need to be part of the solution by considerably cutting their fees and helping pensions attain their return targets.

In other words, if we really want to help future generations save for retirement, we need a global pension summit where we discuss all these proposals including transforming the US Social Security system so it mimics what we have done in Canada with the CPP assets being managed by the CPPIB.

Telling cash-strapped Millennials they need to work longer and save more is basic common sense advice we all need to follow but it irks me in the sense that it's the same failed policy that has done nothing to address the ongoing retirement crisis in developed nations. It basically shifts retirement risk entirely onto employees and leaves them exposed to pension poverty down the road.

Young workers have enough to contend with in an increasingly uncertain labor market, which is one reason why a lot of them are opting to use digital platforms. I believe they deserve better, a lot better but in order to implement the proposals that I'm arguing for -- namely, a universal pension for all workers managed by a large, well-governed public pension fund that invests across public and private markets -- we need the political will to implement these changes.

In this sense, young Canadian workers are already in a better position than their global counterparts because they will enjoy the benefits of an enhanced CPP. Still, a lot more needs to be done in Canada and the rest of the developed world to address the serious challenges retirement systems are facing.

Lastly, yesterday was my nine year anniversary of writing this blog (time just flew by). I have grown and evolved over the last nine years but I remain very concerned about pensions and fundamentally believe we need to do a lot more to bolster retirement systems all over the world so millions of workers can retire in dignity and security.

If you have anything to add, feel free to contact me at LKolivakis@gmail.com. I certainly don't have the monopoly of wisdom when it comes to pensions and investments but I'm doing my part to cover important topics which rarely get the attention they deserve.

Once more, I ask you to please take the time to contribute to this blog via PayPal under my picture on the right-hand side. I sincerely thank all of you who take the time to show your financial support.

Below, Catherine Mann, OECD chief economist shares her forecast on economic growth around the world, stating they are a little more optimistic than a year ago but don't know whether this growth will be sustainable.

You know my thoughts, prepare for US and global slowdown, and young and old workers need to prepare for the 'pension shock' which will inevitably hit them as they prepare to retire in a low growth, low return deflationary world. Now more than ever, policymakers need to address these challenges.