Pension World Reeling From Plunging Yields

Anchalee Worrachate of Bloomberg reports that the pension world is reeling from 'financial vandalism' of falling yields:
A once-unthinkable collapse in global bond yields is forcing pension funds to buy bonds that offer negative returns -- putting the financial security of future retirees in jeopardy.

U.S. institutions managing trillions of dollars in retirement savings -- including the California Public Employees’ Retirement System -- have been ratcheting down return expectations. Japan’s Government Pension Investment Fund, the world’s largest, has warned that money managers risk losses across asset classes. In Europe, pension funds may be forced to cut benefits in part thanks to the decline in rates.

Investors were already taking on more credit risk to make up for dwindling income elsewhere, with some chasing less liquid markets like private debt. Now, negative yields on over a quarter of investment-grade bonds -- with more monetary easing to come -- are increasing the urgency for portfolio managers to find new sources of returns.

“The true madness is pension funds being forced to invest in assets which will be guaranteed to lose, such as in the case of long dated inflation-linked gilts at real yields of -3%,” said Mark Dowding, chief investment officer at BlueBay Asset Management, which has pension-fund mandates. “It is financial vandalism and the government and central banks need to wake up to this.”

Pension funds invest in a variety of assets, but most including defined-benefit plans use low-risk assets such as government bonds as the benchmark discount rate. While that means they have profited from the fixed-income rally, falling yields have also driven up future liabilities -- in turn threatening their ability to meet oncoming obligations.

“The $16 trillion of nominal negative yielding bonds in the world right now -- for the pension industry that’s not a good outcome,” Nigel Wilson, the chief executive offer of Legal & General Group Plc, said in a Bloomberg Television interview.

Ben Meng, chief investment officer of Calpers said earlier this year that the expected return over the next 10 years would be 6.1%, down from a previous target of 7%. Scott Minerd, chief investment officer of Guggenheim Partners, warns that the Federal Reserve’s policy easing is contributing to a likely government-bond bubble and that very narrow credit spreads have greater potential to widen.

Ten-year yields are negative across higher-rated European government bond markets while Germany’s entire curve fell below zero. Similar rates are also sub-zero in Japan, while they’ve recently hit record lows in Australia and New Zealand. In the U.S., 30-year Treasury rates hit an all-time low of 1.91% this month.

‘Dire’ Situation

Peter Borgdorff at Dutch fund PFZW blamed “that ever-lower interest rate” for its coverage ratio that stood at 94.8% at the end of July.

“The financial situation of PFZW is starting to get dire,” Borgdorff wrote in his blog. “A pension reduction in the year 2021 has been threatening for some time. But if we have a coverage ratio at the end of this year that is lower than around 94%, we should already reduce pensions even next year.”

The plunge in yields risks spawning a vicious circle for the industry. The squeeze on returns tends to widen funding gaps, forcing managers or employers to inject more cash into the plans. That’s money which could have otherwise been used to fuel business or consumption so economic growth may take a hit -- boosting calls for even more monetary easing.

Shrinking Assets

“The overall impact is that lower yields can induce households or companies that act as plan sponsors, to save even more for the future,” said Nikolaos Panigirtzoglou, a strategist at JPMorgan Chase & Co, in a recent note. “In our conversations with clients, the experiments of central banks with negative rates are viewed more as a policy mistake rather than stimulus.”

Pension assets dropped 4% in 2018 to $27.6 trillion, according to the Organisation for Economic Co-operation and Development. While gains on stocks have helped plug funding gaps, it’s no secret that income-starved managers have dived into less liquid assets.

One way out of the pension quagmire is to allow more retirement funds to invest in “real assets in the real economy,” said Wilson at Legal & General.

Cases are legion. One of the Nordic region’s largest pension funds is reducing its stock of government bonds for alternative assets, which could include real estate and private equity. A scheme for the retired clergy in England is shifting allocations to private credit. A fund for U.K. railworkers, meanwhile, is looking to boost exposure to private debt to as much as 40% within a private-investment strategy totaling 4.5 billion pounds ($5.5 billion) across two funds.

Chris Iggo, chief investment officer for fixed income at AXA Investment Managers, frets over the fallout from this extended era of ultra-low yields.

“In 2008, most people in the markets had no idea about the leveraged web of instruments that were ultimately linked to the housing market in the U.S.,” he wrote in a note, referring to the subprime debt crisis. “We should be worried about lower and lower bond yields...They may cause some, as yet not fully understood, tensions in the financial system with structural implications.”
The collapse in global bond yields is the biggest story of the year when it comes to pensions.

Repeat after me: Pensions are all about matching assets with liabilities. Period. It's not about who has the highest returns, it's all about the funded status.

And since pension liabilities are long dated (going out 75+ years), their duration is bigger than the duration of pension assets.

This is why I keep harping on how plunging yields wreak havoc on pensions, because they disproportionately impact pension liabilities and swamp any gains from pension assets.

The real pension storm is a 2008 type of crisis when yields collapse and pension assets get clobbered concurrently, a double-whammy for global pensions.

But here is the real kicker, something Jim Leech, OTPP's former CEO and co-author of The Third Rail, once told me: "The starting point matters a lot...pension deficits are path dependent."

Why am I bringing this up? Because, to put it bluntly, while fully funded Canadian public pensions won't escape the next crisis, many chronically underfunded US public pensions falling short of their return expectations this year simply can't afford another 2008 crisis, it will eviscerate them. At that point, one of two things will happen:
  1. Benefits will need to be cut which is constitutionally illegal or
  2. The contribution rate will need to be hiked which will be met with resistance from public-sector unions and cash-strapped state and local governments who will be forced to emit more pension bonds and hike real estate taxes to meet their pension payments (that's not a long-term solution). 
This is why when I wrote my comment on deflation headed to America a couple of years ago, among the seven structural factors that led me to believe we are headed for a prolonged period of debt deflation was the global pension crisis:
  1. The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  2. Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  3. The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  4. Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.
  5. Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  6. Globalization: Capital is free to move around the world in search of better opportunties but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
  7. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create.
These are the seven structural factors I keep referring to when I warn investors to temper their growth forecasts and prepare for global deflation.

And make no mistake, this is a global problem. Reuters reports  that Japan's government unveiled estimates on Tuesday that showed public pension benefits steadily declining during coming decades, as it prepares to open up a debate on social security reforms needed to support an aging population:
Curbing bulging welfare spending is a vital step toward fixing the industrial world's heaviest debt burden, which is currently more than twice the size of Japan's $5 trillion economy.

While Prime Minister Shinzo Abe's government has made welfare reform a top priority, it has moved slowly due to fears that it could alienate the public.

Japan has one of the oldest populations in the world, due to a low birth rate and people's longevity, putting pressure on its pension system.

In its pension estimates - which are issued every five years to gauge health of public pensions - the government estimated monthly pension benefits at 220,000 yen ($2,087.48) per model married couple, worth about 61.7% of pre-retirement income.

This pension-to-wage ratio is projected to fall to about 51-52% by the late 2040s, with the possibility of sliding further to around 45% in the 2050s, depending on growth and population outlook.

By some estimates, the ratio would fall below 40% in the 2050s, assuming the national pension fund dries up while the economy contracts mildly and labor participation stalls.

The government presented six types of estimates based on various scenarios, including a high economic growth case and base-line case.

The estimates also took account of optional scenarios such as a wider range of part-timers include in corporate pension schemes, and delayed pension payments for people who work well past their retirement age.

The estimates were largely unchanged from the prior projections made in 2014, due partly to rises in the number of people paying into the system and rising yields on investment.


The government has vowed to keep the average pension-to-wage ratio from falling below 50%, but worries are persisting Japan's 'pay-as-you-go' pension scheme may be unsustainable, with fewer workers paying into it and a larger retired population drawing from it.

"In Japan, adjustment in pension benefits and burdens has been lagging, while the overhaul of pension system has been left untouched," said Kazuhiko Nishizawa, social security expert at Japan Research Institute.

Pensions in Japan are a politically sensitive topic.

The estimates came a month after July's upper house polls, raising some speculation that the government may have delayed the release until the elections were out of the way.

In June, a report by advisers to the Financial Services Agency said a model case couple would need 20 million yen on top of their pensions if they lived for 30 years after retiring, fuelling doubt about pension sustainability.
Pensions are a politically sensitive topic everywhere, not just in Japan.

Here are some concluding thoughts on this topic which I think every policymaker around the world needs to understand:
  • First and foremost, policymakers around the world need to be cognizant of the value of a good pension. And here I'm talking about a well-governed defined-benefit pension because the brutal truth on defined-contribution pensions is they're not real pensions you can count on, they're supplemental savings programs that are too beholden to the vagaries of public markets.
  • Second, in order for pensions to be sustainable over the long run you need two things: 1) good governance which separates the administration of the pension from governments and 2) some form of risk-sharing. As more and more people retire and live longer, the ratio of retired to active members soars and in order to ensure inter-generational equity, retired members should bear the brunt of any pension deficit. That's why I'm a big proponent of adopting conditional inflation protection, a crucial element which has helped the Ontario Teachers' Pension Plan become young again. Every major fully funded public plan in Canada like OTPP, HOOPP, CAAT Pension Plan, has adopted conditional inflation protection which is a minor burden on retired members because it simply means for a short period of time, their benefits won't be fully indexed to inflation until the plan is fully funded again. Once the plan is fully funded, they can restore full inflation protection and even give back any previous lost benefits if the plan is over-funded.
  • Third, the Canada model needs to go global. It used to be the Dutch and Danes had the best pension systems but I think they went overboard and destroyed their pension systems by discounting their liabilities to the risk-free long bond rate. The insanity of negative rates can remain with us for a long time, and if you're not reasonable in the way you discount future liabilities, you risk imposing overly arduous conditions on your public pensions. This is what happened to the mighty Dutch pension system and I think they ruined a really great system imposing these harsh regulations. Worse still, as discussed below, by imposing overly arduous pension regulations, you risk exacerbating the problem by forcing pensions to "de-risk" and keep on buying more negative-yielding sovereign debt. That's just insane! (of course, as Jim Bianco of Bianco Research points out, “owners of these bonds have been seeing huge price increases,”which is why that near $17 trillion pile of negative-yielding global debt is a cash cow for some bond investors).
  • Fourth, pensions need to be prepare for next downturn just like CPPIB is doing and realize that ultra-low/ negative rates are here to stay. They need to invest more in real assets and private debt to be able to address these structurally low rates but they need to be realistic on their return assumptions going forward.
Anyway, I'm rambling on but the most important point of this comment is the collapse in global bond yields has hit all pensions very hard but some of them will be able to handle their soaring liabilities a lot better than others because they're fully funded and have adopted some form of risk sharing (conditional inflation protection). Others, like the state of Illinois, are running out of pension time.

Below, a once-unthinkable collapse in global bond yields is forcing pension funds to buy bonds that offer negative returns -- putting the financial security of future retirees in jeopardy. Bloomberg's Luke Kawa discusses on "Bloomberg Markets." Listen to what he says about "negative convexity" and pensions, very interesting.

Update: Arun Muralidhar, co-founder of Mcube Investment Technologies, shared this with me after reading this comment:
Just saw this in your piece on yields and pensions – you are so darn right!! I just wrote the attached article for Journal of Investment Management that makes a similar point. In a way, the bad use of MPT/CAPM, that focus on expected returns instead of matching cash flows, took us down a guaranteed path of pension trouble. You should enjoy the paper as I also argue that giving funds awards because they are big is idiotic – we should reward those with the best/most improved funded status.
The published paper is firewalled but an earlier draft of Arun's paper, The F-Utility of Wealth: It’s All Relative, is available here. I thank him for sharing his wise insights.