The Time To Hedge Is Now: Pension Crisis In 2016 And Beyond
by
Spiraling unfunded liabilities and the looming pension crisis have regularly been making headlines for the better part of 2016, and with good reason. The situation is dire both in the US and in Europe, even though the exact scale of the problem has proved challenging to quantify. Differences in calculation approaches have produced a diversity of estimates: Present and future contributions, benefit levels, average salaries, economic growth, life expectancy and demographics are taken into consideration in varying degrees, while liabilities are also discounted using the assumed future return on investments and assets. However, even if we choose the most optimistic and generous of calculations, the unfunded government promises still appear to be unfundable as well.
Although the unfunded liabilities problem encompasses the totality of future benefits and welfare commitments that governments cannot afford to honor on today’s budgets and projected returns, the most urgent of those, and the one that has captured the public’s attention, is pensions. On both sides of the Atlantic, fears over an imminent pension crisis are on the rise. And it is not just state-run plans that are at risk: the monetary policy and economic environment of the last years has thrown private pension fund completely off-course as well.
State-run pension schemes at breaking point
In the US, the government is faced with an abysmal financial chasm between the future and the present, which can prove catastrophic for future taxpayers and economic growth. On an analysis released in April, Moody’s revealed that “The unfunded liabilities of the various federal employee pensions systems, covering civilian and military employee benefits, amount to about $3.5 trillion, or 20% of US GDP,”. This is the amount of promised benefits that is not covered by current fund assets, future expected contributions, and investment returns, under the assumption that rates will range between 3.7% and 4.1%. On a state level, Illinois and New York have unfunded pension debts over $300 billion each, while New Jersey, Ohio and Texas exceed $200 billion. As for California, the gap ranges from $550 billion to $750 billion, depending on the calculation.
State and local government pensions are at significantly higher risk than corporate pension funds, as these have to comply to higher standards and strict regulations, as opposed to their public sector counterparts. According to a recent report entitled “The Coming Pensions Crisis” by Citi Global Perspectives & Solutions (GPS), in the US, current unfunded corporate defined benefit commitments stand at $425 billion, while government employee defined benefit pension plans have from $1 trillion to $3 trillion in unfunded commitments (depending on the discount rate used). “Unfortunately, while governments often impose genuine requirements for funding contributions on corporate sponsors, they rarely impose those standards on themselves,” the report stated.
The problem is far from contained within the US, as seen in the chart below. According to the Citi report, unfunded government pension liabilities for 20 countries belonging to the Organization for Economic Co-operation and Development (OECD) stand at $78 trillion. European countries with extensive state-run pension systems face the biggest challenges: Germany, France, Italy, the U.K., Portugal and Spain had estimated public sector pension liabilities that topped 300 percent of GDP.
Private pension funds thrown off-course
Pension fund managers have so far relied on their investment returns, to accommodate the future payouts to their clients, and through conservative and low-risk investment options that were available to them, they were able to honor their commitments. In recent years, however, this is no longer the case. In our current low-to-negative interest rate environment, “safe” investments and traditional conservative options in 2016 are all but extinct. “In 1995, a portfolio made up wholly of bonds would return 7.5% a year with a likelihood that returns could vary by about 6%”, according to research by Callan Associates Inc. By contrast, in 2015, to make the same returns “investors needed to spread money across risky assets, shrinking bonds to just 12% of the portfolio. Private equity and stocks needed to take up some three-quarters of the entire investment pool. But with the added risk, returns could vary by more than 17%.”
Concerns over pension funds have been on the rise in the UK recently, following the Bank of England’s decision to lower its benchmark rate to 0.25%, the lowest in its 322-year history, and to revive a bond purchasing program from 2012. As Ros Altmann, a minister under David Cameron, put it “The Bank wants to stimulate the economy by bringing down
interest rates, but the Bank is not acknowledging the negative impact these measures are having on pension deficits, and neither is the government”. British government bonds, or gilts, have seen a steep yield decline over the last few years, even before the news of the interest rate cut pushed them to record lows. Pension funds, hold a disproportionate amount of such bonds, believing them so far to be conservative and stable investments, with reasonable and reliable returns, that could guarantee payouts to future retirees. The BoE’s policy move, will now make it even harder to achieve the returns the funds need and stirred fears that managers will be forced to take on even more risk, to keep their commitments.
Collateral damages
Regarding the state-run pension programs, the troubles that afflict them today were predictable years ago: Public sector pensions, like any other welfare-benefits program, is and has been treated like a political football for too long. There was always a number of solutions in sight, but no single political figure or party ever wants to be the one who either openly increases contributions or cuts promised pensions. Voter and union pressure would make such steps politically suicidal. Thus the can kept on being kicked down the road, to the next incumbent, while the deficit grew leviathan.
The widening funding gap in public pension plans is not just the public sector employees’ problem: State and local governments increasingly resort to cutting quality-of-life services, in a desperate effort to keep their pension schemes afloat. And that affects everyone: Apart from public libraries, museums, parks and recreation centers limiting their opening hours or closing altogether, other, more essential community services suffer cuts: Police and fire departments, for example; and everyone would suffer the consequences of that, no matter if their pension plan is with the state or not. Also, with public sector pensions at imminent risk, wide media coverage of the problem and no realistic solution in sight, the idea of a possible need for bail-outs has began to gain traction, justifiably favored by unions and other pressure groups. If such a policy is widely adopted, then the taxpayer will be directly made to pay for the mismanaged and bankrupt state pension plans.
Focusing on the private pension funds, these future retirees have little hope of their savings being rescued by the government. Fund managers everywhere are fighting an uphill battle against low interest rates, while there’s the scary thought that surely haunts them, “If they have delivered such poor performances with stocks in extraordinary highs, how will they fare upon the inevitable correction that lies ahead?”.
The way out
As a general rule, proactively taking back control over one’s pension savings seems to be the viable way out of the sinking ship that is the retirement system world-wide. A wise step would be to minimize and hedge against any state-borne risks, though geographical diversification, by securing assets across multiple safe and predictable jurisdictions. Even in this hostile economic landscape, conservative investments and reliable choices can still be found, but on an individual-portfolio basis, and one size does not fit all. It is therefore up to the individual to tailor their own retirement plan and to seek advice from an asset manager that considers their specific needs and expectations, while ensuring off-shore stability. An investment structure that provides adequate geographic diversification while complying with the relevant legal framework, could be of particular importance to citizens of countries with especially complex and restrictive regulations, such as the US and some EU member-states.
Another significant feature to look out for when exploring retirement plans, would be tax efficiency. An investment structure that satisfies relevant regulatory requirements and allows tax-deferred compounding of the profits, could offer a real long-term advantage. Over time, tax-deferral and therefore compound growth, can make a very big difference in effective retirement saving and investing.
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