The Pension Crisis—Coming Soon to a Retirement near You

The Pension Crisis—Coming Soon to a Retirement near You

Having jumped from one job to another early in life… and with those jobs being across many continents, I haven’t really given much thought to my pension. Looking at the numbers, it seems I’m not the only one. Over 50% of Americans aged 25–34 have no retirement savings. Then again, given the current state of the pension system, it may be a prudent move.

A 2015 study from the National Association of State Retirement Administrators estimated that public pension funds are around $1 trillion in the red—but the problem gets worse.

These estimates are based on funds earning average annual returns of 7.6%. The actual 2015 returns for pension funds came in at 3.2%... a 58% miss. In the same year, America’s largest pension fund, the California Public Employee’s Retirement System, earned a measly 0.6%.

If public funds used the same projection method that their private counterparts must, their deficit would be around $3.4 trillion—19% of US GDP.

At the turn of the millennia, these funds actually had a surplus. So what happened?

Collateral Damage

By design, pension funds should be conservative, low-risk funds, and fund managers should deploy capital into instruments that match these exact criteria (such as AAA-rated sovereign debt).

Historically, pension funds hold around one-third of their capital in high-grade sovereign debt, like Treasuries. Up until recently, Treasuries ticked all the boxes for pension funds—a low-risk, high-grade instrument, which carries a yield that matches estimated returns.

However, the 35-year bull market in high-grade sovereign debt is causing severe problems for pension funds. If we take the bellwether 10-year Treasury, its yield has fallen from 16% in 1981, to 2.5% today.

To put that into perspective—to earn the same returns, a fund investing in the 10-year Treasury today has to put in 11 times the amount that it would have had to in 1981. This equates to investing $100 million vs $1.1 billion—a substantial difference.

Although dwindling yields are a major problem, they’re not the whole story.

While America’s demographics aren’t in as dire shape as those of Europe, they are still a big problem. Due to the increase in life expectancies and the decline in birth rates, around 14% of the population is now aged 65 or over… a 35% increase in 50 years. In the same time, the old-age dependency ratio has increased by around 50%.

As a result of these trends, outflows from funds are increasing rapidly. But it’s not just the number of retirees that’s the problem, it’s the length of time they are living. On average, Americans born in 2010 live nine years longer than those born in 1960. With retirees now collecting their pensions for almost 20 yearsBismarck will be turning in his grave.

While outflows are increasing, inflows are plummeting—around 45% of households have no retirement savings whatsoever. This trend has caused many retirees to rely on Social Security, which now makes up around 90% of the bottom quartile’s retirement income.

With conditions set to deteriorate, what will be the implications of a failing pension system?

Inevitable Intervention

Even by government estimates, which suggests public funds are $1 trillion in the red, they are clearly insolvent. We have already witnessed bankruptcies in Detroit and San Bernardino—in which the respective taxpayers of Michigan and California had to come to the rescue. But now the problems are even larger.

Illinois’ state pension fund, which has liabilities of around $18 billion per annum, is only 38% funded and looks set to run out of assets in a few years. Whether this happens in 2017 or 2020, arithmetic tells us something has to give.

Given that millions of public sector pensions are on the line, you can be sure the federal government will intervene when the problem can no longer be ignored.

Although this will equate to a massive wealth transfer from Millennials to Baby Boomers, this bail-out precedent was set following the financial crisis. The pension system cannot go under for obvious economic reasons.

While the federal government will almost certainly step in and save the day, those with skin in the game won’t escape unscathed.

There Will Be Blood

The federal government must intervene and restructure the public pension system(because it would be political suicide not to). As the current defined benefit (final salary) schemes are completely unfeasible, public funds will have to follow their private counterparts and switch to more sustainable, but less lucrative, defined contribution schemes.

Under the new system, public employees will be contributing more and receiving less than they currently do. Of course, this will cause considerable tensions with unions valiantly defending their members’ “right” to what they were promised under the old system. But given the circumstances, there is not much they can really do about it.

Along with cuts to direct fund outflows, other cost-savings measures will have to be introduced. The retirement age will have to be raised at a rate faster than the current trajectory. That means a longer working life for Americans. Also, taxes will have to increase to offset the billions in liabilities that have been undertaken.

Although this scenario may sound severe, it’s about the best one can hope for given that most funds are simply insolvent and will never be able to meet their obligations.

So, what steps can you take to protect yourself from the looming crisis?

Take the Bull by the Horns

If you are in a public pension scheme, the chances of getting what you have been promised don’t look great—and with little chance of a bailout, the same applies for private schemes. The average funding rate for US corporate pensions is a mere 75%... with private funds having a collective deficit of $500 billion. Also, relying on the average monthly $1,348 social security check is risky business.

With underlying conditions for pensions only set to deteriorate, now could be a good time to cut your losses and take your retirement plans into your own hands. So, how do you do it?

Although future returns across all asset-classes are expected to be lower than what we experienced in the last three decades, for astute investors, there are still opportunities to earn decent returns. A 2016 McKinsey study estimated that returns in US equities over the next two decades will range from 4%–6.5%.

All the cash currently sitting on the sidelines will have to be deployed somewhere over the next few years, and given the favorable macroeconomic conditions, US equities could be the destination. So, what trends should we pay attention to, to give our retirement funds the best possible chance?

Given how politicized the economy is, analyzing sectors which could benefit from President-elect Trump’s policies may prove useful. Also, since interest rates cannot be raised back to “normal” levels—past could be prologue, with low interest rate friendly sectors continuing to do well.

Getting to the heart of this issue: whether you decide to follow macro-trends or invest in US equities is beside the point. Given the dire state of both public and private pensions, now could be the time for you to take control of your retirement plans.

Well, that’s all for this week from The New Abnormal. I hope you are all having an excellent week and are enjoying the run-up to Christmas. Until next time, ciao.

Stephen McBride
Chief Analyst, RiskHedge

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