No country in the world now has a top quality pension system. That’s the conclusion from the latest Report by pensions consultants Melbourne Mercer. As the chart above shows:
- Denmark and The Netherlands have fallen out of the top category
- In the G7 wealthy nations: Canada is in category B; Germany and UK in C+; France, US and Italy in C; Japan in D
- In the BRICS emerging economies: Brazil is in category C; India, China and S Africa are D; and Russia’s system is so poor it is unclassified
Unsurprisingly, the cause of the problems is today’s ‘demographic deficit’, as the authors highlight:
“The provision of financial security in retirement is critical for both individuals and societies as most countries are now grappling with the social, economic and financial effects of ageing populations. The major causes of this demographic shift are declining birth rates and increasing longevity. Inevitably these developments are placing financial pressure on current retirement income systems. Indeed, the sustainability of some current systems is under threat.”
These problems have been building for years, as politicians have not wanted to have difficult conversations with voters over raising the retirement age. Instead, they have preferred to ignore the issue, hoping that it will go away.
But, of course, problems that are ignored tend to get worse over time, rather than go away. In the US, public pension funds saw their deficits jump $343bn last year to $3.85tn – making it almost certain that, eventually, pension benefits will have to be cut and taxes raised.
The issue has been that politicians preferred to believe central bank stimulus programmes could solve the deficit by cutting interest rates and printing large amounts of virtually free cash. And unfortunately, when it became clear this policy was failing to work, the banks “doubled down” and pursued negative interest rates rather than admitting defeat:
- Currently, 17% of all bonds (worth $8tn), trade at negative rates
- Swiss bond yields are negative out to 2027, as the Pensions Partners chart shows
- Most major European countries, and Japan, suffer from negative rates
2 years ago, Swiss pension experts suggested that its pension system would be bankrupt within 10 years, due to the requirement to pay retirees an annuity of 6.8% of their total savings each year. This rate is clearly unaffordable with negative interest rates, unless the funds take massive risks with their capital.
The US faces similar problems with Social Security, which is the major source of income for most retirees. The Trustees forecast its reserves will be depleted by 2034, when benefits will need to be cut by around a quarter. Medicare funds for hospital and nursing will be depleted by 2029. And as the Social Security Administration reports:
“173 million workers are covered under Social Security. 46% of the workforce in private industry has no private pension coverage. 39% of workers report that they and/or their spouse have not personally saved any money for retirement.”
Rising life expectancy is a key part of the problem, as the World Economic Forum (WEF) reported in May. Back in 1889, life expectancy was under 50 when Bismarck introduced the world’s first state pension in Germany. Today, the average baby born in the G7 countries can expect to live to be 100. As WEF conclude:
“One obvious implication of living longer is that we are going to have to spend longer working. The expectation that retirement will start early- to mid-60s is likely to be a thing of the past, or a privilege of the very wealthy.”
Sadly, politicians are still in denial, as President Trump’s proposed tax cuts confirm.
Today is not 1986, when President Reagan cut taxes in his October 1986 Tax Reform Act and was rewarded with higher tax revenues. 30 years ago, more and more BabyBoomers were entering the wealth creating 25 – 54 age group, as the chart from the Atlanta Fed confirms:
The issue is the ageing of the Boomers combined with the collapse of fertility rates:
- The oldest Boomers left the Wealth Creator cohort in 2001, and the average Boomer (born in 1955) left in 2010
- The relative number of Wealth Creators is also in decline, as US fertility rates have been below replacement level (2.1 babies/woman) for 45 years since 1970
Inevitably, therefore, Reagan’s demographic dividend has become Trump’s demographic deficit.
As I warned back in May, debt and demographics are set to destroy Trump’s growth dream. And without immigration, the US working age population will fall by 18m by 2035, making a bad situation even worse. Instead of tax cuts, Trump should instead be focused on 3 key priorities to:
- “Design measures to support older Boomers to stay in the workforce
- Reverse the decline that has taken place in corporate funding for pensions
- Tackle looming deficits in Social Security and Medicare”
Future retirees will not thank him for creating yet further debt headwinds by proposing unfunded tax cuts. These might boost GDP in the short-term. But they will certainly make it even more difficult to solve tomorrow’s pension deficits.
It has been 5 years since we first warned of a looming pensions crisis in Boom, Gloom and the New Normal. Now, finally, it is becoming a mainstream issue. The latest round of central bank stimulus policies has clearly been the proverbial “straw that breaks the camel’s back” for anyone connected with pension funding.
The charts above, from a major series in this week’s Financial Times, highlight its conclusion that we now face:
□ “A creeping social and political crisis (due to today’s…) enormous pension deficits”
□ ”In the US, pensions run by companies in the S&P 1500 index were underfunded by $562bn by the end of last month, according to Mercer — nearly $160bn wider just seven months earlier thanks to further drops in bond yields”
□ ”For US public plans — which are allowed to assume far higher interest rates than are available in the bond market, making their liabilities look unrealistically cheap — the problem is far worse. Joshua Rauh, a professor of finance at Stanford University, estimates that their total deficits, if liabilities were priced in the same way as corporate plans, would be about $3.4tn”
The FT also reports the views of several key players in the pensions industry, who confirm the gravity of the situation:
“Baroness Altmann, the former UK pensions minister, said this month that pension funding had reached “crisis point” and blamed the Bank of England’s quantitative easing policy of buying bonds. The emergency to pension schemes has been caused by QE,” she said. “I don’t see how it is reasonable to ask companies with pension schemes to fill a £1tn ($1.3tn) hole and put money into their businesses as well. It doesn’t add up.”
“It’s existential. That’s the one-word summary of the scale of the challenges,” says Alasdair Macdonald of Willis Towers Watson, an actuarial consultancy. “You can pull different levers, but the declines in rates is an existential problem for the entire pensions system.”
“It’s scary and it’s surreal,” says Carsten Stendevad, who heads ATP, the $110bn national Danish pension plan. “First, if you’re in the business of offering annuities, your product just became very expensive to produce. But secondly we can see that the impact of QE is affecting other asset classes as well. That’s the scarier part. There’s nowhere really to hide.”
The problem, as Altmann notes, has been created by central bank policy. They have abandoned their core role of maintaining stability in financial markets, to focus instead on the seemingly more exciting world of economic policy. Thus Andy Haldane, chief economist at the Bank of England, tokd the FT that:
“The central bank’s top priority must be to stimulate the economy. “I sympathise with savers, but jobs must come first,” he says.”
Yet this is emphatically not the job of a central bank. Economic policy is the job of governments. Only governments can debate the impact of key issues such as increasing life expectancy with the voters, and implement new policies. As I noted last week when discussing the US pension crisis:
“Common sense tells us that demographics, not monetary policy, drive demand. Unfortunately, vast amounts of time and money have been wasted as a result.
It is good news that mainstream media are now focusing on the pensions crisis. Nothing can be done whilst central banks are allowed to pretend that monetary policy can magically restore the economy to SuperCycle growth levels.
But as I also noted, there are no easy answers to the problems that central banks have created. ”The path back to fiscal sanity will be very hard indeed.”
There was one bit of good news this week. For the first time since the financial crisis began, a Governor of the US Federal Reserve acknowledged that today’s demographic changes are having a major impact on the US economy. John Williams, of the San Francisco Fed, argued that:
“Shifting demographics….(mean that) interest rates are going to stay lower that we’ve come to expect in the past…In this new normal, recessions will tend to be longer and deeper, recoveries slower, and the risks of unacceptably low inflation and the ultimate loss of the nominal anchor will be higher…We’ve come to the point on the path where central banks must share responsibilities. There are limits to what monetary policy can and, indeed, should do. The burden must also fall on fiscal and other policies to do their part to help create conditions conducive to economic stability.”
Williams thus confirmed our conclusion from 5 years ago in chapter 2 of Boom, Gloom and the New Normal:
“The Boomers have moved on from being a high-spending generation. Instead, they are becoming a high-saving generation, as they need to save more to survive a longer retirement. And therefore the failure of the various government stimulus programmes since the crisis began should be no surprise. The concept of pent-up demand is now wishful thinking.
“The key issue is that we need a change in mindset. Those companies who continue to expect stimulus measures to deliver a return to the Golden Age are likely to be disappointed. Instead, the winners will focus on understanding how to profit from the demographic changes now underway, as we transition to the New Normal.”
It is good news that one leading central banker now accepts that stimulus policies cannot return the economy to SuperCycle levels. The chart above, showing the labour market participation rates for the US Wealth Creator 25 – 54, and New Old 55+, cohorts, highlights two core issues:
□ Fewer Wealth Creators are working today than in 2000, when the oldest BabyBoomer was about to become 55
□ The US has also done very badly at keeping the New Olders in the work force – their participation rate today at 40% is half that of the Wealth Creators, and is lower than in the pre-1965 era
It is really no surprise that the US economy is struggling, given these figures.
One of the key problems is that current US Social Security rules penalise people who want to work, but need to take their benefits early. This matters, as 10k Boomers are retiring every day until 2030. Only around 2% of these retirees can afford to wait until the age of 70 to take their benefits – even though this would increase their benefits by an astonishing 76% versus taking them at 62:
□ More than 1/3rd of all retirees rely on Social Security for 90% or more of their income, and 2/3rds rely on it for more than half of their income.
□ More than half of American households in the New Old 55+ cohort have nothing saved for retirement
□ A quarter of these households will also not receive any kind of company pension
Company pensions themselves are another issue that Congress needs to tackle urgently. As the second chart from Bloomberg notes
□ Pension plans in S&P 500 companies are currently in deficit by $500bn
□ Congress actually made the situation worse in 2012 by allowing companies to value their pension liabilities by using a “smoothed” discount rate based on average interest rates over the past 25 years
□ This makes no sense, in the light of John Williams’ conclusion that “interest rates are going to stay lower than we have come to expect in the past“.
□ The reason, of course, was that Congress wanted to join the Fed in supporting financial markets by prioritising share buybacks and boosting stock prices. Thus since 2012, many companies haven’t had to fund their pensions plans – and on average, those with large plans have been able to cut their contributions by half
THE NEW CONGRESS WILL HAVE TO FOCUS ON SUPPORTING RETIREMENT INCOME
So here’s the nub of the issue. The Fed, like other major central banks, is close to admitting that its monetary experiments have failed to produce the expected results. The next Administration will therefore be faced with a need to unwind many of the policies put in place since the financial crisis began 8 years ago.
3 key issues will therefore confront the next President. He or she:
□ Will have to design measures to support older Boomers to stay in the workforce
□ Must reverse the decline that has taken place in corporate funding for pensions
□ Must also tackle looming deficits in Social Security and Medicare, as benefits will otherwise be cut by 29% in 2030
It has always been obvious that the Fed could not possibly control the economic fortunes of 321m Americans. Common sense tells us that demographics, not monetary policy, drive demand. Unfortunately, vast amounts of time and money have been wasted as a result. The path back to fiscal sanity will be very hard indeed.
The Western BabyBoomers (born between 1946-70), have been one of the luckiest generations in history. By and large, they have escaped the major wars that have plagued society down the ages. They have also lived in a world where living standards and material wealth have made astonishing gains. Equally priceless has been the rise in life expectancy, which means the average 65 year-old can now expect to live another 20 years.
But politicians didn’t want to acknowledge the impact of this shift in life expectancy on the economy. Nor did central bankers want to reveal that it was demographics that created the long economic SuperCycle between 1983 – 2007 (when the US suffered just 16 months of recession in 25 years). That would have spoiled the myth of their genius, and the forecasting ability of their supposedly all-powerful Dynamic Stochastic General Equilibrium economic models.
Similarly, nobody rushed to have a conversation with the voters about the need for a major increase in pension age:
□ The UK introduced state pensions just a century ago in 1909, when life expectancy was just 50 years. Only 400k of the UK’s 40 million population were eligible to receive it
□ It was “social insurance” – “a small amount of money for a small number of people for a small amount of time”
□ Today, it has become a universal benefit, received by 17% of the population. And this proportion is set to rise as the Boomers move into retirement
Of course, no politician wanted to tell voters that pension age should be increased in line with life expectancy. Nor did they want to face the consequences of the post-1970 collapse in fertility rates. This means that in more and more countries,there are more people over the age of 65 than children under 15. And as Bloomberg notes:
“A shrinking workforce cannot foot the pension bill”.
CENTRAL BANKERS DON’T WANT TO ADMIT THEY WERE LUCKY, NOT CLEVER
But now, the Boomers’ luck is running out, at least in the UK. The warning sign was seen in 2008 with the financial crisis. This highlighted the fact that today’s ageing population are creating a “replacement economy”. Monetary policy is irrelevant when confronted with the fact that 65-year olds do not have the same spending power as when they were 35. Equally important is that they now own most of the things they were buying when they were younger.
But it would be too embarrassing for central bankers to admits they had been lucky rather than clever.
Now the Brexit vote is bringing the chickens home to roost. Last week, the Bank of England put on its “Superman” tunic again – deciding to take interest rates even lower, and weaken the value of the pound.
They chose to ignore the fact that their action probably created a “disaster scenario” for pension funds.
The interest rate for government borrowing is the major factor in determining the solvency of any pension scheme. And a zero, or negative, rate for government bonds makes it almost impossible for a pension fund to meet its commitments to pensioners. The chart above, based on new data from the official Pension Protection Fund highlights the problem:
□ Massive funding deficits have developed since the Bank began its stimulus programme in 2009
□ More than 4 out of 5 defined benefit corporate pension funds are now in deficit – 84%
□ Their total deficit (including the surplus schemes) increased in July to £408bn ($530bn)
□ They were then only 77.4% funded – and the situation will be worse today due to the further decline in interest rates
As the former Pensions Minister, Ros Altmann, told the Financial Times yesterday:
“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.”
As Altmann warns, this deficit will have real world consequences. Either employers will have to increase their contributions, or pensioners will not get their promised pensions. Both outcomes will have negative consequences for the UK economy, as they will either reduce company profitability or reduce pensioners’ future spending power.
One also cannot ignore the potential for political fall-out if pension funds fail to meet their commitments to pensioners.
The problem is that the Bank – like its peers in Europe, USA and Japan – loves to be the centre of attention. It therefore chooses to ignore the fact that by creating further artificial demand for gilts in the short-term, it is creating major economic and political risks for the medium and longer term. And as we all know, there is a moment when a medium-term risk becomes short-term reality.
We may not be too far away from that moment now, as millions of pensioners start to realise their pension funds may well go bankrupt.
Around a quarter of global bonds now have negative interest rates. This means that you get less money back at maturity than you originally invested. And the number of bonds impacted is rising exponentially, as Bank of America Merrill Lynch reports:
- $13tn of global debt has negative yields, compared to $11tn before the Brexit vote, and none just 2 years ago
- You will receive a negative interest rate on Swiss bonds even if you commit your money for the next 50 years
- $250bn of euro-denominated corporate bonds are now trading at negative yields
- Even Italy, in the middle of a banking crisis, offers negative yields on $1.6tn of government bonds
Pensioners, and those who expect to be pensioners, are of course in the direct line of fire as this trend continues. Pension funds, and life assurance companies, have always been major buyers of long-dated high-quality bonds, as this is the least risky way for them to meet their liabilities. Similarly, advisers have always told investors to move into government bonds as they approach retirement, in order to achieve financial security.
The collapse of yield thus highlights the uncomfortable fact that many pension schemes are no longer fit for purpose.
They were developed in a different era when the majority of people never reached pension age, and when life expectancy at pension age was relatively short. Neither Bismarck in Germany, or Lloyd George in the UK, or even Roosevelt introducing Social Security in the US during the Depression, would have dreamed that their concept of a modest form of social insurance would become an universal benefit.
As pension adviser Melbourne Mercer have warned, only Denmark and The Netherlands have “first class” pension systems, and very few countries have linked pension age to increased life expectancy. As a result, most will probably be unable to pay promised pensions, as the chart suggests:
- “A” category countries have a 1st class and robust retirement income system
- “B” category have a sound structure, but need improvement
- “C” category have some good features, but also contain major risks
- “D” category has some desirable features, but also major weaknesses
- “E” category is only at an early stage in introducing a system, or has none
Corporate pension schemes face even more problems, given the pressure from investors to prioritise dividends over pension fund contributions. The UK Pensions Regulator recently reported that more than half of FTSE 350 companies have paid 10x more in dividends than they spent on fixing their pension fund deficits. And the problem is far worse after the Brexit vote, which caused government bond yields to tumble even further around the world. UK corporate pension fund deficits rose by 30% in June, to a record £385bn ($506bn) according to the Pension Protection Fund.
It is now too late to resolve these problems without making major changes either to contribution levels or to entitlements. Given that most schemes operate on a “pay as you go” basis, the former would seem to be most unfair to current Wealth Creators in the 25 – 54 age group, already suffering from high house prices, stagnant wages and tuition fee debts in many countries. As the McKinsey Global Institute reported yesterday:
“Between 65% – 70% of people in 25 advanced countries saw no increase in their earnings between 2005 and 2014.”
The New Old 55+ age group will be equally unhappy that politicians have failed to warn of coming problems.
US SOCIAL SECURITY FUNDS WILL BE EXHAUSTED IN 2029, WHEN BENEFITS WILL BE REDUCED 29%
The Swiss position is symptomatic of the problems, with today’s negative interest rates making it even more likely that the SFr 800bn ($840bn) scheme likely to be bankrupt within 10 years, according to local experts. The US position is equally critical, with a new Report from the Congressional Budget Office warning that:
“Social Security’s trust funds, considered together, will be exhausted in 2029. In that case, benefits in 2030 would need to be reduced by 29% from the scheduled amounts….(Already) in fiscal year 2015, spending for Social Security benefits totaled $877bn, or almost one-quarter of federal spending.”
This matters enormously, as the second chart shows, given that around two-thirds of older Americans rely on Social Security for the majority of their income. And the problem is compounded by the fact that public pension funds are having to cut their forecasts for investment returns back to the levels seen before the SuperCycle began – and every 1% cut in return targets increases pension liabilities by 12%.
US pension income is already well below median earnings of $42k. In 2014, men received $18k in median pension income according to a new report from the National Institute of Retirement Security, whilst women’s historically lower wages mean their income was only around $12k. A similar differential can be seen in 401(k) savings, with men having $37k invested versus $25k for women.
Medicare and Medicaid face similar problems. Medicare supported 54m people in 2014, and Medicaid 70m. But the trust fund supporting the Medicare Hospital Insurance scheme runs out in 2028. After this, it will join the Medicare programme for doctors’ fees, and the Medicaid programme, in being paid out of tax revenues and borrowing:
- This is already a large and growing amount, with $619bn spent on Medicare in 2014, and $495bn on Medicaid
- New government estimates suggest 1 in 5 of all Americans will be on Medicare by 2025
- Average spend per person on both programmes will be 50% higher than today at $18k and $12.5k respectively.
This disaster wasn’t always inevitable. In 1998, at the end of the Economic SuperCycle, President Bill Clinton announced in his State of the Union speech that the US now had a balanced budget for the first time in 30 years:
“It is projected that we’ll then have a sizable surplus in the years that immediately follow. What should we do with this projected surplus? I have a simple, four-word answer: Save Social Security first. Tonight I propose that we reserve 100% of the surplus, that’s every penny of any surplus, until we have taken all the necessary measures to strengthen the Social Security system for the 21st century. Let us say — let us say to all Americans watching tonight — whether you’re 70 or 50 or whether you just started paying into the system — Social Security will be there when you need it.”
Instead, of course, policymakers around the world chose to pretend that monetary policy could somehow fill the gap caused by demographic change. 18 years later, voters are about to start waking up the results of that choice. Either taxes will now have to rise to pay the bills, or benefits will be cut, or a mix of these 2 options will take place.
As John Richardson and I warned back in 2010 in Boom, Gloom and the New Normal, the failure to recognise the importance of demographic change has created massive risks for the economy, as well as for pensioners themselves. US investment magazine Barron’s well summarised the position 3 years ago, warning:
“It is difficult enough to put 50-year-olds on notice that entitlements they expect at 70 will probably not be available. To give them this bad news when they’re 60 or 65 is inhumane.”
10k Americans have been retiring every day since 2011, and 18k Europeans, as the BabyBoomer generation reaches the age of 65. But pension schemes have not adapted to the fact that average life expectancy is now 20 years at age 65. This is causing major problems for the economy as pensioners leave the workforce – and placing a increasingly large burden on the younger generation who have to fund their pensions for the next 20 years.
The problem is that these changes have happened within just a few generations. It is not all that long ago, relatively speaking, that life for people even in the developed world was “nasty, brutish and short”, as author Thomas Hobbes had written in 1651.
- No government thought to offer pensions even 200 years ago, as most had no regular sources of tax revenue
- Average life expectancy in the West then was just 36 years, and only 24 years everywhere else
- People relied on their children to look after them, if they were lucky enough to live longer than average
- So parents typically had large numbers of children, to ensure some would still be alive to look after them
This situation only began to change when Germany introduced the world’s first state pension in 1889. The UK, then the world’s wealthiest country, followed 20 years later (delaying because it was worried about the cost):
- UK life expectancy was only 50, but pension age was set at 70 to ensure it was affordable
- Only 600k of the UK’s 40m population received the pension, which was worth just £17 ($25) in today’s money)
- But today, only 100 years later, it has become a universal benefit, received by 17% of the entire UK population
When we first began to write ‘Boom, Gloom and the New Normal’, we assumed policymakers fully understood the economic impact of today’s ageing populations. It seemed just common sense – more older people, all spending less, and fewer young people inevitably meant slower growth and probably deflation.
How wrong we were! Even today, most policymakers simply ignore this critical topic. Instead, they continue to believe that creating ‘wealth effects’ in financial and property markets will somehow maintain growth:
- Yet older people already own most of what they need, and their spending drops quite sharply as they move into their 70s and 80s
- Plus, of course, there are relatively few young people in the main wealth-generating 25 – 54 age group, as fertility rates have been below replacement level for the past 45 years
Increasing life expectancy is, of course, great news for us as individuals. But for the economy, it means that yesterday’s ‘demographic dividend’ has turned into a ‘demographic deficit’. Now many pension funds are having to face the fact that they risk not being able to pay out the promised benefits.
As the chart shows from the Wall Street Journal, most US state pension funds are now being forced to reduce their expected annual returns on investment. This means that local and state governments will have to increase their payments – either by raising taxes, or cutting spending. And many analysts worry the assumed returns are still too high – which could mean more funds having to cut actual pension payments as in Detroit.
Private and personal retirement saving faces the same pressures as life expectancy keeps increasing. As a result, the typical US corporate pension fund now has only 78% of what it needs to meet its pension promises. And this, of course, is a vicious circle:
- If companies pay more money into their funds, their earnings will fall, leading to pressure on their stock price
- If they don’t pay more and default on their promises. pensioners will have less money to spend in retirement
Nor is the US alone in this problem. In the UK, 4500 corporate pension schemes are in deficit, compared to only 1750 in surplus. Major telecoms utility BT is in even worse shape, with its £47bn ($72bn) pension fund now 150% of its entire market capitalisation. In Switzerland, pension experts expect the national fund to be bankrupt within 10 years.
There is no easy solution to this problem. But the longer it is ignored, the worse it is going to get.