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The Squeeze on Pensions?
Submitted by Leo Kolivakis, publisher of Pension Pulse.
The BBC reports on the squeeze on pensions:
The Conservative Party has outlined plans to raise the state
pension age for men to 66 from 2016 - eight years earlier than planned.
The
pension age for women will also rise to 66 by 2020 under Tory proposals
- something the party says is needed to help reduce the UK's national
debt.
The Labour government has already committed to raising
the pension age for men gradually from 65 to 68 between 2024 to 2046.
For women it will rise from 60 to 65 over ten years from 2010.
So why do the two parties want the pension age to go up?
Currently, there are more than 12m pensioners in the UK - with many more women than men in retirement.
The move by politicians to raise the state pension age comes not
only amid difficult financial conditions, but also as the UK population
ages, putting increased pressure on government resources.
However, the UK is not alone. The world's population is also growing
older and many other countries are facing similar problems.
The ageing UK population means there will be many more pensioners to
support. In 2001, the government's Actuary Department calculated there
were 3.32 people of working age to support every state pensioner.
By
2060, it says the ratio will have fallen to 2.44 people of working age
for every one state pensioner. In other words, there will be fewer
working people contributing towards the system that finances the state
pension.
Both the Conservatives and Labour have proposed raising the state pension age, taking into account people's longer lives.
This means the amount of time spent in retirement, as well as government expenditure, will be reduced.
Meanwhile, the value of state pensions has declined since the link
with average earnings was cut by Margaret Thatcher's Conservative
government in 1980.
Although a top-up benefit or pension credit has been introduced to
ensure no pensioner has to live on less than £130 a week, Labour has
legislated to bring back the link with average earnings by 2015 at the
latest - a plan supported by the Tories.
You can find out more on pension credit on the Directgov site.
There are concerns that the new measures to raise the retirement age in the U.K. will hit women harder.
But longevity risk is a major concern of many governments and private
firms grappling with mounting pension liabilities. Citing research from
Hewitt Associates, Reuters reports that UK pension schemes are likely
to insure over 5 billion pounds of liabilities linked to rising life expectancy in 2010:
Matt
Wilmington, global risk management specialist at Hewitt Associates,
told Reuters the higher costs associated with the risk of retirees
living longer had become a key issue to both trustees and sponsoring
companies.
"Hewitt believes
the longevity swap market will see a minimum of six deals over the next
year, with a total value of over 5 billion pounds," he said."Once the Babcock deal was announced, we saw quite a flurry on interest from clients," Wilmington said.
In May, pension consultants said a longevity swap deal struck by engineering group Babcock International's (BAB.L) pension schemes to hedge 500 million pounds would open the door to more such deals.
Through longevity swaps, trustees pay a bank or some other counterparty to take on some of the risk over a defined period.
Wilmington
said some of the new longevity swaps were at an "advanced stage" and he
expected the bulk to be announced in the first quarter of next year.
Hewitt is advising on some of those deals.
Around
a third of FTSE 100 companies have already raised the age at which they
assume their retirees will die, a move that will increase their pension
liabilities.On September 30, the FTSE 100 pension liabilities stood at 444 billion pounds, against 366 billion pounds of assets.
I
am not so sure that "longevity swaps" are going to be the answer to the
world's pension deficits. In fact, if they become very popular, I am
concerned that they will be the source of yet another systemic crisis.
Pension woes are not only a U.K. problem. David Cho of the Washington Post writes Steep Losses Pose Crisis for Pensions (hat tip to Diane Urquhart):
The
financial crisis has blown a hole in the rosy forecasts of pension
funds that cover teachers, police officers and other government
employees, casting into doubt as never before whether these public
systems will be able to keep their promises to future generations of
retirees.
The upheaval on Wall Street has deluged public
pension systems with losses that government officials and consultants
increasingly say are insurmountable unless pension managers
fundamentally rethink how they pay out benefits or make money or both.
Within
15 years, public systems on average will have less half the money they
need to pay pension benefits, according to an analysis by
Pricewaterhouse Coopers. Other analysts say funding levels could hit
that low within a decade.
After losing about $1 trillion in
the markets, state and local governments are facing a devil's choice:
Either slash retirement benefits or pursue high-return investments that
come with high risk.
The urgent need for outsize returns by
these vast public pension funds, which must hit high investment targets
year after year to keep pace with rising retirement costs, is in turn
fueling a renewed appetite for risk on Wall Street.
Before the
crisis, many public pension funds had experimented with risky trading
techniques or committed more of their money to hedge funds and other
nontraditional firms, which in turn invested some of it in complex
mortgage securities. When these melted down, pension funds got burned.
Now,
facing an even bigger funding gap, some systems are investing in the
same securities, betting that a rebound in their value will generate
huge returns.
"The amount that needs to be made up is
enormous," said Peter Austin, executive director of BNY Mellon Pension
Services. "Frankly, they are forced to continue their allocation in
these high-return asset classes because that's their only hope."
Some
pension experts say the funding gap has become so great that no
investment strategy can close it and that taxpayers will have to cover
the massive bill.
The problem isn't limited to public pension
funds; many corporate pension funds have lost so much ground that they
are also pursuing riskier investments. And they, too, could end up a
taxpayer burden if they cannot meet their obligations and are taken
over by the federal Pension Benefit Guarantee Corp.
Public
systems still have enough to meet their current obligations. If
governments take no action, retirees could keep drawing full benefits
for the foreseeable future even under the most pessimistic projections.
But already, some funds are seeking to trim benefits to
conserve money. Some governments have also proposed increasing the
amount of public money paid each year into the funds. In practice,
however, some political leaders have begun doing the opposite --
cutting annual contributions to pension funds -- as a way of balancing
state and local budgets buffeted in the recession by falling tax
revenue and rising costs.Around the country, governments are struggling with the pact they've made with employees.
In
New Mexico, lawmakers passed legislation this year requiring public
employees to contribute about 1.5 percent of their salary to cover
retirement benefits. Labor unions representing 57,000 of the workers
sued the state in response.
In Philadelphia, officials
delivered an ultimatum to state lawmakers: Allow the city to take a
two-year break from contributing to its pension system or Philadelphia
would lay off 3,000 workers and cut sanitation and public safety
services. Last month, the lawmakers not only granted the request, but
extended the funding holiday to thousands of cities and counties,
despite severe pension deficits in many of these places.
In
Montgomery County, officials last year committed to setting up an
investment fund to finance about $3 billion in retiree health-care
benefits promised to employees. But when it came time to put the first
round of seed money into the fund this year, county officials balked,
citing budget constraints.
"We know we've got a huge
health-care liability," chief administrative officer Timothy L.
Firestine said. "Our plan was to work gradually to fund that. And this
year we abandoned that plan."
Swift Change of Fortunes
Just
a few years ago, it seemed far-fetched that Virginia's pension system
would hit hard times. In 2003, the state's primary pension funds either
had more money than they needed or, at a minimum, were nearly fully
funded. And like their counterparts across the country, state officials
assumed they would earn around 8 percent a year from investing in
financial markets for years to come given the outstanding performance
of stocks in the 1980s and 1990s.
But officials in Virginia
and elsewhere soon began to wonder whether those two decades were a
fluke. As pension deficits began to rise, officials questioned whether
the investment assumptions were too optimistic. In 2006, Virginia's
pension officials suggested scaling back benefits or requiring current
employees to begin paying into the pension fund. The state's lawmakers
took no action.
Then the crisis hit. Virginia lost 21 percent
of the value of its portfolio, or about $11.5 billion. Maryland and the
District, meantime, suffered drops of 20 percent.
The losses
were typical of what pension funds suffered around the country. State
and local government officials had predicted before the crisis they
would have $3.6 trillion in their accounts by now, according to the
Center for Retirement Research at Boston College. Today, they are $1.2
trillion short of that mark.
Pension funds were not equally
affected. Officials in Arlington County, for instance, say their
funding levels remain above 90 percent. And even those that suffered
huge losses say they have enough money to payout retirement benefits
for years to come. Virginia, for instance, still has nearly $43 billion
in its accounts.
But Virginia officials now estimate the funding level of its major pension funds will sink to about 60 percent by 2013.
From
there, the deficit will grow even wider, according to Kim Nicholl, the
national director of PricewaterhouseCoopers public sector retirement
practice. Even if public pension funds were to hit their 8 percent
investment targets every year, Nicholl calculated they would have less
than half of what they need by 2025. This is because a greater share of
the population will be retired and those who are will live longer, thus
collecting benefits longer, she said.
"I
don't think you can invest your way out of this. Plans are going to
have to make changes," Nicholl said. "The scale of the losses was just
so great and the liabilities are growing so fast, much faster than they
can keep up."
For these reasons, billionaire investor Warren
Buffett has called these pensions ticking "time bombs." The financial
crisis, experts say, shortened the fuse.
Last month, Virginia
Gov. Timothy M. Kaine signaled he would consider the politically
sensitive step of requiring the state's 100,000 employees to contribute
part of their 2011 salaries toward their pensions. But the two
candidates running to replace him -- and who would have to carry out
the proposal -- have said they oppose it.
More Risk or Lower Returns
This
is the dilemma confounding pension funds as they emerge from the
wreckage of the financial crisis: If they shy away from riskier
investments, they would be settling for lower returns that leave future
shortfalls unaddressed. But by aggressively pursuing the higher rates
of return they need, pension funds increase the chances they will be
burned again by investment bets gone bad.
"State pension fund
directors face enormous pressure trying to recover their investment
losses. It will be tempting for them to consider investments that
promise a high rate of return," said Sue Urahn, managing director of
the Pew Center on the States, which plans to release a report on
pension losses within weeks.
Traditional investment
strategies, which rely on stocks, haven't fared well in recent years.
To meet their obligations to retirees, pension funds tend to assume
they will earn an eight percent return on investments each year. The
stock market, as measured by the Standard & Poor's 500-stock index,
is actually down 32 percent this decade.
Like many states,
Maryland had begun moving money from stocks into hedge funds and
private equity before the financial crisis. The goal was not only to
earn a higher return but to diversify the investment portfolio. Should
stocks sink, the thinking went, less traditional investments might hold
up.
The financial crisis offered a shocking retort. Nearly all investments, save for government bonds, tumbled at the same time.
Yet
Maryland is now continuing its shift away from stocks and into
nontraditional investments. Pension officials argue they have little
choice.
"How do I act in the new environment? There aren't any
ready answers for that," said Mansco Perry, chief investment officer
for Maryland's pensions. "But I have difficulty throwing away 30 to 40
years worth of knowledge and practice and say that doesn't work
anymore."
Some pension funds are also continuing to engage in other investment practices that got them in trouble during the crisis.
One
such trading technique is called securities lending. In this
transaction, a pension fund lends a stock it holds to a hedge fund and
receives cash in return as collateral. The deal is meant to provide a
twofold benefit: The pension fund can make money by investing the cash
collateral and can continue to benefit from the stock through its
dividends and any appreciation in its value.
Before the
crisis, states committed billions of dollars to this practice. But when
the credit markets seized up last year, pension funds got stuck. They
could not access the investments they made with the cash collateral.
Some had to sell off other investments at a loss to pay retiree
benefits.
California's pension fund lost $634 million from
securities lending as of March 31, but the total could reach $1 billion
after a full accounting is done, according to a report from the
system's consultant, Wilshire Associates. Still, the pension fund says
it remains committed to the practice because it boosted returns in the
two decades before the financial meltdown.
Pension funds have
also been aggressively pushing into real estate and troubled mortgage
securities that were crushed in the crisis. California's pension fund
is putting $2 billion into buying these toxic bank assets. Financial
analysts say the prices for these assets have fallen so far that they
may be a better bet than in the past. But the crisis showed how
unreliable these investments can be. And their prices may not yet have
hit bottom.
In August, California's pension fund took a
similar gamble by investing $463 million in shopping centers across 17
states and the District of Columbia, though many experts forecast a
prolonged slump in commercial real estate.
Even if these strategies succeed, the shortfall may still be insurmountable.
In
Ohio, for instance, the teachers pension system reported that it would
take 41 years for its investments to catch up with the costs of meeting
its obligations to retirees. That was before the worst of the financial
crisis.
During the last fiscal year, Ohio's fund lost 31
percent. Its most recent annual report detailed how long it would now
take for its investments to put the fund back on track. Officials
simply said: "Infinity."
The global pension crisis is a major concern. The uptrend in equities in Q3 boosted pension returns in Canada and elsewhere, but this will do little to address long-term concerns on the sustainability of pensions.
Finally, many of you saw CNBC's recent interview with famous hedge fund
manager Julian Robertson (see video below). Among his gloomy
predictions, he sees U.S. interest rates soaring to 15%-20% if China
and Japan stop buying U.S. bonds.
An astute bond trader shared a few comments with me:
1) The Fed is already looking to remove some excess liquidity via the repo markets (cost of repo borrowing will go up);
2)
Flush with cash, banks continue to make a killing in their trading
operations. They're unwinding their long 2-year positions and moving
down the curve for extra yield. He thinks it's a great time to put on a
curve-flatner, not steepner.3) As for interests rates hitting
15% to 20%: "It will never happen. Pensions will lock in rates at their
actuarial liabilities of 6.5% or 7% in a blink of an eye."
I
agree. In the near term, the Fed does not need to raise rates to remove
excess liquidity. All they have to do is raise the cost of repo
borrowing. Banks will roll over into longer dated bonds and the curve will
flatten, not steepen. And Mr. Robertson needs a course in
liability-driven investments (LDI). He has no idea how many pension
funds are looking to lock in rates at half the rates he's
predicting. That will pretty much cap the upper end of the bond market
for a very long time.
I wish all Canadians a Happy Thanksgiving and all Americans a Happy Columbus day.
»
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There is another problem with the pension funds' private equity investments. Not only are many underwater, but the funds are on the hook to make future contributions in the billions of dollars.
In Oregon, for example, the public employee pension fund has $8 plus billion on the books in private equity (down 25% in the last year), but is also obligated to make another $5.4 billion contribution to the existing private equity programs.
A few of these programs are very recent and of the 'vulture fund' variety, but the majority were entered into when the credit crisis was merely a dark cloud on the horizon. Those ventures will probably be the worst performing of all the PE investments, as the funds were 'buying at the top.' Yet, more billions will be required for funding those deals.
There is another problem with the pension funds' private equity investments. Not only are many underwater, but the funds are on the hook to make future contributions in the billions of dollars.
In Oregon, for example, the public employee pension fund has $8 plus billion on the books in private equity (down 25% in the last year), but is also obligated to make another $5.4 billion contribution to the existing private equity programs.
A few of these programs are very recent and of the 'vulture fund' variety, but the majority were entered into when the credit crisis was merely a dark cloud on the horizon. Those ventures will probably be the worst performing of all the PE investments, as the funds were 'buying at the top.' Yet, more billions will be required for funding those deals.
CalPers currently has over 5,000 pensioners with $ 100k + annual payouts. And there are thousands more, many in their 50s, who will be new members of this club over the next 5-7 years.
That's just one public pension fund in one State, albeit the largest.
State and local pols went on a giveaway bender with the public sector unions. And pensions are a tarbaby that no politician wants to touch.
When....not if....the pullback occurs in the markets, this crazy aunt will be climbing out of the basement for all to see. For now, everybody acts like she's not down there at all.
Scary.
"You cannot even come close to something remotely resembling LDI, unless you are fully funded -- and even then, it's not a panacea as many pension managers think it is."
True, LDI is not a panacea but it's better than the casino mentality that has permeated most public pension funds that are betting on stocks and alternative investments to get them out of this hole. Too many pension funds are focused on maximizing returns, not protecting against downside risk. They got whacked hard in 2008 and realized that they were taking a lot more risk than they thought as assets were more correlated than they thought.
Investments alone will not secure pensions long-term. You need to cut benefits, raise the retirement age, increase contributions, etc. But most of all, you need to bolster the governance of these huge pension funds, making sure that pension fund managers are managing money in accordance with their fiduciary duties and in the best interests of contributors and pensioners.
Indeed - what I see happening is many pension managers wanting to convert to LDI, but waiting to get fully funded first. In other words, they want to use the equity strategy to acheive their goal. The beauty of LDI, as you stated, makes it easier for companies to budget their liabilities. However, what I see happening is something you allude to. That is: Pensions will get whacked at least one more time before many of them convert toward a substantially more stable LDI option... and then, yes, you'll see a lot more benefits decreasing, pensions freezing, retirement age increasing etc.
A lot of (most?) investors don't realize just how penisons affect the bottom line of the company. And on the other side, a lot of people collecting pensions think that money is secured/guarenteed -- far from it. Pension money is 'owned' by government, and owned by the companies -- if the government defaults or if the companies go bankrupt, pensioners are screwed 100%. If I was retiring, I'd take my pension in a lump sum and run.
Nothing is guaranteed except death and taxes. I see major pension reforms happening in the next decade all around the world. If pension funds are indeed "betting the farm" waiting to be fully funded before introducing more LDI strategies, then they're not managing in the best interests of their contributors and pensioners. The problem in Canada is compensation that is geared towards taking excessive risks to produce returns. If you make money, you walk away with a huge bonus, if you lose in a year like 2008, you just fall back on four-year rolling returns and still walk away with a very decent bonus. It's ridiculous and of course, it's all board approved!
Leo,
What you fail to realize is right in the article you pasted: Most pensions are heavily underfunded. You cannot even come close to something remotely resembling LDI, unless you are fully funded -- and even then, it's not a panacea as many pension managers think it is.
Also, on the subject of interest rates: of course they have to rise. You many not like the near term outcome but the idea is to remove all the excess debt; not create more of it and/or paper it over. Instead of monetizing the debt by flooding the market with dollars, high interest rates would remove debt and will allow for real economic growth. Printing money is akin to a crackhead taking another hit to remove the pains of withdrawal, and then thinking everything is cool b/c he feels better. Until the crackhead <economy> realizes that the pain of withdrawal is what is required, the same mistakes will continue to be made unabated.
A good read as aways Leo. Keep jabing and wait for the opening, then let the left hook fly.
Skippy
Whispering:
The states are in a vise, with CA on the live end and VT on the dead end. This vise is inside another vise, with Eastern Europe on the live end and the US on the dead end. The kernal is automatically turning the screw.
All the error buffers in the enterprise system pyramid are full. They each reset their buffers, only to refill on the next error. They couldn't solve this problem effectively, so they simply rebuilt while money was free. Money isn't free anymore, they cannot catch up to costs, and constantly resetting has blown many of the critical components.
The circuit gets shorter and shorter, resistence is reduced, and amperage to the screw grows.
That's what happens when programmers are walled off from eachother, in order to build a sytem to replace the programmers.
The machine doesn't care, and the kernal has a reverse dead man switch.
DaddyWarbucks,
Most of the senior pension fund managers at Canadian public pension funds did not earn their compensation. For years, they gamed their private market benchmarks and called it "value added". This isn't a joke, it's serious stuff. If you look at the track record of some of the presidents, you'd see they added nothing over the years they led their resepctive pension funds and a few of them have lost a whack of dough. Why are they still in power? Ask their incompetent board of directors. It's all a club, the pensions' club. They win, the contributors lose. If I wasn't so focused on exposing these pension parrots and their compensation based on excessive risk taking and bogus benchmarks, I'd be losing my mind too.
"After losing about $1 trillion in the markets, state and local governments are facing a devil's choice: Either slash retirement benefits or pursue high-return investments that come with high risk.
The urgent need for outsize returns by these vast public pension funds, which must hit high investment targets year after year to keep pace with rising retirement costs, is in turn fueling a renewed appetite for risk on Wall Street.
Before the crisis, many public pension funds had experimented with risky trading techniques or committed more of their money to hedge funds and other nontraditional firms, which in turn invested some of it in complex mortgage securities. When these melted down, pension funds got burned.
Now, facing an even bigger funding gap, some systems are investing in the same securities, betting that a rebound in their value will generate huge returns.
"The amount that needs to be made up is enormous," said Peter Austin, executive director of BNY Mellon Pension Services. "Frankly, they are forced to continue their allocation in these high-return asset classes because that's their only hope."
Has anyone here ever sat at a blackjack table and watched a player go on tilt? That is exactly what this is describing. Sometime ago Leo wrote a piece about the compensation of a certain Canadian pension fund manager during a year of record losses. There is no need to pay that kind of money just go to Vegas and wait around the blackjack tables until you see someone take a big loss and the start doubling his bet on every loss thereafter. Hire that player, they are capable of executing the startegy described above at a much lower cost.
When I read statements like the excerpt above and I realize that they were made in all seriousness I feel like I am losing my mind.
Here's what I don't understand. Let's say there are 1.0 billion people going to retire, that had been working 40 years or so. And there are only 0.8 billion people entering the workforce to replace them and therefore to contribute to the pension plans. A 20% drop, which, according to the charts is supposed to mean that there will be 20% less money to pay the 1.0 billion people with. But the planet's resources didn't drop by 20%. And modern technology doesn't produce 20% less with the same amount of resources than it used to. So in fact, if there are are fewer people entering the workplace, that's because there are fewer people in "industrial" countries. There's as much to go around, and fewer people. So there should be no problem. In fact, the general condition of humanity should gradually improve. People should get more years after work to do creative and helpful things they might not have been able to do while toeing the line at work. Is anyone looking at this?
A couple of comments. After 2008, most pension funds face serious liquidity concerns and they're not going to think twice about locking in rates at or over their actuarial rates. LDI investing is very big in the U.K. and Europe and its making its way here in North America. Basically, pensions are focusing more on obtaining their desired actuarial rates to meet future liabilities in the safest possible manner (ie. allocate more to bonds).
On the Fed, they will not raise rates until unemployment starts to fall. They can, however, immediately increase borrowing costs on repos, removing excess liquidity there.
"Basically, pensions are focusing more on obtaining their desired actuarial rates to meet future liabilities in the safest possible manner (ie. allocate more to bonds)."
That's a ground breaking strategy for managing pension funds, I think you're on to something. Let's hope they assess the risk of those bonds this time around, A lot of retirees are using GM bonds as toilet paper right now. I'm not jabbing at you Leo I'm just venting, it's hard to remain calm when reading about this stuff. For pete's sake, pension fund managers are supposed to be conservative(literally)!
Are they locking in real or nominal rates, though? I suppose since liabilities tend to be in nominal dollars, the funds themselves will be able to meet obligations. It's the pensioners who have the potential to lose in real dollars if we end up inflating our way out rather than deflating the debt overhang.
The Fed does need to raise rates, since we are no longer in a state of emergency, hence a ZIRP is no longer required. Raising rates to the 1-2% range (where the ECB is) would still be considered highly accommodative, and would nip the dollar carry trade in the bud.
It's a massive time-bomb slowly ticking...the bond trader's 3rd point seems on the mark. If the endowments/pensions don't learn the lesson in reaching for yield 2-4 years ago, what is expected to happen if they're gonna do the same now ?
its too late mac. they took a big bite of the shit sandwich and now they are afraid to look at the damage realistically and realize it will never come back. nor are they willing to tell all of those state workers who sit at their desk all day dreaming of easy state paid retirement in sunny florida, nor will they tell the teachers who toil daily in drug and gang infested government schools for the peanuts that they get, also dreaming of a easy fun filled teacher retirement.
Exactamundo.