By Stephen Johnston
“There are two ways to be fooled. One is to believe what isn’t true; the other is to refuse to believe what is true.” Søren Kierkegaard
To begin on a skeptical footing if we look at US life expectancy statistics from the 1930s, 58 for men and 62 for women, then compare this to the Social Security retirement age of 65 it begs the question whether Social Security was designed so that people would work for many years paying into the program, but would not live long enough to collect benefits?
Setting skepticism aside for one moment, let’s engage in a thought exercise as to what is the ideal world for pension plans:
- Low Dependency Ratios – stable or declining number or retirees, stable or increasing number of people entering the work force, and stable or declining life expectancy.
- High Bond Yields – high yields on investment grade bonds and low inflation rates which translates into high real returns.
- Achievable Return Assumptions – large volumes of assets available with high risk adjusted returns.
- Portfolios with Low Convexity – shorter duration, higher yield bonds, and liquid investments
- Low Structural Deficits – plan assets growing faster than plan liabilities, which can reduce risk to hit return targets.
Now let’s examine the world that pension plans actually inhabit:
- High Dependency Ratios – the western population is aging rapidly, more dependents for every working age person, and increasing life expectancy of dependents.
- Low Bond Yields – negative interest rate policy (NIRP) means high quality yield is disappearing = real returns have dropped
- Unachievable Return Assumptions – many assets now have poor risk-adjusted returns and reasonable risk-adjusted yields are difficult to find in the current zero interest rate policy (ZIRP)/NIRP environment.
- Portfolios with High Convexity – pension plans have record high duration and record low bond yields = record convexity = large losses in a rising rate environment, pension plans are also increasing exposure to illiquid investments in search for returns.
- High Structural Deficits – plan liabilities are growing faster than plan assets on a long term structural basis – plan managers are being forced to increase risk to achieve return targets.
Let’s address each one of these factors in more detail:
Dependency Ratios: The dependency ratio measures the percentage of dependent people (not of working age = <18 or >65) versus the number of working people. According to Statistics Canada, our dependency ratio is expected to trend as follows: 2009 = 44:100, 2036 = 65:100, 2056 = 84:100. The driver behind this rapid increase is simple - the retirement of the boomer cohort. In 2014 16% of the population was aged 65 or older while by 2030 it is projected that 23% will be aged 65 or older.
The net result of this trend is that more people are moving out of the work force than into it exactly when that extra growth, revenue, and return is needed. Obviously, such a powerful demographic shift has consequences for the economy and, in particular, for returns to financial assets – in fact it has been said “demographics are destiny” when it comes to such matters.’ What are some obvious consequences?
- Higher Government Spending and Taxes: Governments have growing pension and medical benefit commitments. Therefore, as the population ages and the dependency ratio increases government spending and taxes will also increase creating a drag on growth.
- Structural Long Term Plan Deficits: Many pensions haven’t planned for the rapid rise in the dependency ratio or longer life expectancies. Combined with low real rates of return, deficits will continue to accumulate.
- Pressure to Raise Retirement Age: Because of the increased cost of pensions, there could be pressure to raise the retirement age in both the private sector and public sectors.
Zero/Negative Interest Rates: Zero, and more recently negative, interest rates are a futile attempt to save the FIRE (Finance, Insurance, Real Estate) economy by strip mining capital from savers and pensions. More than $13 trillion in sovereign debt currently trades at negative yields and it is growing. Why do negative yields matter to pensions? The average US state or local-government pension fund assumes it will earn a nominal annual return of approximately 7.7%.
Negative yields make it extremely difficult for pensions to generate their required target returns given they typically allocated more than 50% of their investable capital into fixed income securities whose rates are being aggressively suppressed by global monetary authorities. As an illustration on the magnitude of this effect:
- 1990: The yield on the ten-year Treasury bond was more than 8%
- 2015: The yield on the ten-year Treasury bond is approximately 2%
In fact, the problem may be even greater than this simplistic analysis makes it seem. According to fund manager AQR, based on surveyed plans’ current portfolio allocations, they can expect to achieve an actual return of 4.7% (2.7% real). But wait it gets worse, AQR found a 10% probability that returns for the next 30 years will be at or below 2.8% (or 0.7% real). According to a senior AQR analyst “Under such a scenario…the pension deficit would be huge, and there would be no way to avoid increases in savings and contributions, as well as significant reductions in pension benefits.”
Convexity: Convexity is another problem that gets very little public attention when pension solvency is discussed, as to do so would shine an unwanted light on the damaging effects that the current extended period of ZIRP/NIRP is having in the space. Pensions have been investing in bonds with longer durations and lower rates for almost a decade. Convexity is a measure of the non-linear relationship of bond prices to changes in interest rates. The central concepts are:
- Maturity: the longer the maturity the greater the price sensitivity to yield changes.
- Coupon: the lower the coupon the greater the price sensitivity to yield changes.
- Yield: the lower the yield the greater the price sensitivity to yield changes.
Forced to search for yield at ever greater durations by central bank ZIRP/NIRP as well as deteriorating demographics, pensions now have high convexity portfolios which magnify losses in a rising rate environment. The following table is the estimated price effect on bonds of just a 1% fall/rise in interest rates (i.e. gains or losses in principal value):
Consider this table in the context of the likely path of interest rates over the next decade – do you expect rates to fall further from multi-decade (and in some cases multi-century) lows or to begin the process of mean reverting back to historically normal levels?
Structural Deficits: Developed world pension plan liabilities are expected to grow faster than the projected plan assets for the next 70 years due to aging demographics, low rates of returns, increases in life expectancy and deteriorating dependency ratios. Aon Hewitt tracks Canadian defined benefit (DB) pension plans by measuring their assets over liabilities to calculate their solvency funded ratio. As of March 2016 the median solvency ratio was 80.8% and only 7.6% of plans were found to be fully funded i.e. 92% of all plans had some form of ongoing shortfall.
Aon is not alone in their analysis. Ratings agency DBRS has also warned on defined benefit pension plans following an investigation into 461 private pension plans in Canada, the U.S., Japan and Europe. DBRS said that the average DB pension could only cover 78.3% of the future benefits. According to the researcher, “As long as interest rates remain at current lows, pension deficits will continue to be high…The pension shortfall of $536 billion is massive and will take great effort to eliminate in the absence of changes to the interest rate environment.”
It goes without saying that each pension plan is a unique entity, with some, all or none of the above issues. The purpose of this commentary is largely to trigger a needed dialogue between beneficiaries and their advisors around these data points and to look more critically at expected pension payouts. Potentially, you may choose to adjust investment strategies as a consequence.
Stephen Johnston is one of the co-founders of the Capita group of alternative funds which began in farmland late 2007 and has grown into five non-correlated alternative strategies with approximately $600M in mark-to-market AUM: Equicapita (SME buyout), Agcapita (farmland), Enercapita (light oil production), Petrocapita (midstream infrastructure), Rhocore (private debt/credit opportunities). Stephen has over 20 years’ experience as a fund manager and holds a BSc. (1987) and a LLB from the University of Alberta (1990) and an MBA (1994) from the London Business School.