Thursday, March 31, 2016

The Looming Government Pension Crisis

Updated December 2016

We all know that debt, particularly government debt, is becoming an increasingly worrying problem, especially since interest rates dropped to near-zero in the developed economies of the world.  This has led to both developed and advanced economies around the world increasing their total debt levels (i.e. corporate, household and government) as shown on this graphic:

Over the period from 2007 to 2014, government debt has increased from $33 trillion to $58 trillion, an increase of 9.3 percent on a compounded annual growth rate.  In the case of the United States, the federal debt has risen from $9.2 to its current level of $19.2 trillion since the beginning of 2008, an increase of 109 percent over slightly more than 8 years.   While this should be of concern, there is a government indebtedness problem that is even worse; underfunded and unfunded government pension liabilities.  A recent report from Citigroup shows us just how dangerous the problem has become.

In the past, workers believed that, once they stopped working at or about age 65, their defined benefit pension plan would be there to provide for them through to the end of their lives.  In addition to a company or government pension, retired workers could count on a pay-as-you-go pension scheme like Social Security, Canada Pension or other state-sponsored pensions.  However, given the demographic shifts which include longer life expectancies and an increase in the number of retired baby boomers, a significant strain is developing in the state-sponsored pension systems of the world's advanced economies.

Here are some demographic statistics showing how the population of people 65 years and older are expected to grow between 2015 and 2050:

Globally - 8 percent in 2015 compared to 15 percent in 2050

Europe - 17 percent in 2015 compared to 26 percent in 2050

China - 12 percent in 2015 compared to 24 percent in 2050

Japan - 26 percent in 2015 compared to 33 percent in 2050

Japan's demographic problem is the "canary in the coal mine" for the rest of the world.  When a nation has significant growth in the size of its elderly cohort accompanied by a declining fertility rate, it means that there fewer workers supporting a greater number of retirees as shown on this graphic which shows the dropping dependency ratio of workers aged 15 to 64 to the number of retirees aged 65 plus over the years between 2015 and 2050:

As the dependency ratio falls (the ratio of young workers to pensioners), it becomes increasingly difficult for the economy to support a growing number of pensioners, a situation that can result in a cut in benefits or a collapse of the pension system.

We can quite clearly see the growing problem with an aging population on these two population pyramids where the working age population is highlighted in red:

With that background, let's look at government pension liabilities.  Most of the world's largest governments have pension plans for their public sector workers and for the general public through state-sponsored pension plans.  While these pension commitments are not the exactly the same as public debt, they still form a part of a nation's long-term liabilities.  As dependency ratios fall, there is a unsustainable pressure on future tax payers to fund a growing population of pensioners.  Given the current indebted state of government coffers around the world, this will create additional pressure on governments with growth in government pension payments as a proportion of GDP as shown on this graphic:

Here is the estimated increase in government pension expenditures from 2015 to 2050 as a percentage of GDP:

As you can see, for some governments, the dependence on government pension plans will grow significantly over the period between 2015 and 2050.  On average, OECD nations currently spend an average of 9.5 percent of GDP on public pensions.  The combination of an aging population and a rising ratio of pensioners to workers will push this up to 12 percent of GDP by 2050 even with the implementation of measures to limit future pension costs.

Given this information, there are obviously looming problems with underfunded or unfunded public sector and state-sponsored social security pension plans.  These long-term commitments are spread over a long period of time and are not treated in the same fashion as public debt, however, the political consequences of negating on these social commitments would be difficult.  This means that these liabilities should be treated as "contingent".  Here is a chart showing the contingent government pension liabilities as a percentage of GDP for OECD nations, divided into public sector and social security pension plans along with the conventional public debt-to-GDP ratio (grey line): 

This is a rather frightening chart.  The average weighted contingent public pension liability to GDP ratio for the 20 OECD nations is 190 percent of GDP.  This outstrips the average public sovereign debt-to-GDP ratio which comes in at 109 percent of GDP.  These same 20 nations have sovereign debts that total $44 trillion; by comparison, the same 20 nations have unfunded or underfunded government pension liabilities of $78 trillion.

Obviously, this pension funding liability crisis is unsustainable.  Governments will have to take steps to reduce their underfunded and unfunded pension liabilities by taking one or more of these steps:

1.) Increasing retirement age: While this seems to be the simplest reform, it is the one that is most fraught with political backlash.  Not only is the increase in the number of years to retirement important, the speed at which this reform is undertaken is key to meaningful reductions in liability.  Using the example of Portugal, by raising the retirement age by 2 years within the next 10 years, pension liabilities would be reduced by 5 percent.  

2.) Reducing or freezing retirement benefits: This is easiest to enact when it is put into place for new, young entrants into the workforce rather than for older workers.  

3.) Increasing pension-specific taxation levels (i.e. increase worker contributions to pension plans).

4.) Increase the length of working careers by putting incentives into place that increase the pension entitlements.  This will keep workers contributing to the pension system for longer.

5.) Improved administrative efficiencies through central management of public pension schemes.

From the Citigroup study, we can see that the current government pension scheme is going to prove to be problematic over the next three decades as the number of baby boomers retirees grows faster than the number of young workers and improvements to health mean that these retirees live far longer than retirees from previous generations.  Given the recent and ongoing election cycles in OECD nations, it is interesting to note that there is rarely any serious discussion  about the looming public pension plan crisis that dwarfs the size of the public debt.    

1 comment:

  1. The conservative government was well aware of these realities. However, with the Liberal mandate to increase deficit spending as well as expanding government, it will surely make this precarious situation even more so.