Friday, April 21, 2017

The Global Pensions Crisis - Part 2 - The Solution

In part one of this two part posting, I examined the coming global pensions crisis and how both the private and public sector pension plans were facing a significant under- and unfunded issue.  As I noted, this will have a significant impact on aging workers around the globe since it is becoming increasingly unlikely that retirees will be able to count on the pensions that they believed were their "birthright".  In part two of this posting, I will look at some potential solutions to the crisis as outlined in Citi's publication, "The Coming Pensions Crisis".

While the funding levels of pensions will continue to be under stress, there are some steps that could be taken by policymakers (i.e. governments) and the sponsors of corporate and public pension plans.  Let's look at the recommendations by group:

1.) Recommendations for Policymakers:

a.) Measure and publicize pension liabilities - while governments are loathe to publicize the massive size of their unfunded pension liabilities for fear of voter backlash, all governments must make this data available so that voters can clearly understand the scope of the problem.  With calculations showing that there are $78 trillion in unfunded and underfunded pension liabilities not appearing on the balance sheets in OECD nations, simply pretending that the problem is non-existent isn't going to solve anything.

b.) Retirement ages must be linked to longevity - some nations are gradually raising their retirement ages to better reflect longevity.  Raising the retirement age by two years reduces pension liabilities by between 4 percent and 8 percent.   If retirement age was adjusted so that retirees received 12 years of benefits as was the case when the Social Security system was designed, the new retirement age of 73 would save the system about $4 trillion.

c.) Social security pensions should be treated as a safety net - rather than having the government function as a prime pension provider for retirees, the pension system should function as a social safety net.  This is particularly the case for Europe where government pensions go well beyond what could be described as "social security".  If this is not changed, the annual cost of servicing these enriched pensions will rise by 2 to 3 percent of GDP by 2050.

d.) Encourage private pension plan savings through the use of fiscal incentives - by allowing individuals to avoid income tax on retirement savings contributions and by allowing those savings to accrue tax-free investment returns, governments can promote private individual pension plan funding.

e.) Promote "auto-enrollment" in workplace pension plans - by doing this, the system would reduce the number of employees who opt out.

f.) Ensure equal access to retirement plans for all workers.

2.) Recommendations for Corporate and Public Pension Plan Sponsors:

Here is a graphic showing the funding status of U.S. corporate pension plans:


Obviously, significant changes are needed before these pension plans start seeing significant withdrawals (decumulation) by their stakeholders.  

a.) Ensure that corporate and public pension plan sponsors make full contributions to their pension plans  - by ensuring full contributions when they are due rather than allowing a funding deficit to accumulate, it will be less likely that pension underfunding issues will develop.  As you can see on this graphic, there are a significant percentage of United States public pension plans that have not made the annual required contribution to ensure full funding:


b.) Adopt a recovery or exit strategy for pension plans with a funding deficit - when a plan is underfunded, corporations and pension plan sponsors need to consider moving the liability to an insurance company or issue debt to fund some of the deficit.  If it appears that the underfunding issue is insolvable, the pension plan sponsors need to begin to re-negotiate with their stakeholders as soon as possible before the underfunding issue becomes worse.

c.) Increase independent governance of pensions - rather than having pension plans managed by either inexperienced politicians or board members, plans should be managed by independent trustees/managers with the skills necessary to ensure the ongoing funding viability of the pension plans.  It is also important to ensure that pension management is compensated fairly.

In general, pension plans can mitigate their risk profile through several methods:

1.) Freezing the plan to new participants - this limits future growth in the pension obligation.

2.) Issuing debt to fill the underfunding gap.

3.) Changing the plan's investment strategy - by moving to fixed income investments, plans may see a drop in return but this will allow the plan to more closely track liabilities.

4. ) Longevity reinsurance - transfer the risk of higher payouts because of increased lifespan to an insurance company

5.) Lump sum payouts to retirees - this eliminates the uncertainty of long-term pension obligations.

6.) Buy-out - the pension plan transfers its assets and payout obligations to an insurance company.

As you can see, the looming pension issue is far from clear and, as the years pass and increasing numbers of baby boomers retire at the same time as the workforce shrinks, the pension funding issue will become increasingly difficult to resolve.  The days of guaranteed monthly "mailbox money" are behind us and the sooner that governments and corporations deal with the issue of underfunded pension plans, the better will be the lot of those who have already retired and those who plan to retire in the near future.   


Thursday, April 20, 2017

Drilled and Uncompleted - The Roadblock to Higher Oil Prices

Beginning in September 2016, the United States Energy Information Administration (EIA) began to include estimates of the number of drilled and uncompleted wells (DUCs) in its monthly Drilling Productivity Report.  This data is critical to gaining an understanding of where U.S. oil production may be headed, information that provides us with a measure of whether there will be upward or downward pressure on future oil production, a key factor in future oil prices.

Drilled and uncompleted wells are those wells that have been drilled but are standing suspended (i.e. they are not producing hydrocarbons).  These wells have production casing in place but potentially productive formations have not been perforated or hydraulically fractured (i.e. completed).  Obviously, a high and growing inventory of drilled and uncompleted wells has the potential to impact the domestic supply of oil, a factor which has the potential to impact oil prices, especially in the current market where the balance between oil supply and demand is quite delicate.

The drilled and uncompleted wells reported by the EIA fall into one of seven regions; the Bakken, Eagle Ford, Haynesville, Marcellus, Niobrara, Permian and Utica as shown on this map:


Here is a bar graph showing the how the number of drilled and uncompleted wells in the lower 48 has grown since the data was first reported in August 2016:


In just nine months, the number of drilled and uncompleted wells has grown from 5065 to 5512, an increase of 8.8 percent.

Here is a table showing which regions have the most drilled an uncompleted wells in both February and March 2017:


As you can see, the two regions with the most drilled and uncompleted wells are located in the Permian Basin and Eagle Ford of Texas.

While oil production is down from its peak of 9.627 million BOPD in April 2015, according to the EIA, United States oil production is rebounding from its lows of 8.567 million BOPD in September 2016 to  8.835 million BOPD in January 2017 as shown here:


From the EIA data on drilled and uncompleted wells, we can see that it is quite likely that oil prices will be under downward pressure for some time to come unless, of course, OPEC agrees to cut production levels further or a significant number of these wells turn out to be poor producers. 

Wednesday, April 19, 2017

The Global Pensions Crisis - Part I - The Problem

Over the past six years, I've repeatedly blogged on what I call the pension Ponzi scheme.  As the financial world is rapidly figuring out, the pension plans of the past generation(s) are simply not sustainable.  People are living longer and, thanks in large part to the Great Recession, central bankers have pushed returns on safe investments to near zero or, in some cases, into negative territory.  Those who are currently retired may find themselves with their gold-plated defined benefit pension plans in jeopardy and those who are planning to retire in the future may find that there simply isn't enough funding to cover their pension expectations.  A report by Citi, "The Coming Pensions Crisis", looks at the massive growth in unfunded government pension liabilities and the accompanying underfunding in corporate pension plans.  In the report, the authors also provide possible solutions to a problem that will grow over time if it is left unattended.  Since this is a rather important subject, I will address it in two parts; part one will look at the size and causes of the pension problem in both the government and private sectors and part two will look at some suggested solutions that may mitigate the size of the crisis.

Let's start by looking at the scope of the problem in three parts, beginning with demographics and longevity, followed by government pension issues and the private sector pension issues.

1.) Demographics and Longevity:  A century ago, an urban dweller in the developed world could anticipate a life expectancy of 51 years.  In the United States in 1935 when the Social Security Administration was founded, a 65 year old man could expect to live an additional 12.7 years.  Now, the life expectancy of a man has risen from 77.7 years to 85 years, which means that the social safety net has to provide for him for 7.3 years longer than the system was designed for.   In addition, the drop in fertility rates, particularly in developed nations, means that fewer individuals will be contributing to the pension system.  This will result in a shift in the median age; in 2015, people aged 65+ accounted for 8 percent of the global population, a level that will increase to over 15 percent of the global population by 2050 as shown in these two population pyramids:


Some regions will have a far greater problem with 65+ year olds by 2050; China's older population will comprise 24 percent of its total, Japan will have more than one-third of its total and Europe will have 27 percent of its total population among the elderly.  This will push down the dependency ratio of workers (aged 15 to 64) to retired (65+) as shown here:


In the case of China, the dependency ratio will fall from its current level of 7 to 2.2 by 2050 and in Japan, the dependency ratio will fall from its current very low level of 2.1 to 1.1.  Globally, the dependency ratio will drop by half over the next three and a half decades.  As you can quite clearly imagine, any "pay-as-you-go" pension plans will (or already are) unsustainable in the face of dropping dependency ratios.  This will result in one of two things; a cut in benefits or a complete collapse of the pension system.

2.) Government Pension Issues:  Here is a look at pension obligations and deficits liabilities in the private sector in the United Kingdom and the United States:


In the U.S., current unfunded corporate defined benefit pension plan commitments total $425 billion.  Individuals in defined contribution plans or who are without retirement savings are a whopping $7 trillion short of the ability to provide for themselves after retirement.  

Here is a graphic showing how important government pensions (including Social Security) are to  the citizens of many nations when compared to the income from private pension plans:


Obviously, as the decades pass and Baby Boomers retire, government pension payments as a percentage of GDP will rise as shown on this figure:


The average government pension costs to GDP rises from 9.5 percent in 2015 to 12 percent of GDP by 2050, a very significant increase.  This will put additional stress on already stressed balance sheets, particularly as debt levels rise along with interest owing on that debt.

Lastly in this section, here is a graphic showing how the total estimates for all forms of government pension liabilities add up as a percentage of GDP compared to current conventional public debt-to-GDP ratios:


The weighted average contingent liability to GDP from public sector pension liabilities is roughly 190 percent of GDP compared to average sovereign/public debt-to-GDP levels of 190 percent.  For the twenty OECD nations in the graphic, the public debt totals of $44 trillion, slightly over half of the size of the $78 trillion of unfunded and underfunded government pension liabilities.   The biggest pension problem (as a percentage of GDP) lies with European nations that have state pension systems; France, Germany, Italy, the United Kingdom, Portugal and Spain have estimated public sector pension liabilities in excess of 300 percent of GDP.  Interestingly, most of this unfunded liability does not appear on government balance sheets.  In the United States, the pension problem is not just federal; state and local government employee defined benefit plans have between $1 trillion and $3 trillion (the level varies with the discount rate in use) in unfunded pension commitments.  While these numbers seem large, they are dwarfed by the liability in the U.S. social security system which has more than $10 trillion in unfunded liabilities.  The biggest problem with government pension plans in the United States is the fact that government plan sponsors (i.e. Congress and state legislatures) have not made contributions to these plans that come close to meeting their funding requirements and, ultimately, their pension payment levels to individuals.

3.) Private Sector Pension Issues: At the end of 2015, America's S&P 500 companies had pension liabilities of $403 billion compared to total obligations of $2.027 trillion as shown on this graphic:


As well, in the United Kingdom, FTSE 350 companies were expected to have deficits of £84 billion compared to total obligations of £686 billion as shown on this graphic:


These figures greatly understate the private pension problem because they include only the largest companies in both nations.  As well, many publicly traded companies have already taken action by transferring funding from defined benefit to defined contribution pension plans, reducing their future obligations to whatever their employees have managed to set aside.

The biggest factor that has created the current pension funding deficit problem is the discount rate used by the plan, with much lower interest rates resulting in higher deficits.  As shown on this graphic, AA discount rates have declined markedly since the end of the Great Recession with each 10 basis point reduction in the discount rate increasing the pension liability by approximately 1.7 percent:


Additionally, increased life expectancies have impacted pension liabilities with each 1 year of additional life adding about 3 percent to gross liabilities.  Given the significant increase in life expectancy over recent decades, this is having a marked impact on the viabilities of many pension plans.  In my own case, my mother received a pension from her decades of service as a teacher.  In reading through the pension plan literature, it was interesting to note the large number of teachers who were living to 100 years of age and the high percentage of teachers who took early retirement and collected their pensions for significantly longer than their years of teaching service.  This is obviously an unsustainable business model.


Now that you have some idea of the massive scope of the pension problem that looms over the world's advanced economies, I'll close this posting.  In part two, I'll look at some recommended solutions by the authors of the report that may help mitigate the pension crisis.

Tuesday, April 18, 2017

The Economic Impact of Brexit - A No-Win Situation?

A paper by Swati Dhingra, Gianmarco Ottaviano, Thomas Sampson and John Van Reenen at the Centre for Economic Performance at the London School of Economics and Political Science examines the economic consequences of the United Kingdom's exit from the European Union on both the U.K. and the European Union as a whole.  With the European Union being the U.K.'s largest trading partner, Brexit will obviously have a significant impact on both economies since tariff and non-tariff barriers to trade would change.

For the purposes of this study, the authors looked at two scenarios:

1.) an optimistic scenario where the U.K. has a relationship with the EU similar to that of Norway which has full access to the EU single market as a member of the European Economic Area (EEA).  In this case, there would be no tariffs on trade between the U.K. and the EU, however, there would be some non-tariff barriers that do not apply to EU members.

2.) a pessimistic scenario where there are larger increases in trade costs because, in this scenario, the U.K. is not successful at negotiating a new trade agreement with the EU.  This means that trade between the U.K. and the EU is government by World Trade Organization rules, implying larger increases in trade costs than the optimistic scenario.

Let's look at the optimistic case first.  In the optimistic scenario, the authors assumed that in the ten years following Brexit, intra-EU trade costs fall 20 percent faster than in the rest of the world with non-tariff barriers within the EU falling by 5.7 percent over the decade.  They also assume that the U.K.'s contribution to the EU budget would not drop to zero, rather, it would drop by 17 percent or 0.09 percent of national income; in the case of Norway, on a per capita basis, Norway's financial contribution to the EU is 83 percent of the U.K.'s payment.

Here are the results of the effects of Brexit on U.K. living standards for the optimistic case:

Trade effects: -1.37 percent
Fiscal benefit: + 0.09 percent
Total change in income per capita: -1.28 percent or -£850

In the pessimistic scenario, the authors assumed that in the ten years following Brexit, intra-EU trade costs fall 40 percent faster than the rest of the world with non-tariff barriers within the EU falling by 12.8 percent over the decade.  They also assume that, since the United Kingdom is outside the EEA, the U.K. would save more on its current contribution to the EU.  The savings would rise to 0.53 percent which includes only the public finance components and excludes the transfers that the EU makes directly to universities, firms and other non-government bodies.  Assuming that the U.K. government does not cut this funding, the net savings would be 0.31 percent.

Here are the effects of Brexit on U.K. living standards for the pessimistic case:

Trade effects: -2.92 percent
Fiscal benefit: +0.31 percent
Total change in income per capita: -2.61 percent or -£1700

Please note that in both of these scenarios, the authors have used a static trade model that does not account for the dynamic impacts of trade on productivity.  For example, trade can have positive economic effects since it increases competition and promotes economic efficiencies.  Recent research shows that these dynamic impacts on trade may be two or three times larger that the static effects.  Using an estimate that a 1 percent decline in trade reduces income per capita by between 0.5 percent and 0.75 percent, Brexit would reduce U.K. per capita income by between 6.3 percent and 9.5 percent or between £4200 and £6400 per household per year.  This shows that the dynamic impacts of trade could significantly worsen the situation for U.K. households when Brexit takes place.

Now, let's look at the effects of Brexit on other nations.  Obviously, the nations with the greatest trade with the United Kingdom will see the greatest effects.  According to the authors' calculations, all EU member nations are worse off with Ireland suffering the largest proportional losses from Brexit followed by the Netherlands and Belgium.  Countries outside of the EU will experience economic gains as trade is diverted toward them and away from the EU; these include Russia, Taiwan and Turkey.

Here is a graphic showing the effect of Brexit on GDP by nation:


In total, the EU loses between 0.12 percent and 0.29 percent of its GDP whereas the nations outside the EU gain between 0.01 percent and 0.02 percent of GDP.  When looking at actual losses, the United Kingdom will see its economy shrink by between £26 billion and £55 billion and the rest of the EU will collectively see the economy shrink by between £12 billion and £28 billion or about half of the negative economic impact experienced by the United Kingdom.


Obviously, Brexit is going to have a significant impact on the European community as a whole.  The authors note that, when all is said and done, the economic consequences of leaving the EU will depend on the political policies that the United Kingdom adopts after Brexit takes place.