Living Longer and Living Poorer - The Perfect Longevity Storm

A recent publication, "We'll Live to 100 - How Can We Afford It" by the World Economic Forum takes a sobering look at the financial repercussions of living to the century mark, a greater likelihood than it has ever been.  As many current studies have shown, while we may be living longer, we are most likely to live longer and live poorer with a very significant portion of the world in both developed and undeveloped nations simply not saving enough to fund their elder years.

Since the 1950s, life expectancy has been increasing at an average rate of one additional year of life for every five years that passed.  Here is a graphic showing how longevity has been increasing over the past 7 decades:

Of course, these are merely projections based on "past performance"; any number of factors could reduce longevity.  While this all seems wonderful, there is a significant downside; the global dependency ratio (the ratio of those who are in the workforce to those who are in retirement) will drop significantly from 8:1 today to 4:1 by 2050.  This likely means that retirement age will have to rise since there is no way that the current pension/retirement system can be sustained.  As well, the population over the age of 65 will increase from 600 million today to 2.1 billion in 2050.  The rise in longevity and the drop in the dependency ratio will combine to form the "perfect retirement storm" meaning that governments around the world will have to take significant actions to prevent hundreds of millions of their citizens from retiring to a cat food future (if they are that lucky).

Here is a summary of the challenges facing the current retirement system:

1.) Lack of easy access to pension plans - this is particularly problematic in the growing self-employed/informal job sector.

2.) Long-term, low-growth investment environment - the past is the past when it comes to returns on investments.  Baring any sudden changes, equities are projected to perform about 5 percentage point below historic averages and bond returns are projected to perform about 3 percentage points below historic averages.  As well, low returns on long bonds have created a growing underfunding crisis in the pension world where high interest rates are needed to assure long-term viability.

3.) Low levels of financial literacy combined with a high degree of individual responsibility to manage pension funds - this is particularly problematic in our new defined contribution pension plan world where individual investors are expected to make investment decisions on their own.  As it stands now, over 50 percent of global retirement assets are held in defined contribution plans, far different from the 20th century where most pension plans were defined benefit plans that were professionally managed with an assured payout upon retirement.

4.) Inadequate savings rates - to support retirement, 10 to 15 percent of one's annual salary needs to be saved.  Savings rates in most nations are far lower meaning that retirement incomes will be significantly below what is needed to retire with financial security.

With this background information, let's look at the size of the shortfall in pension saving for eight of the world's largest economies with the following assumptions:

1.) governments provide the first pillar pension

2.) employers (public or private) provide the second pension

3.) Individual savings make up the balance needed to retire

Here is a graphic showing the size of the retirement savings gap (in trillions of dollars) assuming that retirees will require income totalling 70 percent of their pre-retirement income to adequately support their needs:

For these eight nations, the individual retirement savings gap (in 2015) is estimated to be about $66.9 trillion with the largest shortfall being in the United States, currently at $28 trillion and growing to $137 trillion in 2050.  The $70 trillion gap is roughly 1.5 times the annual GDP of these eight nations and is expected to grow by an average of 5 percent annually, reaching $427.8 trillion by 2050 or a daily growth rate of $28 billion.

Now let's look at what the pension system funding situation looks like when we add in the shortfalls in corporate pension plans, government public pensions and public employee pension plans and the individual retirement savings gap:

While we in the developed world regularly here about the funding shortfall in the corporate pension system, as you can see here, the corporate pension funding gap is quite small when compared to the unfunded government public pension system and public employee plans and the individual retirement savings shortfall.  Here is a table showing the shortfall for all three aspects of retirement funding for all eight nations in the study:

Let's focus on the individual retirement savings gap in the United States.  Here is a graphic showing the individual retirement savings gap for Americans and how the lower returns on investments have had an impact on the personal retirement savings underfunding:

While some of the shortfall can be blamed on the low investment returns, as you can see, the low returns have increased the $4.1 trillion shortfall by 35 percent to $5.55 trillion, a rather significant increase thanks to central bankers and their low interest rate experimentation.  

Given that this is what has happened over the past three to the percentage of people in the United Kingdom over the age of 65 that are still working:

...and this is what has happened to the U.S. labour force participation rate for Americans over the age of 65 since 2008:

...it looks like individuals have figured out that the old standard of retiring at age 65 no longer applies for financial (and other) reasons, suggesting that the WEF analysis is not far from wrong.

This analysis by the World Economic Forum is sobering.  Given that hundreds of millions of workers will be retiring over the next two decades, there is an urgent need for changes to the system and and an equally urgent need for people to realize that funding their sunset years is key to a happy retirement.  While the prospect of living to be 100 years old is appealing, the prospect of being forced to eat cat food to get there is most definitely not!

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.   

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.