Walter Molano | The global pension fund crisis
A series of converging trends are threatening to create a crisis of epic proportions.
The post-war baby boom generation is retiring enmasse. Advances in medical technology are extending life expectancy and the low/negative interest environment across most of the developed world is depressing yields for traditional fixed-income investments.
As a result, pension funds are seeing increased demands, while watching their returns wither away. The California pension funds system - CALPERS - is a case in point. The agency recently reported that their annual return for the fiscal year that ended in June was 0.61 per cent. This left it well short of the 7.5 per cent needed to meet its obligations.
Right now, CALPERS has 68 cents in assets for each dollar in liabilities. This ratio will continue to deteriorate as long as returns remain depressed.
Fortunately, CALPERS is in a better situation than many of its peers. The Central States Pension Fund (CSPF), which handles the retirement plans for Teamster truck drivers in Texas, Michigan, Missouri, New York and Wisconsin, was forced to cut benefits in July.
CSPF posted returns of 0.81 per cent in 2015, and it has a US$2-billion annual hole. It currently pays out US$3.46 in benefits for every dollar it receives. Some retirees are seeing as much as a 40 per cent reduction in monthly payments, putting a serious crimp on household finances. Many workers did not save while they were working; taking comfort that their retirement plans would carry them through their golden years. However, that no longer seems to be the case.
Up to 2014, the United States federal government did not allow reductions in defined benefits, but that changed in 2014 when the spending appropriation bill included a codicil that allowed cuts to occur if the pension agency could prove that it would be insolvent within the next 10 to 20 years.
Shortfall for funds
At the current pace, CSPF will be insolvent by 2025. A recent study by the Hoover Institution said that state pension funds are facing a shortfall of US$1.2 trillion. The gap in private company plans is of a similar magnitude, while the hole in the Social Security system is north of US$32 trillion.
Unfortunately, the crisis is not relegated to the US. The rest of the planet is in a similar mess.
The private sector gap in the United Kingdom is £1 trillion, and growing. The problem is that the global economy is still reeling from the effects of the 2008 financial crisis. Trillions of dollars in assets were wiped out, while central banks embarked on to a policy of monetary easing of an unprecedented scale.
In a misguided effort to force savers to invest their capital in the real economy, instead of keeping it in banks, central bankers slashed interest rates into negative territory. However, there is no evidence that this policy has really spurred economic growth.
GDP growth levels across the developed world remains depressed. What it has done is fuel silly investment bubbles that then have unintended consequences. A good example is the massive investment that flowed into the commodity sector at the start of the decade.
In 1990, global mining capex was US$6 billion. In 2002, it reached US$14 billion. By 2012, it was US$122 billion. This geometric surge in capex was a direct result of the monetary expansion that was pursued by the developed world. However, the huge increase in commodity output led to a supply gut and a collapse in prices, which only added to the sense of global instability.
While the negative interest rates advocated by economists, such as Larry Summers and Paul Krugman, fit nicely into their macroeconomic models, they are wreaking havoc in the real world.
The low-yield environment in the developed world is forcing asset managers, such as pension funds, to rely more on the equity markets and the emerging markets. Yet, the large equity markets are starting to resemble Ponzi schemes, as valuations climb only due to the large inflows.
Company returns remain lacklustre, due to the low-growth environment, and PE ratios are risible.
A similar situation is occurring in the emerging markets. Bond yields are reaching record lows, and allowing irresponsible borrowers, such as Argentina, to load up on debt. Instead of cutting expenditures to reduce its fiscal deficit, Argentina is gorging itself in the international capital markets.
This is a story which will not have a happy ending for the country and investors. Interestingly, the pension fund crisis is not just a developed-world phenomenon. It is being replicated across all countries that have defined-benefit systems, such as Chile. Low returns and a shortfall in company contributions are putting a great deal of stress on Chile's AFPs, to the point that there is a cacophony of voices calling for the nationalisation of the system.
We need to be attentive to the next crisis that is about to grip the global economy.
- Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.