A recent report from the World Economic Forum highlighted a significant, and frequently overlooked, problem building up in the global economy. In its May 26 paper, titled “We’ll live to 100 – How Can We Afford It?”1, the WEF estimated that across world’s six largest advanced economies, including the U.S., UK, Japan, the Netherlands, Canada and Australia, cumulative expected shortfalls in pensions will reach US$224 trillion by 2050. Adding China and India, the gap rises to $400 trillion. The U.S. alone is expected to account for $137 trillion of this. In comparison, the estimated 2015 underfunding of pensions stood at $70 trillion across the eight economies, with the U.S. accounting for $28 trillion of this number. By 2050, the average pensions gap in the advanced economies will reach $300,000 per person.
Crucially, the WEF forecasts that the annual growth rate in the pensions gap will be around 5 percent over the period of 2015-2050. Compared to 2010-2016 growth rates, the rate of growth in unfunded pensions liabilities will exceed the rate of economic growth in all countries surveyed, which means that real incomes and purchasing power will have to drop.
This is the key problem for a range of the advanced economies, where pensions, funded via current revenues, are contractually secured for public sector workers on a defined benefit basis and backed by powerful unions and constituencies.
Consider the U.S. Earlier this year, Professor of Finance with Stanford University, Joshua Rauh, published a new paper attempting to quantify the pensions gap within America’s local and state public pensions systems. Based on his numbers, cities and states faced accelerating shortfalls, with 2015 figures for pensions gap up staggering $434 billion, to $3.85 trillion, compared to 2014 numbers. This research covers 649 public pension funds. In a sign of a massive crisis, in 2015, Rauh was unable to find a single pension plan where contributions exceeded liabilities. California state system, CalPERS is the case in point: According to the State Treasurer’s report, published in May, the state will be forced to reduce its pensions obligations by more than $11 billion over the next 20 years to avoid increasing the already sky-high state income tax.
The reasons for the shortfalls
The key drivers for the ever-expanding pensions gaps are not demographic, as suggested by the World Economic Forum. Instead, they are political.
Over the two decades preceding the Global Financial Crisis, politicians around the world have increasingly relied on gold-plating public pensions to avoid industrial unrest and placate powerful trade unions, especially those that organize the key state and municipal employees, such as police, fire departments, teachers and medical staff. This resulted in a transfer of fiscal resources from taxpayers to public sector pensions. This transfer relied on the policymakers’ belief that rapid economic growth and low inflation were the new normal. Under the growth assumptions required to balance out public pensions alone, advanced economies should enjoy 3 to 4 percent real economic growth, on average, into perpetuity, boosting simultaneously returns on pension funds’ investments and maintaining healthy growth in government revenues.
As a legacy of these underlying assumptions, public pension funds even today are expecting average annual returns on investments in excess of 7.5 to 7.6 percent. This is more than triple the average risk-adjusted returns realized over the 2014 to 2016 period and more than ten-fold what CalPERS delivered in 2016. Taken differently, even without adjustments for risk, the average growth rate in state revenues across the U.S. in 2012-2015 was around 3.8 percent per annum, or roughly half the rate of targeted growth in pension funds’ returns necessary to maintain benefits payouts at contracted levels.
This analysis excludes other risk and uncertainty considerations that should not be ignored in longer run projections, but to-date do not factor in the majority of public pension funds’ forecasts.
One: global economic growth has entered a new trend period, arguably reflecting the effects of long run secular stagnation in both aggregate demand and aggregate supply – a topic covered previously in these pages. Thus, both, inflationary and growth dynamics forward are unlikely to support asset returns in excess of 3 to 4 percent per annum.
Two: asset prices volatility, especially over the longer-term horizons (e.g. across business cycles) has risen sharply in recent decades, as exemplified by the research from the Bank for International Settlements, also covered previously in this column. This means that risk-adjusted returns to financial assets have declined, relative to the past decades.
Three: a combination of the recent crises and slower current trend growth imply lower life cycle wealth and income profiles for the younger generations. This risk factor suggests that economies’ ability to sustain higher rates of taxation on income in the period from 2020 through 2050 and beyond will be severely constrained.
Four: shortfalls on public pensions funds provisions are now coincident with low rates of savings and investments in private pensions. This risk factor looms large in terms of future demand for public pensions and social security nets. It is also correlated with the governments’ capacity to extract further tax revenues from the already under-invested younger generations to pay for contracted pensions in the public sector.
Finally, there is a problem with the structure of returns as they apply to pension funds. Mandated pension schemes are heavily dependent on highly-rated government and corporate debt securities. In simple terms, this means that sustainability of private and public-sector investments requires higher yields on government and corporate debt. Yet, sustainability of the current entitlement schemes (ex-pensions) requires higher bond prices (and, thus, lower bond yields) to finance present day deficits across the economies.
Monetization of growth in public debt in recent years, in the form of quantitative easing programs, has resulted in investment losses or sub-par returns for private and public-sector pension funds, while sustaining fiscal deficits necessary to keep social services, including public pensions, provisions at their current levels. In other words, governments around the world have opted to transfer returns, via monetary policies and in some cases directly through taxation of pensions wealth (e.g. in Ireland), from private and public pension funds to current social expenditure accounts.
Ending such a transfer means less spending on current social welfare and public investment programs and reducing current economic growth, leading to greater pensions shortfalls in the immediate future. Continuing such transfers means further undermining solvency of public and private pensions through depressed returns.
Altogether, the above means that in the U.S., as across other advanced economies, the problem is simply insurmountable, absent deep reforms of the pensions provision and security systems; reforms that are seemingly impossible for politicians to structure and implement. In basic terms, pensions shortfalls are now growing out of control at the local, state and federal levels, while private sector pensions provisions are increasingly becoming a hostage to potential risk spillovers from the public-sector liabilities.
The way out
Across the U.S. and indeed much of the advanced economies, the lip service paid by politicians to the impeding pensions crisis is accompanied by a dire lack of tangible reforms, even in the states already facing deep crises.
Temporary insolvency protection in Detroit and emergency budgetary measures in the deeply insolvent Illinois did not significantly alter future accumulation of public sector pension bills, nor created a sustainable model for funding these. In Puerto Rico, where government bankruptcy has been ongoing for over a year now, local authorities and central government continue to insist on long-term viability of public pension plans.
In California, America’s home for most lavish and grossly underfunded public pensions, unfunded pension liabilities, meanwhile, have shot up by 22 percent in 2016 alone. Faced with an acute crisis, with CalPERS already cutting pensions payouts to a number of local authorities, in May, the state governor finally introduced a plan to help lower future liabilities. The plan is delusional at best, damaging to the prospect of the state at worst.
The state will borrow $6 billion from the Surplus Money Investment Fund (SMIF), currently yielding about 1 percent in interest to the state, to shore up pension funds deficits. Explicitly, the hope is that CalPERS will be able to earn higher returns on state money. The SMIF is a low-earner for a good reason: it is used to provide state liquidity to cover short-term expenditures. In other words, by its nature it has to be both highly liquid and low risk. Here’s a problem, however. CalPERS has managed to earn just 0.61 percent in 2016, while projecting pensions payouts consistent with 7 percent annual returns. Adding insult to injury, CalPERS investments are less liquid and higher risk than those of SMIF.
California’s proposed solution exemplifies the problem with all political reforms proposals claiming to address pensions shortfalls. The proposal simply transfers more funds from taxpayers to public pensions recipients, without changing the levels or the nature of pensions entitlements in the public sector. In effect, the California ‘solution’ and other major pensions ‘reforms’ proposals in the U.S. and elsewhere simply trade private workers’ ability to save and invest for their future for maintaining egregiously high and unfunded pensions payouts to public sector employees.
Thus, the cure threatens to make the disease incurable.
Instead of continuing to transfer funds from taxpayers to public sector pensions funds, real reforms should start by rationalizing committed expenditures and creating a system that favors long term solvency of pensions funds across the entire, public and private, workforce.
To achieve these goals, legislators need to cap current payouts to public sector retirees at a fixed proportion to the median public and private sector wage in the state. Instead of paying 60 or 75 percent of the employee’s last earned wage, public pensions should be set to not exceed two-and-a-half to three times the median wage in the state where the retiree worked. This will eliminate abnormally high payouts based on superficial inflation of jobs titles and wage scales that are common in the public sector in the last few years of employee tenure.
For current employees, there is a dire need to abandon the defined benefit schemes and replace them with defined contributions schemes, while raising the retirement age to match the reality of longer life expectancies and improved quality of health in later years of life. In addition, pensions contributions by the employees should be raised to reflect long-term expected rates of returns of 3-4 percent per annum, instead of 7 percent. There is also a need to remove early retirement age allowances for all federal, state and local employees.
In the longer run, there is a need to dramatically increase the rate of workforce participation for working age adults. This will require creating tax incentives, lower labor and income taxes, for job creation and participation, encouraging life-long learning and skills development (which, in part, also requires lowering the tax burden on returns on human capital investments – or put differently, tax cuts for upper middle class), and supporting new business formation (through improving access to markets and lowering costs and burdens of regulatory compliance). At the same time, forward-looking reforms will require stimulating households’ investments in private pension funds, by streamlining tax incentives and reducing burden of tax compliance. In addition, making pensions savings more liquid can help increase voluntary contributions to pension funds.
In the end, the elephant in the room when it comes to pensions shortfalls, is the lack of surplus income available for pensions savings for private sector employees. Absent a massive reform of income taxation, there is simply not enough money in the household budgets to deliver investments required for securing sustainable retirement in the future.