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Buttonwood
A trillion here, $500 billion there
The huge shortfalls in pension plans
Oct 15th 2011 | from the print edition
THE pension hole just keeps getting bigger. The assets owned by pension schemes have generally been falling in price while their liabilities have been relentlessly rising. One of the culprits is quantitative easing (QE), a tactic devised by central banks to revive the economy.
The numbers can boggle the mind. Mercer, a consultancy, reckons the hole in final-salary corporate plans in America was $512 billion at the end of September, the highest figure since the second world war. The average corporate pension plan had a funding ratio (the proportion of liabilities covered by assets) of just 72%, down from 81% at the end of 2010. In Britain the Pension Protection Fund reported this week that the aggregate deficit of the schemes it insures stood at £196 billion ($309 billion) at the end of September; the average funding ratio was 83%.
Those numbers look tiddly beside the public-sector pension deficits. In 2009 Joshua Rauh of the Kellogg School of Management at Northwestern University and Robert Novy-Marx, then at the University of Chicago’s Booth School of Business, estimated that the deficit of American state and local-government pension plans was $3.1 trillion. Mr Rauh reckons that the deficit is now $4.4 trillion. In other words, a cool $1.3 trillion has been added in two years.
These figures will not be accepted by everyone. Many states still discount their pension liabilities by the assumed rate of return on their assets, often around 8%. But this is a highly dubious assumption. Government bodies still have to pay the pensions, regardless of whether they achieve those returns or not.
Instead, some Warren Buffett-like principles ought to apply. If a promise to pay someone money in the future isn’t a debt, what is it? And if a debt shouldn’t be recorded at cost, how should it be recorded? A company might borrow $50m in the bond markets to build a factory, after all, but it cannot record the debt on its balance-sheet at less than $50m on the ground that it expects to earn a higher return from the factory than its cost of borrowing.
A public-sector employer could replace its pension plan by buying a promise of equivalent value in the markets and handing over the proceeds to its employees. Since pension promises are legally (and sometimes constitutionally) protected in many states, the equivalent promise is a government bond. That is why the government-bond yield is the appropriate measure for discounting public liabilities, as Messrs Rauh and Novy-Marx assert.
The Bank of England recognises this issue. Its employees are guaranteed an inflation-linked pension so it meets that promise by buying inflation-linked bonds. The current cost is 55% of payroll, far more than most employers put aside. Other employers are paying less into their funds and taking a gamble that the equity market will deliver the rest. In effect, they are handing a guarantee of future stockmarket performance to their employees; something that would be very expensive to buy.
Oddly enough, the Bank of England has played its part in escalating the costs of other British pension schemes. The aim of QE is to lower bond yields. This raises the liabilities of pension funds (since it takes more money to deliver the same pension). The Pensions Corporation, an insurer, reckons the first round of QE increased the British pension hole by £74 billion. Regulations require that this hole be closed within ten years, costing companies £7.4 billion a year, money that could have gone into building factories and employing new workers. The National Association of Pension Funds has called for an emergency meeting with the regulator; the hope is that the contribution rules can be eased a bit.
These same issues apply to those on private and defined-contribution pensions. Struggling asset markets mean they build up a smaller pension pot; low bond yields mean the annuity income from that pot is lower. The result, according to a study by PricewaterhouseCoopers, a consultancy, is that Britons retiring today will end up with a pension income 30% lower than those retiring three years ago.
Workers approaching retirement should be saving more, not less, as a result of low rates. First, they will need to build up a larger pot to generate their desired income in retirement. Second, filling that pot will require more capital because investment returns will be lower.
It may be that, in aggregate, these side-effects of QE are outweighed by the relief brought to borrowers from lower rates. All the same it is an unfortunate piece of collateral damage, something the authorities have so far failed to address.
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