Increasing longevity and population aging are global trends that are placing increasing financial strain on social security safety nets as well as employee benefits such as defined benefit (DB) retirement plans. In the U.S., Americans entering retirement are in worse financial shape than the prior generation for the first time since Harry Truman was president, according to the Wall Street Journal, which reported in June that more that 40% of U.S. households headed by people aged 55 -70 lack sufficient resources to maintain their living standard in retirement.
Institutional Allocator in June asked retirement industry practitioners to comment on the question of potentially inadequate retirement savings in the U.S. and its implications for asset prices and retirement income for an entire generation of Americans.
IA’s Question: The U.S. pension industry may be moving inexorably toward a potential crisis based on demographic changes. The so-called “Baby Boomer time bomb”, in which large numbers of workers have begun to move from retirement saving to retirement-income spending, could have very unpleasant consequences for pension schemes, particularly for underfunded public defined benefit plans. An increasing number of pensioners, along with corresponding decline in retirement savers, could drive a decline in asset values across the board as capital and investment markets spiral downward due to this transition. Is this scenario of concern to you? And if so, what are your brief thoughts on steps to address?
“It is hard to see how this demographic challenge will unwind in any other way than as a drain on investable dollars in the economy and hence, a decline in asset values over time. As the supply of investable dollars falls, you would also expect interest rates to rise. This, too, could put additional strain on the markets,” said Paul Smith, president and ceo of CFA Institute. “However,” he added, “I think this challenge is likely to be one that is spread over many years and may not be quite as disruptive of the markets as your question suggests. I believe it will simply be one contributing factor to a sustained period of lower growth and higher interest rates.”
According to Tim Barron, cio at Segal Marco Advisors, “The good news about changing demographics is that the scenario playing out now has been well covered and should come as no surprise. The bad news is that preparations for our aging population have been less than complete at least in general. Public pension plans have come under great scrutiny of late, in part due to increases in costs as many funds reduce projected returns based upon forward expectations for interest rates and growth levels. As they move into payout mode over the next 15 or so years several negative consequences may occur, including heightened concern about liquidity, which may impact returns as well if retirement plans have to reduce the duration of their portfolios. In addition, there could be increases in contributions as a percentage of payrolls
with longer career employees retiring with their generally higher wages. This could be offset with less senior replacement workers being brought in at lower pay.”
Barron said that he is not concerned that investment markets overall will decline due to public pension plans solely, “But we are concerned that with government debt already high at the federal level and the bills coming due for Social Security and Medicare combined with the influence of lower earning and spending by the Boomers, we face even greater struggles to escape from a very slow pace of growth.” He explained that, importantly, economic growth is driven by a combination of labor force growth and productivity increases, and that if the latter stays relatively flat—as has been the case since the financials crisis—and the former declines due to retirements, GDP growth, a key driver of stock returns, will be anemic at best.
“Clearly pension systems that are substantially underfunded must step down now to ensure that future liabilities can be adequately met. But the biggest concern for me is Baby Boomers (there are many of them) who will enter retirement without adequate savings,” said David Damschen, Utah State Treasurer. “The dependence they might end up having on public assistance could significantly stress state and local governments, as well as our healthcare system. For governments with underfunded pension systems, this could turn into a very unpleasant one-two punch.”
And according to the CIO of large Western state public fund who spoke on condition of anonymity, “I think demographics are important, but likely the change in spending habits as the population gets older will have a greater impact on industries and specific companies than the gradual withdrawal of assets on the overall market trend. Although there may be additional selling on the margin from older generations, I think we will see increased savings from younger generations to partially offset the outflows. The outflows from DB plans have been going on for decades as we have seen the market reach new highs. Valuations will be the key to market levels not marginal changes in flows. Overall, current valuations are a greater concern than expected cash flows.”
Not necessarily a doomsday scenario?
“I am not a believer in the crisis asset value scenario based on changing U.S. demographics,” stated Tom Tull, CIO at the Employees Retirement System of Texas. He said “as global investor in a variety of asset classes, I expect our investment models to change with time just as the environment changes. As such, we will all need to be more proactive rather than reactive with more emphasis on being tactical, timely and opportunistic. More emphasis will likely be placed on alternatives versus the public markets and on the emerging markets as they transition to more developed markets, representing more significant shares of world GDP and market cap. Their populations are younger than the developed markets and their progression up the quality-of-life chain are expected to be significant. The effects of AI, technology, human capital management and preservation of capital will also remain paramount.”
Similarly, Michael Rosen, CIO at Angeles Investment Advisors, is circumspect regarding the scenario presented in IA’s question, agreeing with the first part of our scenario but not the second. “Demographics are destiny, as the great French sociologist Auguste Comte said,” Rosen declared. “Our pension system, broadly, is not a savings plan, as is often thought—that is, you take out what you’ve put in—but a scheme premised on current workers paying for the retirement benefits of retired workers. This works fine as long as (a) there are a lot more current workers than retirees, (b) retirement benefits are modest relative to contributions, (c) retirees die within a reasonable time. All three foundations have been eroding for decades, putting stress on the entire pension system.”
He continued: “Let’s distinguish between public and private pensions, because companies have been required for years now to have relatively well-funded pension plans. This has been accomplished by a combination of contributions, investment gains, limiting benefit growth and the freezing of plans. For private DB plans, demographics is not a big factor in funding since (a) the plans are frozen, (b) companies are required to fund them. Public DB plans are much more challenged for all the opposite reasons.”
He said the second part of IA’s scenario, that the surge in retirements will lead, inexorably, to a decline in asset values, is logic he “categorically” rejects. “The value of a financial asset is linked to the cash flows it generates over its life. Obviously, its value will depend on many exogenous factors, such as growth and inflation, but an aging population will not directly lead to asset values falling simply because we’re getting older. I’ll note that most of us have been getting older for many years now, and asset values have not fallen.”
How to fix the problem?
There is a retirement readiness crisis globally. According to CFA Institutes’ Smith, the vast majority of people everywhere are under-saving for retirement. Most have no pension or savings. “If you are lucky enough to have a defined benefit plan as part of your retirement resources, the benefits promise to you is just that – a promise. If the promise is woefully underfunded, it can only be fixed through a combination of higher employer and employee contributions along with consistent investment returns, Smith said. He continued: “There may even be the need to actually trim the benefits promise itself and/or convert to defined contribution for any new beneficiaries. If we are talking about a government public fund or social security, the ‘employer’ contribution is really the paying taxpayer. It has been called generational theft that the next generations of taxpayers will be strapped with a larger bill and with fewer taxpayers to pay it. While investment returns are key to helping stabilize the decline in defined benefit pension funding levels, they are not a fix to demographic realities or the decades of missed or forgone pension payments by governments. So, even the pension area is a mess of monumental proportions which can only be delayed.”
Smith concluded that as a policy matter “we wish it could be fixed via recognition of a mutual mistake, where states and beneficiaries agree too much was promised, not enough was contributed and the plan needs a work out or it will default. Leaving it to the next generation will soon be (already is) exhausted as an option.”
Solutions are difficult, Barron acknowledged. “They fall into three broad categories – improving productivity through more targeted support for R&D and increased competition; improving the degree of worker productivity through training and education; and, unfortunately, continuing to move out retirement age for underfunded programs.”