Retirement Solutions
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Peter Dixon, Global Equities Economist

Whilst low interest rates were accepted as a necessary evil in 2009 in order to stave off the threat of financial meltdown, there are today increasing concerns that they cause more problems than they solve. The debate has turned to the issues which low rates pose for savers. Pensions in particular represent a form of long-term saving, whose asset values depend on the lifetime returns on the pension fund. But falling birth rates and rising longevity suggest that low interest rates are not the only problem we face. Indeed, there is a strong argument that we need to rethink the whole model of pension provision, with workers given greater incentives to continue working beyond the current retirement age.

At its most basic, low interest rates reduce the flow of interest income accruing from investments. But low rates also reduce interest outlays (e.g. mortgages) and a look at household income balances suggests that most people are not made worse off by low interest rates. But pensions represent a longer-term form of saving where a number of challenges are emerging. On the one hand, a number of secular trends, such as demographics, will increase the challenge of meeting the needs of future generations of pensioners. This will be exacerbated by the impact of low rates on the value of pension funds. Pension provision essentially takes two forms: Either it is guaranteed by the state, or individuals make provision for their own retirement. There are mounting problems with both models which will increasingly require policymakers to demonstrate flexibility in order to deal with them.

The public sector pension problem

The bulk of state pension systems are unfunded and thus paid out of current income, and since they are not classed as contractual obligations – because future benefits can be withdrawn or changed – they are not recognised as liabilities on the public balance sheet.

It is thus very difficult to assess the level of pension liabilities. But to give some idea of the magnitudes involved, the UK government has made an estimate of its long-term pension liabilities which in fiscal year 2014-15 were reckoned to be almost £1.5 trillion (81% of GDP) – an increase of almost one-third over the previous five years. By the middle of the century, the UK government calculates that it will be spending around 8% of GDP on state pension outlays, which is only moderately higher than current levels. Across the OECD as a whole, pension outlays are projected to rise from 9% of GDP today to around 10% by 2050 (chart 1).

The countries with the biggest problems over the next 30 years are likely to be newly industrialised economies. OECD projections suggest that by 2050, governments in Turkey and Brazil will be spending 17% of GDP on pension outlays unless there are significant revisions to pension entitlements. Indeed, Brazil has one of the most generous pension systems in the world with recipients able to retire aged 58 – eight years earlier than the US or UK – whilst the pension replacement ratio is 80% of pre-retirement income compared to 60% across the OECD on average. President Temer has thus proposed measures such as raising the minimum pension age to 65 and increasing the number of years required for qualifying payments. Nonetheless, a number of structural features have already been built into the system which will increase the strains on the Brazilian system for some years to come.

Demographic challenges are one of the biggest threats to state pension funds, as an ageing labour force reduces the numbers in employment relative to those of pensionable age (chart 2). Other things being equal this will require future generations of workers to contribute more to cover the costs of those in retirement or, more likely, future retirees will be forced to accept lower real incomes than previous generations. The burden can also be trimmed by raising the age at which people can claim their pension. Empirical work conducted in the UK suggests that extending working lives by one year would raise the working age population by 1.5% after three years and produce an increase of 1% in GDP after five years. This in turn results in a reduction in social transfers (i.e. lower pension outlays) and generates an improvement in the government deficit equivalent to 0.6% of GDP. A three year extension in the retirement age has roughly three times the impact on GDP and the deficit. Higher life expectancy justifies some increase in the retirement age: Across the OECD, men now spend 18 years in retirement compared with 11 in 1970 (the corresponding figures for women are 15 in 1970 and 22 today). Given the reduced strain on public finances which can be generated even by a one year extension, increasing the retirement age is clearly a policy worth considering for governments in industrialised countries.

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The private sector pension problem: (i) Defined benefits

Increasingly, most industrialised countries encourage workers to save in private pension plans in order to reduce the burden on taxpayers. The problem of low asset returns is particularly acute for private funds although the burden falls on different groups. For defined benefit (DB) schemes, pension returns are guaranteed by covenant and the risk of pension provision is borne by the provider. For defined contribution (DC) schemes, in which the beneficiary receives a return proportional to their contributions, low asset returns reduce the value of the future pension pot with the result that they must bear the burden of adjustment.

In DB schemes, the mounting gap between the funds’ assets and liabilities poses strains on the corporate sector which will have to ensure that its pension responsibilities are fulfilled. What makes life particularly complicated for such funds is that low interest rates magnify the difference between the two sides of the balance sheet. Regulators essentially treat DB pension funds like a bond in the sense that it is a future financial payment which is contractually guaranteed to be settled (unlike state pensions, where no such contract exists). Just as the value of a bond is determined by the net present value of future income payments, so the accounting regulations require DB funds to assess their liability position by monitoring their net present value. Standard discounting techniques imply that the lower the interest rate, the higher is the net present value of the quantity in question. When that quantity happens to be pension liabilities, it is clear that a period of low interest rates magnifies liabilities with the result that company pension schemes must report a deficit.

As an illustration of the problem, chart 4 shows the balance sheet position of the 5,794 DB schemes registered with the UK Pension Protection Fund. Note that the volatility of the aggregate pension fund position is primarily due to the volatility of liabilities since the value of assets is generally smooth. Moreover, the ongoing rise in liabilities has coincided with the decline in UK bond yields which in turn has dragged down corporate bond yields which are used as a discount factor on the balance sheet. According to rules of thumb derived by the UK pension regulator, each 0.3% decline in bond yields raises assets by 1.6% but swells liabilities by 5.9%. To a large extent, the actions of central banks in driving down market rates via their QE policies have exacerbated the pension deficit problem. And to the extent that interest rates are likely to rise over the medium-term, we should view the pension deficit problem as artificially inflated.

But what if we really are in a world of secular stagnation in which yields remain permanently lower? Under such circumstances, investment managers may be forced to take more risks to boost the asset side of the balance sheet. This would see a reduction in “safe” fixed income securities at the expense of more volatile asset classes such as hedge funds and will likely exacerbate the current trend towards property and infrastructure. In principle, this could raise the risk of insolvency and pose an additional threat to financial stability if it were to bid up the prices of assets way above fundamentally justified levels.

(ii) Defined contributions

For all the time which policy makers spend worrying about them, DB schemes are increasingly less common today and many of them have been closed or offer less generous terms to new employees. Indeed, DC schemes are much more widespread and in many cases tax incentives are offered to encourage their use. But low interest rates are even more of a problem for future generations of pensioners because they now carry the risks resulting from low rates of asset return. Whereas DB schemes must ensure that retirees receive their guaranteed return, retirees on a DC scheme face the same problem as those retiring on a state pension: either accept a smaller pension than they might otherwise expect or work longer in order to both maximise their retirement income and minimise the time they spend in retirement. Either way, the full impact of a prolonged period of low interest rates on household savings will not become evident for a considerable time.

In addition, issues of intra-generational equity begin to play more of a role. Future generations of pensioners are paying into their retirement fund in the knowledge that their future pot will be smaller than it otherwise would be – and certainly smaller than that built up by previous generations – whilst not paying any less tax to fund existing pay-as-you-go schemes. At the same time, some governments – notably the UK – have recently reduced the limits on the lifetime value of accrued pension contributions. This raises a serious question of whether taxpayers will be prepared to hand over such a large amount of tax to the government at a time when austerity means they are getting fewer services in return, whilst at the same time worrying about their retirement income. It is hardly surprising that European electorates are becoming restive.

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Pension issues and changes in labour market conditions

One of the problems with pensions which is often overlooked is that workers who spend at least part of their career working outside of the country where they plan to retire can be severely disadvantaged when they reach pensionable age. This is in part due to the huge differences in pension arrangements, even across countries which share common economic and political goals such as the EU. Factors such as market fragmentation and differing degrees of consumer protection act as obstacles to cross-border business by hampering labour mobility. They also raise consumer costs and increase uncertainty levels whilst reducing investor returns and undermining trust in the private pensions system.

Matters could be complicated further by Brexit, as EU (British) citizens who worked in the UK (EU) may find difficulties in ensuring that the pension contributions they paid whilst working abroad are accepted in their home country as counting towards retirement provision. The EU recognises the extent of this problem and the Directive on Institutions for Occupational Retirement Provision (IORP) came into force in January 2017, which is a first step towards unifying the rules on pension governance across the EU.

Another issue is the increased fragmentation of careers into periods of work and learning. Many workers today enter the labour force far later than previous generations, as a result of extended academic or vocational education programmes. Since the retirement age has generally not risen in line with the number of years that younger people spend in training, this implies that many of them will have shorter working lives which mitigates against efforts to build up a pension pot although the impact tends to differ across countries (chart 5). Moreover, it is commonly accepted that workers may have to undertake periods of retraining throughout their career in a way which their parents’ generation did not.

Many women face a similar problem if they decide to put their career on hold in order to have children – an issue which was never envisaged when female participation rates were lower. Indeed, OECD research highlights that women who take a five year career break can significantly reduce their pension entitlements, with German women taking the biggest hit, although those in the UK and US do not suffer any such loss (chart 6). Not surprisingly, these costs broadly double after a ten-year break.

The traditional model, which allowed workers to remain with one employer for a long period and build up a retirement fund, may become less applicable in the future. One way to overcome this problem is to allow the more widespread use of pension credits, whereby workers can gain concessions on rules governing minimum years of contributions depending on the reason why they drop out of the workplace. Unfortunately, the recent period of slow growth which has punched a large hole in public finances has prompted many governments to reduce the generosity of many schemes.

In any event, these are not a fix in themselves: Most experts in the pensions field increasingly believe that a radical overhaul of the way in which we think of work and pensions is required. For example, better (and in many countries, cheaper) childcare facilities would allow women to get back into the workforce more quickly, thus reducing their pension gaps. Thus, it might be possible to allow some form of tax deductibility for childcare costs. Although this imposes a cost on the state, this has to be set against the benefits of getting people back into employment more quickly which leads to higher tax receipts. It may also act as an incentive to raise the birth rate which in turn would go some way towards reducing the long-term dependency ratio. There is also a strong argument against imposing a fixed retirement age. With labour market practices much less physically strenuous today, most people are far healthier at age 65 than previous generations. Thus, for example, it might be possible to extend each individual’s retirement age in line with any time they have spent in training.

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LAST WORD

It is less the case that we have a pensions problem so much as we have a retirement problem. The fact that people live increasingly longer after they cease full-time employment means that the current pensions system is not fit for purpose. It is true that low interest rates reduce the value of pension assets, which increases the burden on future generations of retirees. But this is only half the problem, the solution to which is increasingly allowing for greater participation in the labour force by older workers.

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