By Richard Marin, Managing Director, SEDA Experts LLC
In 2013 I was a Clinical Professor of Finance at Cornell’s Johnson Graduate School of Management and one of the courses I had created and taught for six years at that time was a course on pensions. When I first gave the course, I called it Defined Benefit Pension Plans in Transition and I drew seven students. The next year I renamed the course Liability Driven Alpha and I sold out the lecture hall with almost fifty students. There are a number of lessons in that, but the course led me to observe a growing and troubling phenomenon about the state of our world and how central the pension issue was becoming to our collective economic health.
I had been on the sell and buy sides of Wall Street for thirty years then and the one common element I found was that everyone on Wall Street does most of their business with the institutional investors that comprise the pension market. Even the retail side of Wall Street was running up against the impact of the growing tide of Defined Contribution pension money and its impact on the markets. This all drove me to write a book based on secondary research into data gathered by Towers Watson (recently announced to be acquired by Aon). That book was called Global Pension Crisis: Unfunded Liabilities and How We Can Fill the Gap, published in 2013 by Wiley & Sons.
I wanted to call the book You Can’t Build Your Walls High Enough, which was a favorite comment I made to my students.Wiley was adamant that the title include “Unfunded Liabilities” because their search word research said that was the winning phrase about which everyone was wanting to read more.The premise of the book is very simple.I believed that the global pension crisis was the biggest issue facing the world economic order because the world was severely underfunded in terms of the amount of assets needed to defease the pension obligations for the coming wave of Baby Boomer retirees.While my research lays out the differing degrees of shortfall that exist for the various countries of the world, and certainly some countries are better off than others, in a globalized, connected world, the collective problem was what matters and that collective shortfall is overwhelming.
Dimensioning the Global Pension Crisis
On the order of magnitude, I calculated that the world was at least $100 trillion underfunded (some, like Dr. Laurence Kotlikoff of Boston University, would contend that the gap it 3-4X that amount and that we may find the world at a “game over” state economically speaking).
At the time (2012), I estimated the total global monetized wealth to be $132 trillion (I would estimate that now to be up to $240 trillion with $105 trillion in bonds and $95 trillion in equity, the rest being in real assets including real estate). To put that in perspective, our global GDP is running at about $90 trillion. And in 2013 I estimated dedicated pension assets quite liberally at $50 trillion, so one third of what I predicted would be necessary. That compares to the level today that is estimated at $47 trillion, so my “liberal estimate” would put that at $70 trillion. That is still well short of what will be needed.
I predicted in that book what I called a species-defining event that would pit the needs of our aging population against the needs of the young to have a source of growth and hope for a better existence. This pernicious “Sofie’s Choice” dilemma was somewhat theoretical even though the math was compelling. As often happens, nature has a way of forcing decisions on us and here we are today in the midst of the Coronavirus wondering what this is all saying about where we are headed with this underlying pension crisis, which is not only not faded away, but is, indeed, simply eight years closer to its ultimate moment of truth.
I am sixty-six years old and was born in 1954. The Baby Boomer generational cohort consists of those born between 1946 to 1964 and totals 76 million Americans (23% of the population) and an estimated 1.6 billion worldwide (21% since the rest of the world tends to be weighted to younger people). The current age range of this outsized generational cohort (just last year exceeded in size by Millennials) is 56-74 with the midpoint being more or less smack dab on my age of 66. I just hit the Social Security Administration’s definition of retirement age in January. That means half the world’s Baby Boomers are at or beyond the technical definition of being at retirement age. There isn’t much further for kicking this can down the road before the bill comes due (to mix metaphors).
The Impact of Longevity on Asset Allocation
When most modern pension systems were established after WWII (pensions existed before that, even Social Security existed since 1935), the typical retirement age was set at 65, but in the U.S. the average male life expectancy was 64 years. A retirement of 5+ years was a nice long end-of-life break for the working man. Of course, that has all changed in the last seventy years and now the average life expectancy is closer to 80 years depending on country of nationality and gender. Now a retirement at 65 must last 15 years. It’s easy to see how all of this has wreaked havoc with pension math. The math is straightforward in its simplest form. The pension liability is driven by the amount of the need and the number of years it is needed. The adequacy of pension assets to support that liability is driven by the amount of assets accumulated over a lifetime of working and then the compounding of that accumulation during the retirement period as it reduces during what is called the decumulation phase as retirement payments are made to support the retiree lifestyle.
A great deal of asset management thought has focused on the asset allocation for pensioners over their pension lifecycle. The common wisdom is that the young can afford more risk and that at the point of retirement the allocation should shift to less risky allocation.As longevity has grown, this old rubric may need to be reevaluated.As an example, in today’s environment and at a 5% compounding or reinvestment rate, a pensioner has only accumulated (from employee contributions, employer contributions and reinvestment to that day) 50% of their retirement income quantum.The other 50% is compounded from the large sum accumulated by retirement age and how it is reinvested until demise, presumably some 15+ years hence on average.What this says is that the most important time to get bang from your pension buck is in the final 15 years of investment.It’s simple financial math, but it surprises most people who haven’t thought much about the span of compounding.
The Passive Management Juggernaut for Pensions
This new math really changes the way in which pensions need to invest (whether defined benefit or defined contribution plans) and that could easily start to affect markets in various ways.With passive management, mostly driven by pension investing, finally equaling and even passing active management, many analysts are voicing great concerns about what some think is a distortion of the markets brought about by passive investing.The biggest concerns are the co-movement impact brought about by indexing such that in times of high volatility, the programmatic, technically driven (as opposed to fundamentally driven) impact exacerbates volatility.
If you hadn’t thought about that before, the market action of the last few weeks should make you ponder it more.John Bogle pushed us all to not get shorn by active managers, but now as the huge passive block moves like a very big flock of sheep, following rather than leading the market, it’s hard to tell the sheep apart anymore.Even John Bogle foresaw the difficulty of managing passive management when and if it ever got “too big.”And that’s exactly where it sits now as the following charts show:
Pensions Heading More Underwater
So, you can see why I worried so much about the global pension crisis in 2013. I wish I could say that we have spent the last seven years addressing the problems and making it all better, but I think it’s fair to say that the opposite has happened. There has certainly been more reality brought into the asset return assumptions of pensions, but the ongoing low level of interest rates has been a double whammy for pensions as many have realized. First there is the underperformance of bond portfolios, but there is also the dramatic increase in the NPV of liabilities in such a low rate environment that has made the funding gap even more severe. Oh, and longevity continuing to extend the retirement liability hasn’t helped either.
As human nature always seems to do, the reaction to falling behind has been increasingly to swing for the fences by increasing the allocation to alternative assets.The combination of hedge funds, private equity (including venture capital) and real estate funds have all been viewed as a solution following in the footsteps of David Swenson (of Yale endowment fame) in finding higher quantum’s of alpha and supposedly lower correlations to help use Modern Portfolio Theory to justify those fence-swinging actions. All this free-for-all has pushed this pension investment issue more and more into the spotlight as the gaps are remaining very dauntingly high.
Just When You Didn’t Think It Could Get Any Worse...
On March 12th, Bloomberg published an article that market professionals had been worrying about as long ago as early 2018 when the market volatility and VIX Crash raised alarms. The article is titled, Risk Parity Trade Made Famous by Ray Dalio Is Now Ringing Alarms by Justina Lee. The telling chart highlighting the pernicious combination of market volatility (let’s face it the only volatility that gets everyone’s attention is that which trends down) and co-movement, not among equities, but between equities and bonds....
So now, in addition to passive management pushing volatility through equity co-movement, it turns out quantitative hedge funds (now managing close to $1 trillion, mostly for pension funds) deploying strategies like the risk parity trade and other forms of relative value trading, have leveraged up their portfolios to juice the returns. All of this is exacerbating volatility in a Perfect Storm sort of way just as we are struggling with the fundamental changes being inflicted on the world economy by the Coronavirus crisis.
What do hedge fund managers do when risk rises as it most certainly has of late? They deleverage.
Deleveraging means selling lots and lots of bonds and moving to safer havens at the shortest duration end of the yield curve possible. As evidence that this deleveraging is more than a casual and business-as-usual event, look at what is happening with the sell-off in gold.Gold, as we all know is the ultimate safe haven asset, but it is also an asset which can be more easily sold in a difficult market (indeed, the storehouse of value benefit it provides) and the fact that it is going through a sell-off shows us how far this deleveraging push has taken us.The next time you wonder where all the restaurant waiters are going to work, also think about where all the quantitative strategy hedge fund staffers are going to work now that the Coronavirus-induced volatility has undermined their sugar-daddy trades.
Conclusions
I have now seen several things about the Coronavirus that have made me ponder how this new crisis will affect my pet pension crisis. One thing that’s hard to ignore is the way the virus has far greater malevolent impact on the aging population. Nature attacking longevity that gets too big for its britches seems to be the tale being told. But then rates, which were starting to tick up, have been slammed down again by Central Bank intervention, so there goes any liability relief for pensions. But now with equities going into serious bear market territory we are in triple whammy zone as asset levels give back all their recent improvement as liabilities rise and bonds look horrible and too choppy to play hero with.
The demographics of decumulation won’t help either as pensioners start to draw down their IRA’s and 401(k). As for the defined benefit pensions, I’ve already seen the suggestion that DOL grant some relief for damaged companies to defer their pension contributions. That’s certainly not going to help the underfunding problem.
The Pension crisis is a long-term crisis that used to have time on its side. That is no longer so true, as the Baby Boomer cohort gets into the retirement stage of life. Nevertheless, it clearly must take a backseat to the Coronavirus economic crisis that is unfolding before our eyes. I fear that the pension crisis will go the way of the aged virus sufferers that get triaged behind the younger afflicted patients. What becomes clear and will be reinforced in this time of excessive crises, is that nature always favors the young (as perhaps it is supposed to) and that means that there will be lots of pensioners feeling betrayed and forgotten. They will see cuts in benefits (whether Social Security of other state or municipal pensions) and reduced medical care facilities dedicated to them rather than the young and vital.
None of this is a happy message, but I am reminded that I taught ten years of MBA students that nothing would rule their lives and their prosperity more than the global pension crisis.While there is still truth to that observation, I failed to realize that another, more dramatic crisis might step in front of the pension crisis and now it is clear that is exactly what has happened.Let’s hope that in crisis calculations 1+1 equals something less than 2.
Richard Marin, as a former finance senior executive with over 40 years of industry experience, and as a former clinical professor at Cornell University is a world-class testifying expert in asset management, alternative investments, private equity investments, securities lending, retirement and pensions, and real estate/project financing.
He was a senior executive at three major financial institutions; Bankers Trust Company, Deutsche Bank and Bear Stearns. His initial career spanned corporate finance, sales and trading, structured products, emerging markets, processing, and several other disciplines.