Central Banks Will Kill Your Pension

Economic analysis by Filipe R. Costa

While US investors are happily swapping their artificially-inflated holdings of US equities for their high-flying European counterparts; the European peripheral governments applaud the ECB’s 1.1 trillion euro asset purchase plans as they see their booming debts being sold at ever lower prices; and while the equity market rally is heading towards its seventh birthday completely reversing – and more – the epic losses of the sub-prime crisis, it seems there is at least one group that has no reasons to be that happy.

I’m referring to all of us that are part of the active population and expect to retire some day with an income. Starting in the 1990s, central banks have been so exceptionally competent in fighting inflation that they brought us into a world of deflation, negative interest rates, very low government bond yields, and with it, killed our pension plans. If the current scenario persists, most pension funds will be bankrupt in a matter of years, leaving us only two alternatives for our retirement: 1) accept a large reduction in living standards upon retirement; or 2) keep working until our final days.

Central Banks Have Sight…

When I have a health problem, I prefer treating it with the help of a GP whenever possible instead of using the services of a specialist. A specialist may indeed be better prepared at tackling the problem, but the GP is almost always a better evaluator of general health. Treating your specific problem is a top priority for a specialist, but for a GP it always involves weighing the effects of treatment against your overall health.

Central bankers are specialist practitioners. While they may possess the best expertise and the highest skills in monetary issues (in particular those that are directly related to inflation), they tend to ignore the broader picture under which their applied solutions will take effect. They are so committed to fighting inflation that they may be tempted to use their most powerful medicine just to tackle the mildest of the problems. In doing that, they’re ignoring not only short-term qualitative changes in the economy (not least through wealth redistribution) but also the long-term damage that may be wrought. Abusing a strong medicine may damage the patient’s long-term health. Today’s cure is tomorrow’s disease.

…But Not Always Vision

To tackle a problem of below-par price rises (not even a deflation problem), the ECB announced a massive asset-purchase programme worth more than 1 trillion euros which, no matter how successful it may be, has already cracked the yields on government debt around Europe and is contributing to what could be the worst problem Europe will face in the near future – the death of pension funds.

Pension Funds Are Changing

In managing the retirement savings of working people, pension funds and life insurers take the broader role of effectively mobilising savings from those who have them in excess to those who need them to invest in the real economy. With a long-term vision, pension funds provide long-term financing for the real economy and act as a counter-cyclical force which helps to stabilise the economy, minimise financial market volatility, reduce systemic risk, and help markets achieve an efficient outcome.

Investing in equities is risky, as the short-term volatility for this asset class is usually much higher than for other asset classes like fixed income, for example. But when we move the investment horizon to the long-term, equity volatility is drastically reduced. As most pension schemes target an investment horizon near 30 years, pension funds can very well hold equities while minimising risk due to their investment horizon.

Just look at the above chart depicting the evolution of the S&P 500 over two time-intervals. Let’s say you had invested in equities in 2007 or 2008. Due to the sub-prime crisis, you would soon be in deep red numbers, just to recover later. Even if you had kept your investment for a sufficient number of years to reverse the losses, the volatility faced in this relatively short period would have been huge (left side of chart). But consider now an investment over a very large period. The S&P 500 rose 2,900% during the last 53 years, showing a compound annualised rate of return of 6.6% (right side of chart). Volatility for the whole period is relatively low when compared with the same for the period described above. Through increasing the time interval, pension funds are able to capture equity returns while smoothing the negative effects of volatility. So, even under a low risk profile, pension funds can engage in equity investments without being hit as hard as other investment vehicles that need to deliver results in a shorter time interval.

A recent discussion paper by the Bank of England and the Procyclicality Working Group concludes that pension funds are changing and no longer delivering a counter-cyclical cushion to the market. They’re no longer targeting the long-term, as the pressure for short-term results is increasing. During the last 30 years, pension funds have been changing their attitude towards investment. They now add equities to their portfolio when everybody else is buying and slash them when panic infuses the market, which means they now act pro-cyclically, further contributing to increased market volatility. Pension funds are becoming ever more short-term in nature. In doing so, they cease to be mobilisers of long-term financing to the economy and fail to maximise the retirement funds of policyholders.

Over the last few years, several changes were made to the regulation, valuation, and accounting principles applied to pension funds, all of which negatively impacted the longer-term perspective pension funds used to adopt. While marking investments to market is a good way of achieving more transparency on a company’s balance sheet, it is also a significant pressure for pension fund management. Just imagine you buy a house that you plan to hold for the next 30 years and the government requires you to mark its value to its market value, forcing you to recognise any gains or losses at every quarter or half year. When the market value rises you record a gain and pay taxes on it (even without effectively having sold it), and whenever it decreases you record a loss. Such treatment would increase volatility and distort the longer-term goal. In the case of defined benefit schemes, companies holding the pension funds must rebalance their assets for changes in liabilities (which depend upon interest rates). Being part of their balance sheet, the pension schemes will have quite an impact on financial reporting under mark-to-market rules, which press for short-term results.

Under the current scenario of ever decreasing (and already low) interest rates, companies have been experiencing a huge increase in pension liabilities, leading to large imbalances in their pension schemes. So, the focus has now turned to asset and liability matching instead of maximising future retirement income. A mix of legal changes and “monetary policy effectiveness” (lowering interest rates and thus increasing liabilities) led to massive de-risking. Pension funds have been increasing their exposure to UK Gilts and decreasing overall exposure to the equity market over the years.

Life and pension funds currently manage around £3 trillion in the UK. Due to the decreasing discount rate (as a result of lower interest rates), it is estimated that there is a deficit of £367.5 billion between assets and liabilities. The persistent low yields are forcing companies to reinvest at ever-lower yields. For companies with defined benefit plans, the future may be dark, as they promised very generous annual returns to policyholders but are recording loss after loss. With the recent QE announcement made by the ECB and the wave of destruction that came with it in terms of forcing many central banks into adopting negative interest rates, pension funds will be forced either into bankruptcy or freezing pensionable salaries, capping future pension income, increasing retirement ages, and eventually closing plans to new and existing members.

Alternatively, pension funds can be tempted by a world of opportunities presented by emerging market debt, infrastructure bonds, private equity, and direct corporate loans to achieve a higher yield. But such behaviour may be desperate in essence and thus not desirable. At the same time, it will entice pension funds to increase risk exposure when everybody else does the same while decreasing when there is panic, which is a pro-cyclical behaviour, contributing to the feedback trading that has been forcing us from financial crisis to financial crisis for the last few decades.