Many will be disappointed by what their pensions pay out © Peter Dazeley
There is something afoot in the developed world: the growth in population that began when the industrial revolution released us from a Malthusian era of agricultural dependence and famine is coming to an end. This is already visible in Japan and in parts of Europe, where the population is shrinking. At the same time the world’s rich are living longer. Projections by the United Nations suggest that the proportion of the European population aged 60 and above will rise from around 15 per cent now to 27 per cent in 2050.
Increasing longevity in the rich world ought to be a matter for rejoicing. Instead it has unleashed deep concern about the affordability of pensions and the welfare state. This is because welfare systems have much in common with Ponzi schemes—fraudulent investment operations that require an ever-increasing flow of money from new investors to fulfil generous promises made to existing investors. With pay-as-you-go state pensions it has been easy for European politicians to promise excessive retirement incomes when huge contributions were coming in from large working populations and little was going out to much smaller retired populations. Until now the stability of private sector financial institutions such as defined benefit pension schemes and life assurance companies has also been underpinned by a steady supply of young new entrants.
Today the tables are turned. Retired populations are set to grow and working age populations to shrink. So a moment of truth is approaching. Public sector debt in the US, Japan, the UK and much of continental Europe is unsustainable, giving rise to fears that governments will default on state pension obligations. In the private sector most defined benefit pensions schemes have been closed to new entrants. The pensions paid out by defined contribution, or money purchase, schemes will for most people be disappointing. The question is whether there is a neat economic escape route from this bind.
The globalisation of capital flows ought to provide a potential solution. According to economic theory, rates of return should be higher in poor countries than in rich ones. Capital might therefore be expected to flow from rich to poor countries to take advantage of these differences in returns and prompt a higher level of investment than the domestic savings of poorer countries would naturally permit. Developed world pensions could thus be bolstered by the high return on investments in emerging markets.
But as the American essayist HL Mencken remarked, for every problem there is a solution that is neat, plausible and wrong. What is wrong here is that capital does not obey the economic theory. While recent research by Goldman Sachs supports the idea that rates of return are higher in low income, fast growing economies, it also shows that private sector capital flows are largely unresponsive to return differentials. That tallies with what we know about the behaviour of emerging market economies over the past 40 years. If we look at Asia, growth has been financed less by foreign capital inflows than by domestic savings. And because savings in China and the Tiger economies exceed investment, these excess savings flow uphill, in effect, from the poor to the rich.
The implausibility of the globalisation solution and an important aspect of the challenge for pension provision in the west can best be understood by looking at China. The national savings rate in China, which includes the savings of the public and corporate sectors as well as households, has been running at a phenomenally high level of more than 50 per cent, up from around 38 per cent 10 years ago. The average savings rate of urban households relative to their disposable incomes rose from 18 per cent in 1995 to nearly 29 per cent in 2009. In part this reflects the high proportion of the population in what Goldman Sachs calls the “prime saving” age of 35-69 years old. But given China’s high rate of growth, which would naturally encourage people to anticipate higher income and thus to save less, and given the negative real return on bank deposits in China, this increase in savings seems counter-intuitive. What it reflects is a strong precautionary motive. Declining public provision of education and healthcare along with the privatisation of much of the housing market—the breaking up of “the iron rice bowl”—has forced people to save more, as has the pension reform of 1997, which reduced entitlements. Since China’s overall savings exceed domestic investment, they contribute to the global savings glut. This helps depress real interest rates while accommodating chronic over-consumption and debt accumulation in much of the developed world.
The naivety of assuming that the Chinese might help with western pensions has recently been demonstrated by a rash of accounting and corporate governance scandals surrounding the many Chinese company flotations in the US and Canada. Several cases of fraud clearly demonstrated that many Chinese entrepreneurs regarded western investors as targets for looting—a high degree of financial interdependence cannot work without trust. It also requires solid property rights in the country receiving the capital inflows. China is a low-trust society, deficient in property rights, which anyway has demographic problems of its own. It is ageing faster than any society has done at such an early stage of development and the demographic strain is exacerbated by Beijing’s lunatic one-child policy.
The most helpful thing that China and other Asian markets could do for the west in their own interest is shift their economies away from investment towards consumption, which would mitigate global imbalances. Yet this re-balancing is happening at snail’s pace and it seems probable that demographic pressure will continue to generate increases globally in savings relative to investment. Against the background of asset purchase programmes by the developed world’s central banks, that suggests real interest rates may remain at historically low levels, even if they have now ceased to fall. While this helpfully reduces the servicing cost of government debt, it is bad news for private sector defined benefit pension schemes. The lower the interest rate applied in discounting pension liabilities, the higher the present value of the bill for future pensions. The return on fixed interest bonds, which is what pension funds invest in when they have a growing number of pensioners, is negative in real terms, while at today’s prices index-linked gilts offer inflation protection at the cost of a certain real loss on the investment.
Meantime, the cost of increasing longevity is becoming a more pressing concern, not least because it has been consistently underestimated by statisticians. David Blake, director of the Pensions Institute at Cass Business School, has pointed out that in 1981 the UK Office for National Statistics estimated that male life expectancy at birth would rise to 74 by 2031, but it hit that in 1994. In 1991 the estimate rose to 77 by 2031, but it reached that mark in 2007. In 2002, the 2031 estimate was 81 but that is now expected to be passed in 2019. This, says Blake, reflects political pressure designed to ensure that the full cost of longevity increases does not fall on the current generation of either politicians or voters. He worries that there is a recipe here for inter-generational conflict.
Those who stand to be hardest hit by all this are members of defined contribution schemes in which members build up an individual nest egg. This is a poor investment because it lacks any benefit from pooling longevity and investment risk. If markets are depressed at the time of retirement, smaller pensions result. And while there are ways of reducing market risk, none are perfect. The really invidious feature is that most contributors to these schemes are engaged in “lifestyle” approaches to investment, whereby money is automatically switched from riskier investments such as equities into lower risk bonds, as retirement approaches. For those whose money is being switched now, the outlook is dismal since bond prices are wildly over-priced. And on retirement, annuities offer hopeless value for the same reason.
For defined benefit schemes this bond bubble hurts less. The trustees can look to alternative asset categories with reasonably inflation-proof income streams such as infrastructure investment or inflation linked property leases. Yet many have felt obliged to defer plans to move their portfolio from equities into bonds. Even so, the return on quoted equities has been poor over the past 10 years and not because the corporate sector has been doing badly. The structure of global capital flows has been singularly unhelpful.
The huge excess savings of surplus countries such as China have been substantially recycled to deficit countries via official reserves invested mainly in government debt. So global imbalances are bad for equities. The fact that the developed world’s pension funds have more retirees also means that their investment preferences have shifted away from equities to bonds. The size of governmental funding requirements results, too, in regulatory encouragement for bond buying by institutional investors and banks. And the tax system discriminates against equities relative to corporate bonds, on which interest is tax allowable. The outcome is that equity markets are less effective in raising capital, as well as offering unattractive returns.
It is possible to be too pessimistic. We are not talking of a return to 1930s-style soup queues. From a government perspective much of the demographic strain can be reduced by politically acceptable forms of default such as linking retirement ages to longevity. As longevity increases, benefits are reduced. People respond by working longer, which produces additional pension contributions, extra investment returns on accrued pension capital and shorter retirement periods. Some governments have chosen instead to follow companies in shifting longevity risk onto individuals via mandatory defined contribution schemes. Either way, in a debt constrained developed world there is a great deal of pensioner disappointment ahead.