Sep 3, 20195 min
The Atlantic recently had an excellent article warning that The Next Recession Will Destroy Millennials. The author is absolutely correct. Millennials are in for a tough time as they have little to no savings. However, boomers are unlikely to fare very well in the next recession either – in fact, they might even be worse off than millennials. Boomers are in trouble because it’s almost a certainty that pension funds are going to be absolutely wrecked in any future recession.
Low Interest Rates
The main problem for pension funds is interest rates. Since the Great Recession, interest rates have fallen to historic lows. The U.S. 30-year bond is now offering the lowest interest rate in its history after falling below 2%. And America stands apart from the developed world with the highest interest rates on government debt. The bonds of many other countries have actually gone negative, with lenders paying for the privilege of lending to governments for years. Many analysts say it’s only a matter of time before U.S. rates go negative as well.
The wave of ultra-low interest rates we’ve seen in the wake of the Great Recession have slowed growth, created zombie companies, and contributed to a worrying rise in corporate debt that might well be the spark for the next recession. However, falling interest rates have also changed the allocation of pension funds over the decades - a shift that has not received the attention it deserves.
Low interest rates have forced pension funds to take on riskier assets to maintain yields. Even well-funded funds have increased their risk by shifting into equities, and many pension funds are now both underfunded and invested in risky assets.
Back in 1962, pension funds projected an average annual return of 8% and the yield on long-term bonds was much higher than it was today. A pension fund could put all of their money in extremely safe assets and meet their projections. And that’s exactly what they did. In 1962, roughly 95% of pension fund assets were in fixed-income securities and cash. Today, the average pension fund projects an annual return of 7.6%, while the 30-year treasury rate has fallen from 7.7% in 1977 to just 1.963% today.
In order to meet the returns required for future pension costs, public pension funds have thus been pushed into equities and other riskier assets. In 1992 just over half their allocation was still in fixed income. As of 2012, only 25% of public pension fund assets were allocated in fixed-income assets or cash - with the remaining 75% in equities and other higher yield alternatives. According to a recent report from the PEW charitable trust:
In a bid to boost investment returns, public pension plans in the past several decades have shifted funds away from fixed-income investments such as government and high-quality corporate bonds. During the 1980s and 1990s, plans significantly increased their reliance on stocks, also known as equities. And during the past decade, funds have increasingly turned to alternative investments such as private equity, hedge funds, real estate, and commodities to achieve their target investment returns.
The report goes on to say that because of this shift towards riskier assets “Public pension systems may be more vulnerable to an economic downturn than they have ever been.” And this was from six years ago, when interest rates were much higher. Today the famously conservative central bank of Germany is talking about negative interest mortgages.
Accounting for Risk in Public Pension Funds
There is one other key reason that public pension funds have transitioned into riskier assets.
States have passed laws exempting state government pension plans from the standards that private pension plans are held to. These public pension plans are permitted to use generous assumptions about risk that are not permitted in the private sector. So, while public pensions have moved into objectively riskier assets, they haven’t been forced to account for that risk.
According to a 2018 report, if public sector pension plans were held to the same standards as the private sector, even with their own extremely optimistic estimates, only Wisconsin’s would be considered stable. To quote the report:
However, the Pension Protection Act does not apply to public sector DB pension plans. Using the states’ own estimates of their liabilities and assets, 32 states are at risk of default by private sector standards. If the Pension Protection Act were applied to the public sector and states had to use a similar discount rate as the private sector, about 4.5 percent, only Wisconsin’s pension system has enough assets to be considered stable.
And this is not a controversial point – an overwhelming majoring of leading economists agree that the government accounting standards used by U.S. state and local governments understate their pension liabilities and the true cost of future pensions. A recent estimation from 2018 calculates that “Unfunded liabilities of state-administered pension plans, using a proper, risk-free discount rate, now total over $5.96 trillion. The average state pension plan is funded at a mere 35 percent.”
Pensions Never Fully Recovered From The Great Recession
It’s true that in addition to now being invested in risky assets, pensions are largely underfunded. Much of this stems from losses incurred during the Great Recession. Reuters reported in 2018 that:
Ten years on from the financial crisis, many U.S. state and local public pension systems are still the worse for wear. Investment returns have been uneven and funding levels have yet to recover. Many pension funds have meanwhile attempted to boost returns by loading up on alternative investments to levels unheard of a decade earlier. “Some just cannot grow their way out of it. We have had several years of stellar (stock market) returns and it barely improved the underfunding situation.”
Out of Time
Today the youngest baby boomers are around 55 years old. The oldest are in their 70s. We have really just started the beginning of the boomer retirement wave which will continue for another decade or so. If we assume that baby boomers retire at 65, the peak retirement year will be 2022. There will be no time for boomers to recoup from their losses from any future recession.
In a recession, all of the losses pension funds would see – especially from the public pension funds – are likely to fall on the states just as tax revenues collapse in the recessionary environment. This is one more reason that The Next Recession (Whenever It Comes) Will Be About Sovereign Debt.
Sleeping on a Volcano: The Worldwide Demographic Upheaval and the Economic and Geopolitical Implications Makes the case the sovereign debt is unsustainable in an aging world. The book takes into account not only the rapidly changing and uncharted waters of the global economy under unconventional monetary policy, but also the longer demographic and geopolitical trends which have already begun to shift.
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About the Author Joshua Konstantinos Founder and Global Macro Strategist at Cassandra Capital LLC and author of Sleeping on A Volcano: The Worldwide Demographic Upheaval and the Economic and Geopolitical Implications, Joshua has been obsessively following global trends and collecting data for over a decade. His analysis takes into account not only the larger view of the rapidly changing global economy but also the longer demographic and geopolitical trends.