How Gold Can Rescue Pensions

by Alasdair Macleod, GoldMoney:

The World Economic Forum, in conjunction with Mercers (the actuaries) recently estimated that the combined pension deficit currently stands at $66.9tr for eight countries, rising to $427.8tr in 2050. The eight countries are Australia, Canada, China, India, Japan, Netherlands, UK and US. Of the 2016 figure, $50.5tr is unfunded government and public employee pension promises.

Yes, we are now talking in hundreds of trillions. Other welfare-providing states missing from the list have deficits that are additional to these estimates.i

$66.9tr is roughly 1.5 times the GDP of the eight countries combined, and $427.8tr is nearly ten times. Furthermore, if we take out the non-productive government element, the figures relative to the private sector tax-paying base are closer to twice productive GDP today, and thirteen times greater in 2050. That 2050 deficit assumes a 5% compound annual growth rate. This is a linear projection, but the deterioration in finances for unfunded government pensions may turn out to be exponential, in line with the accelerated increase in the broad money quantity since the great financial crisis.

The problem is mainly in the welfare states, so we know that the welfare states are in big trouble. Governments routinely offer inflation-protected pensions to state employees, funded out of current taxation. The planners in government treasury departments are coming alive to the scale of the problem, though the politicians would rather ignore it. Government finances are already being subverted by both unfunded pension obligations, and by additional rising healthcare costs for aging populations.

Furthermore, people are living longer. Someone born in Japan ten years ago who retires at 60 can expect to live to 107, leaving the state picking up a forty-seven-year welfare and pensions bill. And it’s not much less expensive in other countries, with 50% of North American and European babies born in 2007 expected to live to 103.

The global dependency ratio, those in work relative to those in retirement, is expected to deteriorate from 8:1 to 4:1 by 2050. When most people retire, they stop paying income tax and become a burden on the state welfare system. Therefore, retirement ages must rise. Not only must they rise, but they must rise by enough to pay for those who are otherwise fit but mentally incapacitated by dementia, Alzheimer’s and Parkinson’s, set to spend the last decades of their lives expensively kept.

That is the background to a global problem. But we shall just say “poor taxpayers”, and move on. Instead, this article focuses not on the problems of funding state pensions (which is admittedly 75% of the problem), but is an overview on why the current low growth, low interest rate environment is so detrimental to private sector pensions.

Forty years’ servitude, and what do you get?

In the last millennium, one of the benefits of working for a company was a company pension scheme. There were intended to garner enough savings during their working lives for employees to retire on up to 70% of final salary. Nearly all but the smaller companies offered a pension scheme, of this defined benefit type. Since then, many of these schemes have been replaced by defined contribution schemes. Both types of pension are based on how much you and the company have contributed. Where possible, defined benefit pensions are being wound up, because mounting deficits on these pensions can threaten the survival of the contributing companies, and are being replaced by defined contribution schemes, where any shortfall merely reduces the pensioner’s pension.

Irrespective of whether a pension scheme is a defined benefit or defined contribution scheme, this system of saving for retirement is failing. Besides rising life expectancy, the principal variables that affect a pension’s benefits are how well the pension’s investments perform, and the ability of the funds in the pension plan to cover the pension payments over the expected lifespan of the retirees. Investment returns are forecast based on current bond yields for government securities, and a long-run assessment of equity markets, including dividends.

This gives rise a problem, brought about by central bank interest rate policies. By suppressing interest rates and bond yields, central banks force pension trustees to increase their estimates of the amount of capital required to cover pension payment streams over the expected life of the pensioners. For example, let us assume a pension fund has an income from its investments of 5% and has no deficit. If that income is slashed to 2 ½ per cent, the income falls by 50%. Simple arithmetic tells us the amount of capital required to maintain the original payment stream doubles.

In practice, the calculation is much more complicated, but clearly, current interest rate policies are giving rise to substantial actuarial shortfalls. Another source of deficits is lower than expected investment returns on the inflation hedges that are expected to benefit from artificially cheapened money. These are principally listed equities, and unlisted property.

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