Commentary on Political Economy

Wednesday, 2 December 2020


There's a Toxic Cloud Behind the Stock Recovery

Rising share prices haven’t helped to alleviate the looming pension crisis.

Every silver lining has a cloud.
Every silver lining has a cloud. Photographer: RapidEye/E+/Getty Images

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Bad News for Pensions

Every silver lining has a cloud. Stock markets’ recovery since March has been prodigious. Now the notion of a reflationary 2021 is turning into a new orthodoxy. But the combination of events in the last few months has been toxic for some of the crucial building blocks of the financial system that was already in trouble — pensions. 

Retirement plans lean on equities in large part to build their assets. But their liabilities, the guaranteed incomes they have promised their members, depend on bonds. The higher the yield they pay, the cheaper it will be to guarantee any given income by buying bonds. This logic applies with only slightly less force to “defined contribution” plans where retirees have no guarantees — higher bond yields will make it far easier for them to turn any given lump sum into an income. 

That leads to the problem for pensions. Reflationary ideas are afoot, and inflation expectations for the next 10 years, as derived from the Treasury market, are their highest in over a year. Normally, higher expected inflation would help to push up the nominal yields payable on fixed-income securities. But that is only happening to a very limited extent. While breakevens are back to their norm of the last five years, nominal yields remain a step change lower:

Sharply rising breakevens are matched by small move in nominal yields

That means that real yields remain punishingly low, and largely negative. In the U.K., real yields (those paid on index-linked gilts) have been outright negative since before the Brexit referendum. Yields on German index-linked bunds are higher but also unremittingly negative, and this year U.S. inflation-linked Treasuries, or TIPS, have joined them:

Inflation-linked bond yields have risen only slightly since March

This is a horrible combination for anyone trying to run a pension plan. What follows is the estimate by Mercer of the funded status of the corporate defined benefit pension plans run by companies of the S&P 1500 — it shows the the value of assets as a percentage of the value of liabilities (the cost of buying the guaranteed income). By Mercer’s calculations, these pensions have been in deficit ever since the early days of the credit crisis in 2008, and this year’s rally has left them with assets of $2.17 trillion, still far short of their $2.6 trillion in liabilities. November’s historically strong stock market only succeeded in reducing this deficit by one percentage point, because at the same time the companies suffered a fall in the discount rate:

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Bear in mind that, apart from the first and last years on this chart, these dreadful deficits formed over a decade-long period when a bull market raged almost uninterrupted. Rising share prices, and asset price inflation, don’t help put together a pension.

Mercer conducts a similar exercise for the U.K., where deficits are less severe thanks to a longstanding emphasis by regulators on “liability-matching,” which effectively forced managers to build up bond holdings to be sure of being able to pay guarantees. Even so, FTSE-350 company pension plans have slipped into deficit over the last two years:

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Part of the problem is low nominal government bond yields. But a further issue as the year drags on has been the remarkable support that central banks, led by the Federal Reserve, are giving to corporate credit. Pension liabilities are typically calculated using high-quality corporate yields as a benchmark. A sharp rise in corporate spreads in March ironically helped pensions by sharply increasing their discount rates. Since then, they have done nothing but tighten, creating a “double whammy” for pension managers. This chart shows how the Moody’s index for AA-rated U.S. corporate debt has performed compared to the 30-year Treasury yield:

After March's spike, quality corporate credit spreads are as tight as ever

With solvency issues now apparently behind them, many investors are prepared to bid corporate yields ever lower in their hunt for yield, given the minuscule payouts available on government debt. In these conditions, the winds are set very unfair for pension funds. 

That is leading to a crisis of confidence. To see how deep that crisis is, it is necessary only to read the latest annual report on the pension fund sector produced by CREATE-Research of the U.K. and sponsored by Amundi SA. This research, run by the British academic economist Amin Rajan, has been going on for two decades now, and involves regular intensive interviews with a range of the most powerful pension fund managers from across the world. This year, 1,458 managers from 17 countries responsible for more than $2 trillion in assets were questioned. These are the people in overall charge of asset allocation, rather than the fund managers who are entrusted with chunks of their portfolios, and their views can be surprisingly different from others in the pension sausage-making machine. 

Most alarming is this chart, which summarizes what managers expect to have to do to stay viable in the wake of the pandemic. Almost half are going to ask for more of a contribution from their sponsors (many of whom are in the public sector and are seriously hurt); about a third intend to reduce retirement benefits (even though these are hard-wired into workers’ contracts of employment); and 30% are planning to switch from defined benefit to defined contribution, which entails giving up on offering a guarantee and leaving pensioners to shoulder the risk:

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Pension fund issues are deep-seated and build up over time. As Rajan puts it:

Sponsors want to reduce the benefits simply because they don’t have the cash. But this is nothing new. It’s been built up for the last 10 years, and politicians have been kicking the can into the tall grass. It should have been addressed about the middle of the last decade when it was becoming clear that rates would stay lower for longer. 

However, the pandemic has added a fresh element to the managers’ despair. Now they think that inflation will at last come unanchored and increase. The world has been braced for such a development for a decade. CREATE-Research’s respondents seem convinced that it is at last going to happen. By big majorities, they see inflation taking over after the crisis, central banks losing their power and independence, and asset returns diving:

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Pension managers are also braced for a return to governmental intervention in place of free markets, and (with only slightly less conviction), the return of nationalism and a sharp switch toward redistributive policies:

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That they are so convinced of a leftward and corporatist shift in the world probably owes something to knowledge of their own economics. Defined benefit plans have government “lifeboat” funds in both the U.S. and the U.K., and those lifeboats are likely to be overburdened within a few years. That will leave governments with two invidious choices; either let pension plans go under, and hence allow companies to renege on promises made to their workers, or come up with yet more money from taxpayers to pay them. The latter involves yet another example of switching money away from the young and toward the old. Inter-generational conflict looks ever more likely as people growing up without a realistic chance of even buying their own home or providing a pension for themselves watch an older cohort retire in comfort. From the point of view of pension fund managers, it seems obvious that the market won’t be allowed to make these decisions, and that the government will have to intervene. As Rajan puts it:

This populism really, really worries pension plans. It’s very easy to harvest resentment in the general population. Doing something about it is quite another matter, and this generation of populist politicians haven’t been able to find a solution. It’s a journey into the unknown.

The problem with the pension crisis, as with climate change, is that it isn’t urgent. These issues unfold over a very long time, and it is always possible to say that there is no harm in waiting another day before acting. Meanwhile, pressing issues, such as the crises of 1998 and 2020, demand an immediate response and get one — which by lowering bond yields only serves to make the pension crunch, with all its implications for social cohesion, that much more intractable. 

What do pension funds plan to do in the next few years? The league table of the assets they find most interesting follows:

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The confidence in a broadly reflationary move that sees a rotation out of the U.S. and bonds and into equities seems very high — and does at least imply some decent hope that discount rates will rise. Pension managers intend to pour money into global stocks, infrastructure, private equity, and a range of long-term debt. They don’t seem at all convinced about gold, most aren’t allowed to invest in cryptocurrencies even if they wanted to, and, most spectacularly, they have no interest whatsoever in hedge funds. Only 4% say they are interested in total return investments, even though hedge funds bill themselves as the ideal alternative to generate gains in these challenging conditions. This varies by region, with Europeans now adamantly turned against hedge funds, which they feel have failed to deliver on their promise of uncorrelated absolute returns. They have lost patience after a decade in which they would have been far better off in simple vanilla index funds. 

In the U.S., where pension managers went into hedge funds earlier, largely thanks to the influence of the large university endowments (which had great success with them in the decade before the global financial crisis), there is still slightly more willingness to give them the benefit of the doubt. 

There is one other surprising development in the survey: Pension managers turn out to be enthusiastic about ESG investing. Many are under pressure from trustees. And many believe — according to Rajan — that the shareholder model of capitalism is probably coming to an end, to be replaced by a stakeholder model. Many believed that if they were in the business of offering pensions, they also needed to be in the business of helping to maintain sustainable climates and societies into the future.

To be clear, I find this surprising, as does Rajan, who is as respected an observer of the sector as any. There appears to be a shift in psychology driven by the horrors of the last year, and plan sponsors’ understanding of the intractable pension crisis that awaits in future. These people are practical and it is unwise to put an ideological label on the problem. Many think the current model of capitalism is unworkable and that something more statist will come, but they are abandoning hope because they think markets have already been hopelessly distorted by government intervention.

This all sounds very miserable, no doubt. But it is logical. The response to the market crises of the last 20 years has been cheap money, and this has worked for many parts of the economy. The one significant sector that is harmed ever more seriously by lower rates is the one where, by its nature, the problems will take the longest to emerge. That is the cloud behind the resurgent reflation hopes and continued low bond yields of today.

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