A Cup of Sake Suggests Bond Yields Should Be 12%
Reaching your 100th birthday in Japan is marked with a silver sake cup, courtesy of the prime minister. But with almost 32,000 people reaching that milestone this year, the government has downgraded the cup to silver plate from sterling silver, halving the cost of the gift. That parsimony is a stark reminder of how a combination of demographics and financial market shifts threaten to make retirement a lot less comfortable around the world for those who can afford it. Many more won't be able to until well into old age.
The current central bank enthusiasm for ultra-low interest rates in many parts of the world is wreaking havoc in pension funds. On an accounting basis, lower yields today lead to higher pension-deficit calculations for the future. On a real-world basis, finding investments that deliver sufficient returns to pay pensions becomes harder.
As the working population ages, more money gets put away, which in turn also helps drive yields lower. Pension funds among countries in the Organization for Economic Cooperation and Development, for example, have reached a record $25 trillion.
"There are a lot of very negative feedback loops," Credit Suisse Chief Executive Officer Tidjane Thiam told the audience at the Bloomberg Markets Most Influential Summit in London this week. "There's been a glut of savings that impact real interest rates. You can't make any money on the assets, and the liabilities explode. People born in 1968 and the following 15 years will have an enormous pension deficit because they've made nothing on their assets."
Germany has just borrowed 3 billion euros ($3.4 billion) that it will repay in September 2018 at the lowest borrowing cost it has ever achieved for two-year money. Investors bid for almost twice as many bonds as were sold; the successful buyers will pay out 0.7 percent during the life of the investment. This is what negative yields, courtesy of the European Central Bank and its peers, are doing to the bond market.
And pity the Swiss pension funds trying to invest their customers' money to safeguard their retirements. The Swiss central bank has driven its benchmark interest rate down to -0.75 percent. As a consequence, no matter how long you're willing to lend money to the Swiss government for, you cannot make a return:
"As a Swiss pension fund you can choose whether you lock in a small loss for a long time or a big loss for a short time," UBS Chairman Axel Weber said at the Bloomberg summit. "That's not a choice. There are very negative demographic developments. I've never seen an economy grow when the labor force is shrinking."
So that's what's happening on the asset side of the pension equation. On the liabilities side, demographics, specifically the shifting balance between more retirees and fewer working-age taxpayers, is worsening the mismatch between how future pension liabilities will grow and how big and profitable the pool of assets to meet those obligations will be.
Japan, for example, has more than 65,000 centenarians; in 1963, the number was just 153. Here's how retirement populations have swollen in Japan and Germany, the countries with the two lowest birth rates in the world:
The U.S. has a pension deficit that could be as high as $3.4 trillion. The funding level for the California Public Employees’ Retirement System, the biggest pension fund in the U.S., has fallen to to 68 percent of the money needed to meet commitments, down from 76 percent two years ago.
Stress tests earlier this year suggested that pension schemes across the European Union face a combined funding shortfall of at least $490 billion euros, which could rise to more than $860 billion if the region suffered a financial shock that drove interest rates lower and stoked inflation.
Jim Leaviss, who helps oversee about $374 billion at M&G Investments in London, argues that the world demographic picture suggests bond yields should be much, much higher than they are. In the past, projecting population changes gave you a good guide to what economic growth would do, how labor-market supply would affect wage demand and inflation, and how demographics would affect production versus consumption of goods and services.
Those economic indicators in turn told you where bond yields would likely settle. Using that model, Leaviss says the 30-year U.K. gilt yield, for example, should be closer to 12 percent than the 1.4 percent the government currently pays to borrow for three decades, with U.S. Treasuries similarly mispriced:
A combination of globalization of production, central bank interest-rate policies, technological advances and people working past traditional retirement ages have destroyed that predictive power, according to Leaviss.
The overall result of the current environment for bond yields and interest rates is that the world's bond markets aren't generating sufficient interest to keep pace with the global pension pot's liabilities. "Virtually no pension fund in the world has enough long-term assets," former Deutsche Bank Chief Executive Officer Anshu Jain said this week, sharing the stage with Weber at the Bloomberg event. "Keep rates where we are and I think we'll have real problem with the pension funds."
The backdrop also poses the risk that pension funds managers, typically among the most cautious of investors, will take on unwanted risks in an effort to boost returns. The OECD highlighted this risk in its 2015 report on the retirement- funding industry:
The current environment of low growth, low inflation, and low interest rates poses serious challenges to pension systems. Pension funds may become involved in an excessive 'search for yield' in trying to secure explicit or implicit benefit promises by increasing the risk-profile of their portfolio. The concern is that, as pension funds move into riskier investments, they may be seriously compromising their solvency situation (for defined benefit plans) and their capacity to deliver adequate retirement income (for defined contribution plans) in the event of a negative shock in financial markets.
Central bankers aren't blind to the impact their unconventional interest-rate policies are having on the pensions industry, or indeed on the banking sector. But, as Bank of England Deputy Governor Minouche Shafik told the same Bloomberg audience this week, their overriding goal is financial stability. Shafik said their actions are designed incubate an economy that eventually benefits asset values and in turn is good for pensions and pensioners.
There's little prospect of bond yields rising anytime soon. And demographics is pretty much immutable; just 13 percent of the populations of Germany and Japan are aged below 15, and as those youngsters become workers, the percentage that's paying taxes rather than drawing down pensions will shrink commensurately. So the world will have to get used to the idea that retirement ages will continue to lengthen, and going to work in your 70s and 80s will become the norm, rather than the exception.
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