Mature pension funds will not survive another financial crisis

Pension schemes have been severely affected by the recent financial crisis. But, according to Cardano’s Theo Kocken and Joeri Potters, the prognosis for recovery is dependent on the maturity of the individual schemes – unless there is widespread systemic reform

The recent financial crisis has wiped billions of dollars off the value of pension schemes, but the long-term outlook for these funds is linked closely to their maturity. This is because a major financial crisis is much less harmful to a young pension system than a minor crisis is to a pension system already in the payout phase.

In the past decade, pension funds have learned to their cost that contributions are no longer a valid control instrument while in the future they will find out that structural net payouts have an extremely destabilising impact on pension dynamics. Even moderate shocks – inevitable over a longer period of time – are capable of transforming enormous pension savings pots into uncontrollable ‘Sinking Giants’.

That is unless vital changes of pension design and risk management are implemented. The impact any change in pension system dynamics will have on western economies is so huge resolving its impact cannot be done by trial and error. To effectively anticipate the future, however, requires insight into the dynamics of the pension process and their consequences.

Accumulation to decumulation
The gradual maturing process during the past two decades, as schemes move from the accumulation to the decumulation phase, has weakened the dynamics of pension systems in the West. What was once a robust, long-term investment vehicle with resilience and recovery potential, thanks to its human capital, now relies on an accumulation of financial capital that is not only unable to draw on contribution payments in order to recover from shocks, but is also unable to rely on expected returns on investments to make up serious shortfalls. The first phenomenon, the ‘blunt contributions instrument’, has become all too familiar to pension professionals in the past decade. However, the second phenomenon, the ‘bluntness’ of returns on investments, has received much less attention.

To illustrate the strongly diminishing effectiveness of ‘expected returns’ as a control instrument, we have applied a simple calculation model to two hypothetical pension funds. Both have a funding ratio hovering at about 100% and an identical strategic asset allocation: half of the assets are invested in bonds; the other half is allocated to risky investment categories, such as equities and property. Both funds have decided to take investment risk despite their fully funded position because they want to benefit from future economic recovery. In our model, the bonds represent the risk-free investment category that is assumed to grow at the same pace as the value of the liabilities.

The most important difference lies in the maturity of the funds. The first has lots of older employees and retirees, giving its liabilities a 12-year duration – a typical level of maturity for schemes in the Netherlands and the US. The second fund is considerably less mature and has liabilities with a duration of around 27 years. In the rest of this article, the funds are referred to as the ‘old’ and the ‘young’ fund. (See figure 1.)

Our model assumes that no new economic crisis occurs in the coming decade and that funding ratios remain at about 100%. Then a financial crisis causes a fresh shock and the funding ratios for both schemes plummet to 80% – a realistic scenario in the light of the events of the past decade. What we are interested in here is not the exact extent of the decline, but the consequences if a pension fund becomes underfunded when it is in the payout phase, in comparison to one still in the accumulation phase.

A world of difference
In this hypothetical scenario, the strong decline of the investments in 2020 is a rude awakening for the young scheme and reignites debate over the best way to increase its funding levels. The young fund decides it must continue to invest in high-risk assets, as despite the risks, this approach gives it a chance of restoring its funding levels. As ever, the frequently used argument to justify the long-term investments of pension funds wins out: recovery can take a long time, possibly even a very long time but, eventually, the risk premium will triumph and the funding ratio will climb back to above the 100% mark.

To make a quick estimation of the fund’s recovery potential, we initially leave contribution income and pension payments out of consideration. The fund then exclusively consists of investments (in equities and bonds) on the one hand and liabilities on the other. Because the crisis has slashed the funding ratio to about 80%, the investments must bridge a gap of 25% (=20/80). If the fund assumes that the funding ratio will grow by 1.5% annually¹, it will take 15 years before the funding ratio is back above 100².

However, if we take the pension payments on board in the analysis, the recovery takes even longer. Figure 2 shows that it lasts more than 20 years for the funding ratio to climb back to above 100%. This period may be too long for a realistic recovery plan, but the young fund can at least justify its claim that it will recover in the long term.

The situation with the old fund is entirely different: the funding ratio does not recover at all. After its plunge to 80% in 2020, the funding ratio continues to decline at a steadily gathering pace until its assets completely run out before 2040 (see figure 3). This is despite very smooth and positive returns on risky investments for decades in a row.

The difference between the two funds is not explained by the severity of the crisis, because the crisis is equally severe for both. And the recovery is equally kind to both. The difference lies in the maturity of the fund. The second fund is much more mature and is therefore confronted at a much earlier stage and to a far stronger degree with a net outgoing cashflow.

By comparison, the young fund’s pension payments that it expects to make in the coming 10 years have a discounted value of 12% of the liabilities. In the same period, the old fund pays out 46% of its liabilities in pensions. For the period 2010–30, they expect to pay out 33% (young fund) and 78% (old fund) of the liabilities. In other words, in the coming 20 years the old fund’s pension payments will equal its remaining assets after the shock.

To make up the shortfall, this fund will need a far higher risk premium in the coming two decades to compensate because in the case of underfunding, the outgoing cashflows will push the funding ratio steadily lower. To recover, the old fund will need to generate an annual 7–8% arithmetic return from its risky assets on top of the earnings from its bond investment³.  

And will have to do so tens of years in succession. Even the most optimistic investor will admit that such returns are not realistic for decades in a row. With a very high probability, the mature fund is doomed to go under as soon as a moderate shock causes it to become underfunded in the future⁴.

In table 1 we show the development of the funding ratio for the old fund, after the funding ratio has declined in 2020 to 80% or 70%. The calculations once again assume an allocation of 50% to equities and property, which are assumed to yield gains corresponding to a risk premium of 3%.

The table reaffirms that in these cases the fund never recovers. Once a crash causes the funding ratio to fall to 80%, it will continue to sink to 50% in the subsequent 15 years –after which the decline gathers pace: after 20 years the fund is entirely exhausted.

Time for a redesign
As long as 100% of entitlements are paid out to the retirees, the active members will see the remaining capital, over which their pension entitlements must be divided, continue to decline – unless there is an explicit adjustment of the pension contracts. As discussions over this type of problem usually take many years to reach a solution, the funding ratio of many pension funds will decline by tens of percentage points in the meantime – even with reasonably good investment returns.

If the decision is then taken to reduce the pension payments in proportion to the funding shortfall, the damage has already been done and the members will be left with only 50% or less of their expected (nominal) pension rights.

The prospects are particularly gloomy for younger members of pension funds in, for example, the UK and the US. Despite funding ratios of 60–70%, the current retirees are receiving 100% of pension payments. Under normal market conditions, the decline of the funding ratio will take place rapidly. So young American or British people can more or less write off their pension entitlements when making their financial plans for the future.

Though stylised, this example of the ‘Sinking Giants’ is relevant for the coming years and makes two explicit points:

1. Talk of pension funds as long-term investors should be put into perspective: there is no long term if funds are unable to absorb short-term shocks. There is no remaining recovery potential for mature pension funds after a shock and, even when assuming steady positive returns, the long term will bring an accelerated erosion of the funding ratio instead of a recovery.

2. The current design, without explicit arrangements about hard versus soft commitments, can in very conceivable situations lead to strongly reduced pensions for the active member. Clearer, more symmetrical arrangements must be made to counter this skewed development⁵.
Ageing has crept into our pension system at a stealthily slow pace, but must now be rapidly taken on board in terms of risk management and redesign if we want to continue the system on a stable course.

Footnotes:

1. Here the fund assumes a risk premium of 3% (actuarial) for a mix of equities and property. As half of the portfolio is invested in high-risk assets, the risk premium for the entire portfolio is 1.5%.

2. So this concerns an actuarial risk premium of 3% and 15-year growth without volatility. In practice, volatility will lead to a lower geometric return, hence a lower average growth path. This article ignores that effect as well as the impact of the accrual of new rights (this is particularly limited for the old fund).

3. A surplus return of 5.4% on top of bonds is required in geometric terms to recover. In a normal, ‘mildly volatile’ world, this corresponds with an arithmetic surplus return of around 7–8% risk premium.

4. Studies into the sustainability of pension funds in various states of the US (Rauh (2009) and Rauh (2010)) conclude that the pension funds of seven states will be entirely exhausted in the coming 10 years. A further 30 states will follow suit in the subsequent 10 years. In the US, these problems are even less visible because of questionable pension accounting. See Biggs (2010).

5. See the recommendations of the Goudswaard Committee in the Netherlands regarding more clarity about absorbing worse – and better than expected –results in order to make pension funds future-proof.

Literature

• Biggs (2010), An Options Pricing Method for Calculating the Market Price of Public Sector Pension Liabilities. Working Paper, March 18, 2010. American Enterprise Institute http://www.aei.org/paper/100088
• Goudswaard et al, (Goudswaard Committee). Een sterke tweede pijler: naar een toekomstbestendig stelsel van aanvullende pensioenen
• Rauh (2009) , Are State Public Pensions Sustainable?, Kellogg School of Management/NBER Working Paper
• Rauh, The Day of Reckoning For State Pension Plans. Working Paper, March 2010. http://kelloggfinance.wordpress.com/2010/03/22/the-day-of-reckoning-for-state-pension-plans

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