Why It Is Important To Review Your Pension Now

Coronavirus crisis inflicts a double blow to pensions as retirement plans have suffered tumbling asset values and ballooning liabilities.

During a CNBC interview last month, Governor Phil Murphy said New Jersey’s retirement system “like . . . pension plans across the country, have been hit hard sideways” and would need time to “stabilise”.

He was speaking after the asset value of his state’s retirement system had fallen by more than 13 per cent since the beginning of its fiscal year in July 2019. Back then, its assets could cover only 40 per cent of what it owed to its current and future retirees.

The perilous state of pension finances in general was underscored in August 2019 by the Pension Benefit Guaranty Corporation, which insures the US retirement systems against insolvency. Even in the midst of the longest bull market in history, it warned that its own Multiemployer Insurance Program was heading for insolvency by 2025, affecting 10m members.

Similarly, in 2017, the UK’s pension industry trade body, the Pensions and Lifetime Savings Association, warned that about a quarter of its members’ eligible employees — about 3m people — had only a 50 per cent chance of seeing their pension benefits paid in full.

That situation has most probably worsened with a rise in the deficits of UK defined benefits plans from £210bn in January to £254bn in March, according to the Pension Protection Fund. More red ink is expected for April.

By turning a raging bull into a ferocious bear in record time, the coronavirus crisis has inflicted a double blow: tumbling asset values from falling markets and ballooning liabilities from falling interest rates. This combination was last experienced during the 2008 financial crisis, except for one difference. Since then, thanks to ageing demographics, the proportion of plans with negative cash flow — pension outgoings exceeding income from contributions and investments — has more than doubled, limiting their room for manoeuvre.

Last year, for example, 64 per cent of plans in Europe had negative cash flow; in the UK, the proportion was 73 per cent, according to pension consultancy Mercer. Of those in positive territory, 72 per cent expect to become negative over the next 10 years.

A combination of underfunding and negative cash flow makes for a lethal cocktail. Those affected by it cannot afford to take a long-term view and rely on markets to recover: they are forced to sell assets to meet pension obligations.

More generally, though, two deeper concerns have surfaced lately.

First, extreme events have been far more frequent than are captured by the risk models in use. These have failed to anticipate, for example, the five worst outliers among the 15 biggest drawdowns recorded by FTSE All-Share index since January 1981, according to data compiled by Investors Chronicle, the Financial Times’s sister publication.

Second, many plan sponsors might face bankruptcy, if governments’ pledges to “do whatever it takes” fail to avert a deep prolonged recession. They may be forced to seek a government backstop. In any event, public expenditure is set to rocket, while tax revenue will take a big dive. The monetisation of the resulting public debt by central banks raises the spectre of 1970s-style runaway inflation.

European plans have increasingly hedged inflation and interest rate risks, according to Mercer data. In 2018, 27 per cent of them had hedged more than 90 per cent of their funded liabilities, rising to 41 per cent in 2019. This exposes the rest to varying degrees of risk.

Those with hedges in place tend to have a healthy funding status and more headroom to hunt opportunities in the current dislocation.

Even so, the immediate issue is whether the majority of DB plans can survive without increased contributions and reduced benefits. This is in spite of switches to defined contribution plans in the past two decades — even in former rock-solid DB markets such as Canada and Japan. Although it is providing financial respite to plan sponsors, it is shifting the pain to their employees.

Risk has been transferred from those who were unable to manage it to those who do not understand it. The problem is much less acute where DC funds are managed by a professional board of trustees. Yet, few expect DC plans to deliver better retirement outcomes than DB plans.

That begs a bigger question: with two of the three worst financial meltdowns of the past hundred years occurring in the past 12 years, can our societies rely on financial markets to deliver decent retirement outcomes for millions around the world? It is time for an honest debate.

Source: Financial Times