Pensions and the coming savings boom
The explosion in company pension fund shortfalls in Britain nicely illustrates issues which will dominate economics and investment in coming years: the re-pricing of risk, a disillusionment with equity markets, and the boom in savings these shortfalls will help to drive.
Under current accounting rules, the pension funds of companies in Britain’s FTSE 100 index are together 96 billion pounds ($170 billion) underfunded, more than double the deficit of a year ago and an all-time record, according to a report from pension fund consultants Lane, Clark & Peacock.
This is partly for the very positive reason that people are living longer but principally because of the dire performance of financial markets, especially equities, over the past year.
To make matters worse, the surge in corporate bond spreads, which are used to calculate the current value of pension plans’ future liabilities to retirees, has actually minimised how underfunded British pension plans look when accounting measures are applied. Minimised how underfunded they look, but not how underfunded they are.
One of the net results of all this is that companies are getting out of the pension providing business as fast as they can, pushing employees into plans where the saver takes all of the investment risk and the company is purely a contributor and a facilitator.
Individuals are less able to take the long view and hold riskier assets like equities during downturns, meaning they are more likely to hold more in cash and bonds than are company pension plans.
Individuals are also going to be increasingly aware of the shortfalls of the pensions they have coming, which will push the savings rate still higher.
A growing awareness that we are going to live a very long while will also support this. It’s nice to live to 90, but it takes savings to fund that old age, even if you plan to work until you are 70.
Put simply financial markets have been fantastically volatile during the past two years, making it difficult to figure out how much to save and even tougher to figure out how much those savings might earn over the longer term.
Amazingly, more companies in the Lane, Clark survey raised their estimates of long-term returns from equities than cut them in the past year. But even after a huge rally in recent months, five and ten year returns in many of the world’s equity markets look pretty uninspiring, especially if you apply any kind of penalty for the very extreme level of volatility.
Assumptions about equity market returns will likely fall in coming years and more pension funds and individual retirement savers will ease up on the percentage of their portfolios they allot to shares.
SAVINGS UP, CONSUMPTION DOWN
One of the key false assumptions of the pre-credit crisis age was that we lived in a newly tame economic era. This conditioned people to save less and take on more risks, as borrowers, lenders or investors. This leveraged economy grew more quickly than a more conservative one, and we rationalised away the risk by saying that better macro-economic policies meant we were in a new era where rainy days were fewer and less severe.
That obviously has been proved wrong, and the results are written in the pension plans deficits. We live in a more volatile, riskier world than we believed. As that realisation spreads, and as many retirees find they have too little in savings, behaviour will change in important ways.
A growing awareness of the fragility of growth and the volatility of markets will not just change the behaviour of investors but also others.
Banks, as we’ve already seen, are going to want more security and a better margin. That will crimp growth. Companies will be more cautious in how they borrow, invest and expand. That too will crimp growth. This is not a bad thing, but it is bad if you have a business or personal plan that is predicated on very high growth.
All investors will be less comfortable with equity risk, and as individuals will bear more of those risks alone, they will accentuate a trend away from equity investment.
But more powerfully, the fact that there is no benevolent company or government which can fund our 25 year retirements will push all of us to save more, as well as to be more cautious with how we invest the money we do save.
This will have a big dampening effect on economic growth, especially in the ageing West, and isn’t likely to be very helpful to long term equity valuations either.
Monetary and fiscal policy can work against these forces, as we’ve seen, and can ease the transition, but they can’t do it by themselves forever.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )