John Rapley is a political economist at the University of Cambridge and a senior fellow at the Johannesburg Institute for Advanced Study.
Some time ago, on one of my regular trips to Canada, I ran into an old school friend. He told me that he had recently retired from teaching and was now enjoying his new life. The news took me by surprise – he was in his 50s, fit, lively, in excellent health. The thought of its reparation to a life of leisure seemed premature to me.
After a quick mental calculation, I realized that he would probably spend more years collecting a pension than contributing to it. I was wondering how it worked. Although his journey, which involved annual vacations in Europe and winters in Florida, was particularly happy, it was not out of the ordinary. As people live longer and healthier lives and retirement ages decline, the phenomenon of people spending more time in retirement than working is becoming more common.
This, combined with rising interest rates and changing macroeconomic conditions, is creating problems for the funds that manage our pension plans. Canadian funds, whose total assets peaked at the end of last year, have been caught in a downward trend and have seen their total assets fall this year. Sooner or later, pensions will become a hot political topic.
For starters, live longer was not the plan. When Otto von Bismarck instituted the world’s first public pension in 1889, he set the retirement age at 70 – roughly the age at which Germans then lived. When other Western countries adopted pension systems in the first half of the 20th century, they too set the retirement age a few years below the average life expectancy. Essentially, they created social insurance programs to prevent those too old to work from falling into destitution.
This shift from a few years of income support to living our best lives happened quite suddenly – essentially, over the decades straddling the turn of the millennium. Part of what made this possible was the long bull run in asset markets over the past 40 years. Especially over the past decade, macroeconomic stability and cheap money have combined to inflate fund asset values. With central banks underwriting stocks and providing a floor whenever markets fell, fund managers were free to engage in high-risk investments that yielded big gains. They’ve gone beyond bonds and publicly traded companies to buy commercial real estate, infrastructure, and more recently, crypto, as the US Teachers’ Pension Plan recently did. Ontario and the Caisse de depot et placement du Quebec.
However, we could consider this period as a pension peak. The past few years have been an extraordinary time, but the particular confluence of conditions that made it all possible has come to an end. For starters, the era of cheap money is over and the markets are feeling it.
As a result, some of the income streams that pensions use to pay their monthly dividends lose value. The commercial real estate sector, in particular, has been hit hard during the pandemic and doesn’t seem likely to recover any time soon, especially in major cities like London and New York. Until now, the funds had not had to record these losses on their books since the leases had lasted for several years and the managers remained hopeful that the market would rebound. But now, as funds seeking to generate cash are forced to sell their holdings, we will see substantial declines in fund assets.
Going forward, the markets are unlikely to generate the kinds of returns we have become accustomed to. The evolution of global labor markets reveals an ongoing structural change in the economy. The future will be one of rising wages, tighter profit margins and permanently high interest rates. This will be good for the economy, but less good for asset owners. Meanwhile, given the massive stock of public and private debt that built up in the easy money era, central banks might be tempted to extend today’s negative real interest rates indefinitely, in order to allow the swelling of the debt. This will be good for debtors but bad for creditors – pension funds in particular, given that they rely heavily on bonds for the revenue streams they use to pay their members.
Rising wages will increase pension contributions, which will keep the funds healthy. But if fund managers use them to support existing bonds, their active members will rebel. As the combination of an aging population and slowing population growth strains the finances of the most important funds, we will be faced with some tough choices.
Nick Silver, a London actuary who advises pension fund managers, says Western societies need to resume conversations about the social contract that underpins pensions. It is not certain that a model developed in the last century is the least appropriate in this one. But he is also not convinced that governments will want to tackle this thorny issue. Without clear action to ensure the sustainability of pensions, the most likely scenario will be that fund managers end up offering benefit increases below inflation, eroding the value of pensions over time.
This recently retired friend of mine might therefore be wise to engage in his own financial planning, to make sure he’s not living big now to face a more precarious late retirement.