Baby boom and bust
The bull in me wants to believe Milken. The bear in me believes in Siegel.
There are many things to consider here:
1. The social impact of older people working late into their lives: If the old keep working, will they make place for the young. The only way out of that is if the employment pie is big enough for all. The French had a massive problem on their hands when they came up with the policy of hiring and firing youngsters.
2. The biological impact: People generally marry by late 20s, have kids by mid 30s and educate and marry the kids off by late 50s and settle down to enjoy their retirement after 60s. If they have to go through another phase of working life, then where will they fit in in the social fabric, remains to be seen. They will have to define a new role and identity for themselves (esp if they have to live for another 60 more years - till 120 as Milken says)
3. Motive to save: There is some motive to save in the 30s to 50s as you would want to support your kids. However, if you know that there will be continuing cash flows till after 60, then retirement planners will need a very strong reason to convince people in their 30s to start saving. If people stop saving in 30s and 40s as they expect to earn in their twilight years, we can see a massive sell off just based on that!
I think more will definitely be said and heard as we go forward. This will become an important topic of discussion as people start realising that the boomers are not dying! I dont expect this to catch market fancy till 2010-2015! But when this does, I think the effects will be fairly savage.
It is interesting that while the younger generation has always fought with the older generation over ideas, this will potentially be the first inter-generational fight over economic resources!
The Economist
Will share prices crash as baby-boomers sell their assets to pay for retirement?
MICHAEL MILKEN will celebrate his 60th birthday on July 4th. The former “junk-bond king” is still going strong, having seen off prostate cancer, and remains as controversial as ever. The debate over whether Mr Milken deserved his jail term for manipulating the high-yield bond market he largely created rumbles on nearly 20 years later, most recently during the Enron trial, where Mr Milken's genius was championed by none other than Kenneth Lay (as the saying goes, with friends like that...).
Jeremy Siegel turned 60 last November. The Wharton business school economist, whose book “Stocks for the Long Run” was the bulls' bible during the last bubble, is going strong too, trim and fit, with his mind as lively as ever—despite being called “demented” at last weekend's Berkshire Hathaway annual meeting by one of the firm's bosses, Charlie Munger. (“He's a very nice guy,” retorted the other boss, Warren Buffett.)
Mr Siegel and Mr Milken are among the first members of the post-war “baby boom” generation to enter the decade of life in which most people retire. (Mr Siegel puts the dates of America's baby-boomers at 1946-64, which he says technically makes him a pre-boomer.) Lately, both men have been giving considerable thought to what impact the impending retirement of the baby-boomers will have on the prices of financial assets. They have reached sharply different conclusions, which they aired in a conference last month at the Milken Institute.
Having built his career on arguing that buying shares and holding them is the best long-term investment strategy in almost any circumstances, Mr Siegel is now surprisingly worried about the impact on asset prices of the demographic time-bomb in the rich world represented by the baby-boomers' mass retirement. Many boomers have bought assets such as bonds and shares to fund their old age. Arguably, these purchases have helped to drive up prices over the past couple of decades. Now, he says, all else being equal, the sale of these assets will lead to a sharp fall in prices, because there are too few people in the smaller generations that followed the boomers to buy all of those assets at today's prices. For instance, in the developed world share prices could fall by as much as 40-50% over the coming decades because of boomer selling, calculates Mr Siegel. Unless they retire later, baby-boomers could see their standard of living in retirement halved, relative to their final year of work.
Mr Siegel's one great hope is that the shortfall of buyers of assets in the rich world will be made up for by a surge in demand from the developing world, as it gets richer fast thanks to the information revolution and globalisation. The demographic time-bomb of a lot of rich-country boomers having to be supported in their retirement by a smaller group of younger workers disappears when the huge, far younger population of the developing world is added to the mix. Indeed, Mr Siegel calculates that shares will continue to perform as well as they have in the past—generating real returns of above six percentage points a year since 1802, according to the research that made his name—provided that the developing world continues to grow strongly, and that buyers there are able to snap up all the shares they want.
That would need to be a lot of shares, says Mr Siegel, who is writing a new book on the subject, “The Global Solution”. By the middle of this century, he reckons, most multinational companies would need to be owned by investors outside today's developed countries, he says, especially investors in Asia. The challenge is to integrate global capital markets so that selling assets from the old in the rich world to the young in developing countries is no harder, nor more unusual, than today's sales of assets by elderly folk in Florida to younger people in other American states. From this perspective, America's external deficits, particularly with some developing countries, may be both long-lasting and nothing to worry about.
The biggest danger is that growing protectionism in the rich world will both slow the rate of growth in the developing world and prevent its demand for shares being met. Mr Siegel views the recent opposition to purchases of American firms by companies from China and Dubai as decidedly ominous.
Milken honey
Mr Milken, by contrast, is hugely optimistic, mainly because he thinks that many boomers will live far longer than is expected today, thanks to existing medical practice and spectacular advances, such as a cure for cancer, that he expects in the near future. He thinks that average life expectancy could eventually reach 120 years. With good health at a far greater age, people will want to keep working, not retire, he says—just as he and Mr Siegel do. (This prediction, Mr Siegel notes, goes against the trend for rising average life expectancy to coincide with falling retirement ages in the rich world.)
Undaunted, Mr Milken insists that working for longer will become easier thanks to technological innovation, such as using the internet from home. That will increase wealth, fuelling demand for assets. Hence the real issue for the world over the coming decades, predicts Mr Milken, will be not whether there are enough people to buy the assets of the baby-boomers, but whether there are enough assets to buy, given all the extra demand in the world.
Most economists will tend to agree with Mr Siegel that Mr Milken's forecast is “more hope than reality”. But Mr Milken's greatest achievements, from creating the high-yield debt market to beating cancer, have been the result of his refusal to accept conventional wisdom. Perhaps he will be proved right again. And if not, there may be an ounce of good news among the bad. If politicians realise that foreign buyers are needed to prop up the value of America's retirement savings, they may be less inclined to flirt with protectionism.
Thursday, May 18, 2006
Monday, January 30, 2006
Actuaries and the pensions crunch
The Economist
Can actuaries help to sort out the mess in corporate pensions?
AMONG the many jokes about actuaries, one cruelly hits the mark. An actuary and a farmer are looking at two fields of sheep. The farmer asks the actuary how many sheep he thinks there are: “1,007”, is the quick and confident reply. The astounded farmer asks how the actuary reached that number. “Easy, there are seven sheep in that field and about 1,000 in the other.”
False precision and reckless approximation have defined the actuarial profession's role in the crisis that has enveloped corporate pensions on both sides of the Atlantic. Although actuaries have not been the only cause—companies, trustee boards, governments and accounting rules have all played their part—they have been surprisingly hapless at their main task: forecasting funds' future liabilities and assessing how many assets will be required to meet them.
Their failure has hastened the collapse of final-salary (defined-benefit) pension schemes, many of which have ballooning financial deficits. In Britain 70% of such funds have been closed to new entrants in the past few years. Recently, led by IBM in America and Rentokil in Britain, companies have gone further and begun to close schemes to further accruals. As a profession, actuaries stand accused of negligence on a grand scale.
This is truest in Britain, which is where the pensions mess is most acute—and is also where actuaries are laying a path for their colleagues in America and continental Europe on how to put their mistakes right. Since the mid-1990s, the profession has completely recast its ideas and practices, such that Britain is arguably now the world's most sophisticated forum on how to price long-term financial promises and guarantees. This is doubly ironic. First, British actuaries failed disastrously in their reckoning of these issues during the 1980s and 1990s. Second, many of these ideas came from academic work in America, where the application of modern finance theory to companies and their balance sheets flourished from around 1970.
America has fallen behind mainly because its corporate pensions crisis, though grave, is less severe than Britain's. Fewer retirement benefits there rise in line with inflation, meaning that they are much less expensive in the long run. Only in a few extreme cases (such as General Motors) is the solvency of a big company at risk because of pension liabilities. Further, the pensions industry in America is a shared endeavour, shaped by rules and accounting regulations as well as actuarial practice.
Most members of retirement schemes have little idea of what actuaries do. In essence, they make forecasts across the many variables that affect pension funds. These include not only big factors such as inflation, interest rates, rates of return on assets and how long people will live, but also a host of other more technical things, too. Every three years or so, its actuary calculates whether a fund is in surplus and how its balance has changed since the previous exercise. Pension-fund trustees and sponsoring companies then try to agree on the appropriate level of ongoing funding.
Such “multivariate” forecasting is notoriously difficult—far more so than, for example, guessing the future growth of an economy's GDP. In actuarial exercises, the right question to ask is not whether the overall forecast will be wrong, but by how much it will be wrong. But until the mid-1990s, few people asked this of their actuaries, who tended to act as if they were infallible even while their forecasts were going spectacularly awry. A set of orthodoxies suited the cosy corporate culture of that earlier period, when actuaries endorsed the idea that funds were in healthy surplus, and trustee boards were toothless and saw no need to argue with companies. Most pension schemes held 80% or 90% of their assets in equities, which rose strongly in an inflationary era. Accounting conventions allowed companies to post “profits” derived from the future expected returns on these equities. Although they were not directly responsible, most actuaries were happy to endorse this.
Many companies also used surpluses to justify lengthy “contribution holidays”, meaning the scheme's actuaries agreed that there was no need to put fresh money into their funds. Before the arrival of a robust mark-to-market culture during the 1990s, actuaries were happy to smooth equity values by not writing them down during tough markets and understating them during bull markets (a habit that goes back at least as far as the 1974 stockmarket wobble in Britain, when a collapse in pension assets was overcome by actuarial fiat). They also endorsed the bizarre practice of assuming that holding equities magically reduced a fund's net liabilities, which meant that the sponsoring company could justify lower contributions.
In hindsight—and not just actuaries were slow to spot the role of inflation in allowing it—this was a perverse way to run a pension industry. First, pension funds held assets that, despite outperformance during a period of robust inflation, proved a poor and risky long-term match for liabilities that are bond-like in that they span many years and require reasonably predictable cashflows. Second, by embracing the idea that high returns from equities would lead to lower net liabilities, actuaries set the scene for an overall level of funding that left many schemes vulnerable when equity markets crashed, as they did in 2000-03. In Britain some actuaries went so far as to allow sponsoring companies to assume unusually high returns on their assets, making funds appear healthy when they were in fact in poor shape.
Some of these orthodoxies have been overturned in recent years. Martin Taylor, chairman of the trustee board of WH Smith, a British retailer, has described the actuarial convention that the composition of the assets should determine the size of the liabilities as “one of the weirdest emanations of the human mind. It's a metaphor—like saying that the advent of jet planes made the Atlantic narrower—and metaphor has limited place in finance.” Plenty of actuaries now agree.
Indeed, the most radical attack on actuaries came from within the profession itself. A defining moment was the presentation to Britain's Institute of Actuaries in 1997 of a paper by Jon Exley, Shyam Mehta and Andrew Smith. In “The financial theory of defined benefit schemes”, they systematically analysed pension funds as part of overall corporate finance theory. Their arguments, which drew on earlier work by academics such as Zvi Bodie of the Boston University School of Management in America, laid the foundations for a completely new actuarial school.
New wares to peddle
According to the new thinking:
•A pension fund should be seen as part of the sponsoring company's balance sheet and risk profile.
•Because funds have tax privileges, shareholders have an interest in wanting them to be fully funded, indeed in modest surplus, so as to maximise that benefit.
•When a company has a pension scheme and accrues liabilities to it, it is in effect issuing long-dated index-linked bonds.
•Assets are worth what the market will pay for them, so £100 worth of equities is worth no more than £100 of bonds.
•The natural assets for a pension scheme are deferred annuities.
One of the strongest arguments made by the new actuaries was to debunk the idea that holding equities somehow reduced a fund's liabilities. They used a simple analogy to show how nonsensical the original thinking had been. Imagine you borrow £1,000 from the bank (ie, a liability) and invest it in equities (ie, assets). Do you owe any less to the bank as a result? Further, do you think you could persuade the bank manager to allow you to make smaller or slower repayments on the grounds that your equities will produce returns in future that will make up the difference? Of course not, said the new actuaries. What a fund does with its assets has obvious consequences, they pointed out, but these do not include altering the value of its liabilities.
To the layman or to observers versed in finance, these ideas might seem obvious. But for actuaries they represented an entirely new way of thinking about pensions. Initial resistance to the new school crumbled amid tumbling equity markets after 2000. Supposedly healthy pension schemes suddenly had huge deficits, not just as a result of lower share prices, but also because falling real interest rates pushed up the net present value (but not the long-term costs) of their liabilities. Something had clearly been wrong with the actuarial status quo, and that opened the way for advice from a new generation of actuaries.
Lane Clark & Peacock (LCP), a firm of British actuaries, conducts an annual survey of the pension schemes of the biggest British companies. Ninety-two of the top 100 companies that make up the FTSE-100 share index have defined-benefit schemes, and these have mostly lurched into deficit in recent years (see chart one). New pension-fund accounting and valuation rules, known in Britain as FRS17, mean that these deficits are more comparable than they were. The headline deficit of £37 billion in July 2005 represents five months' worth of the companies' pre-tax 2004 profits, a year's worth of dividends, or 3% of the FTSE-100's market value. But LCP argues that the figure is not equivalent to the full extent of the challenge facing companies—add other factors and the total deficit might be as much as one-quarter bigger.
The reason why the reported FRS17 numbers could be much too small may, though, be another case of false precision. If a company tried to walk away from its pension liabilities then it must top up the assets so that the accrued benefits can be fully met by purchasing the appropriate annuities from an insurance company. Just now, this is an expensive option: if all the FTSE-100 companies with deficits went down this route, the shortfall would be nearer £150 billion. A recent estimate by Mercer, another firm of actuaries, put the buy-out costs at twice that—though the new school of actuaries would be the first to point out that this is just a snapshot. If real interest rates were to rise, then annuities would become cheaper and the cost of winding up a scheme would fall.
Actuaries, along with the rest of the pensions industry, have also been surprised by an unprecedented increase in the longevity of pension schemes' members, particularly of a cohort that is now in its 60s and 70s. Obviously the longer people live, the longer they will draw pensions, so this is a critical variable for schemes (as well as for governments trying to finance social-security systems). Greater longevity has also had another, more subtle, effect on pension schemes, because it has led insurers to model more carefully how long people might live and hence to charge a more accurate (ie, higher) price on the long-dated life policies and annuities they offer.
With such an array of pension problems, no wonder many companies developed an aversion to defined benefits. According to Britain's National Association of Pension Funds (NAPF), by mid-2005 about 70% of defined-benefit schemes had been closed to new members; some 9% had been closed to further accruals by members (a trend that has accelerated). Christine Farnish, the NAPF's chief executive, has said that she expects defined benefits to disappear from the private sector within five years.
The deterioration of a once flourishing sector led to political intervention and the introduction of a regulatory framework designed to shepherd pension schemes to safety. This includes a new Pension Protection Fund modelled loosely on America's Pension Benefit Guaranty Corporation. In its first full year it will levy £575m from Britain's pension schemes, as it begins to phase in risk-adjusted premiums that call on healthier funds to pay less than creaking ones. A Pensions Regulator has also given more powers to trustee boards to claw back deficits from scheme sponsors over shorter periods, or to ask for security over other assets such as properties.
That is one of several trends embraced by actuaries that have gradually encouraged pension schemes to become more conservative in the assumptions they make and the assets they hold. One landmark was the decision in 2000-01 by Boots, a retailer, to switch all of its £2.3 billion of assets into a portfolio of long-dated cashflow-matching bonds and to make a linked share buyback that benefited shareholders. The deal, which proved well-timed and has since had some imitators, was deemed so radical at the time that many actuaries balked at suggesting anything similar to other clients. Coming near the peak in share prices, it was dismissed by many companies as merely a trading strategy. In fact, the deal came after years of internal debate, between Boots' managers and their financial advisers, pension-fund trustees and, yes, actuaries, about how to apply new actuarial ideas.
Many schemes have since been lowering their exposure to equities, investing more in property, private equity, hedge funds and commodities, as well as buying more bonds. At the heart of this trend is a concept known in the pensions business as “de-risking”. At present this is being touted as effectively by investment banks eager for fees as it is by actuaries. The banks see an opportunity to use their financial-engineering expertise to create structured portfolios of assets that are suited to pension schemes' future cashflows. They point out that even though equities have performed well since the end of 2002, funds' health has worsened. The reason is that liabilities have grown even faster than assets. (The accusation that actuaries failed to warn of the growth in liabilities is implicit.)
The solution, argue the banks, is to look more closely at the risks embedded in liabilities and then to reduce funds' riskiness with “Liability Driven Investing” (LDI). The big financial risks relate to inflation and interest rates, while the biggest non-financial risk is changes in longevity. Using derivatives and swaps, the financial risks can be largely stripped out (for a fee, of course) so that funds can be much more certain about their ability to meet future cashflow requirements.
Two LDI pioneers have shown what is possible. Friends Provident, a life insurer, implemented a hedging programme with Merrill Lynch in late 2003. In September 2005 the pension-fund trustees of WH Smith sold all of the £870m ($1.6 billion) fund's assets and invested 94% of the proceeds in a portfolio of interest-rate and inflation swaps, with the balance invested in equity options designed to capture returns from shares over the next decade or so. The company was persuaded to embrace the plan when its advisers explained that the level of risk in the pension fund was so high that the group's solvency could be at stake if things deteriorated.
It is too expensive to reduce long-term risks entirely, so the idea behind LDI is to focus on the big risks and narrow the range of possible future outcomes, limiting the bad ones. LDI is a bit like a hedging programme that zaps the negative effects of interest-rate and inflation risk. There is a range of LDI strategies and structures. In a sense, Boots implemented an LDI programme, but one using bonds rather than snazzier derivatives.
A long squeeze
One problem with LDI is the constraints on the supply of the instruments it uses, particularly when a pension scheme needs to stretch at least 50 years into the future (which is the limit of long-term swaps and bonds). Last year Merrill Lynch pointed out, for example, that Britain has some £700 billion of defined-benefit liabilities, but a mere £7 billion of 35-year index-linked (ie, inflation-proofed) government bonds. As more funds switch their attention to reducing risks, these supply constraints are likely to worsen. In a recent technical squeeze in the market for 50-year gilts, prices have risen so high that real yields have collapsed to historically low levels. This week, for example, the latest auction of 50-year bonds was oversubscribed and offered a real yield of just 0.46%. Demand is coming from pension funds (and insurance companies) looking for very long-dated investments, but also from investment banks seeking to hedge their own LDI-related trading books.
LDI springs from the new actuarial thinking in that it puts the risks in a pension scheme in the context of the sponsoring company's overall risk profile. But actuaries have begun to point out that LDI is not the answer for every fund. Those with financially strong sponsors, or with sponsors prepared to give pledges or guarantees to their funds, might have no need for a transaction that can be expensive. Moreover, a fund that locks in security at today's high bond prices might come to regret it a decade hence if real interest rates revert to their long-run historical levels.
Even so, the insight that pension schemes need more security is becoming well established in Britain and in America. Ultimately, the old actuaries failed because they did not properly anticipate, calculate and communicate the rising costs of retirement provisions, especially once inflation slowed and real interest rates fell from the mid-1990s onwards. The promise of the new actuaries is that, as their ideas spread, such mispricing will never happen again. If that has come too late for many defined-benefit schemes, at least it might offer a bit more certainty when planning for the next generation's old age.
Can actuaries help to sort out the mess in corporate pensions?
AMONG the many jokes about actuaries, one cruelly hits the mark. An actuary and a farmer are looking at two fields of sheep. The farmer asks the actuary how many sheep he thinks there are: “1,007”, is the quick and confident reply. The astounded farmer asks how the actuary reached that number. “Easy, there are seven sheep in that field and about 1,000 in the other.”
False precision and reckless approximation have defined the actuarial profession's role in the crisis that has enveloped corporate pensions on both sides of the Atlantic. Although actuaries have not been the only cause—companies, trustee boards, governments and accounting rules have all played their part—they have been surprisingly hapless at their main task: forecasting funds' future liabilities and assessing how many assets will be required to meet them.
Their failure has hastened the collapse of final-salary (defined-benefit) pension schemes, many of which have ballooning financial deficits. In Britain 70% of such funds have been closed to new entrants in the past few years. Recently, led by IBM in America and Rentokil in Britain, companies have gone further and begun to close schemes to further accruals. As a profession, actuaries stand accused of negligence on a grand scale.
This is truest in Britain, which is where the pensions mess is most acute—and is also where actuaries are laying a path for their colleagues in America and continental Europe on how to put their mistakes right. Since the mid-1990s, the profession has completely recast its ideas and practices, such that Britain is arguably now the world's most sophisticated forum on how to price long-term financial promises and guarantees. This is doubly ironic. First, British actuaries failed disastrously in their reckoning of these issues during the 1980s and 1990s. Second, many of these ideas came from academic work in America, where the application of modern finance theory to companies and their balance sheets flourished from around 1970.
America has fallen behind mainly because its corporate pensions crisis, though grave, is less severe than Britain's. Fewer retirement benefits there rise in line with inflation, meaning that they are much less expensive in the long run. Only in a few extreme cases (such as General Motors) is the solvency of a big company at risk because of pension liabilities. Further, the pensions industry in America is a shared endeavour, shaped by rules and accounting regulations as well as actuarial practice.
Most members of retirement schemes have little idea of what actuaries do. In essence, they make forecasts across the many variables that affect pension funds. These include not only big factors such as inflation, interest rates, rates of return on assets and how long people will live, but also a host of other more technical things, too. Every three years or so, its actuary calculates whether a fund is in surplus and how its balance has changed since the previous exercise. Pension-fund trustees and sponsoring companies then try to agree on the appropriate level of ongoing funding.
Such “multivariate” forecasting is notoriously difficult—far more so than, for example, guessing the future growth of an economy's GDP. In actuarial exercises, the right question to ask is not whether the overall forecast will be wrong, but by how much it will be wrong. But until the mid-1990s, few people asked this of their actuaries, who tended to act as if they were infallible even while their forecasts were going spectacularly awry. A set of orthodoxies suited the cosy corporate culture of that earlier period, when actuaries endorsed the idea that funds were in healthy surplus, and trustee boards were toothless and saw no need to argue with companies. Most pension schemes held 80% or 90% of their assets in equities, which rose strongly in an inflationary era. Accounting conventions allowed companies to post “profits” derived from the future expected returns on these equities. Although they were not directly responsible, most actuaries were happy to endorse this.
Many companies also used surpluses to justify lengthy “contribution holidays”, meaning the scheme's actuaries agreed that there was no need to put fresh money into their funds. Before the arrival of a robust mark-to-market culture during the 1990s, actuaries were happy to smooth equity values by not writing them down during tough markets and understating them during bull markets (a habit that goes back at least as far as the 1974 stockmarket wobble in Britain, when a collapse in pension assets was overcome by actuarial fiat). They also endorsed the bizarre practice of assuming that holding equities magically reduced a fund's net liabilities, which meant that the sponsoring company could justify lower contributions.
In hindsight—and not just actuaries were slow to spot the role of inflation in allowing it—this was a perverse way to run a pension industry. First, pension funds held assets that, despite outperformance during a period of robust inflation, proved a poor and risky long-term match for liabilities that are bond-like in that they span many years and require reasonably predictable cashflows. Second, by embracing the idea that high returns from equities would lead to lower net liabilities, actuaries set the scene for an overall level of funding that left many schemes vulnerable when equity markets crashed, as they did in 2000-03. In Britain some actuaries went so far as to allow sponsoring companies to assume unusually high returns on their assets, making funds appear healthy when they were in fact in poor shape.
Some of these orthodoxies have been overturned in recent years. Martin Taylor, chairman of the trustee board of WH Smith, a British retailer, has described the actuarial convention that the composition of the assets should determine the size of the liabilities as “one of the weirdest emanations of the human mind. It's a metaphor—like saying that the advent of jet planes made the Atlantic narrower—and metaphor has limited place in finance.” Plenty of actuaries now agree.
Indeed, the most radical attack on actuaries came from within the profession itself. A defining moment was the presentation to Britain's Institute of Actuaries in 1997 of a paper by Jon Exley, Shyam Mehta and Andrew Smith. In “The financial theory of defined benefit schemes”, they systematically analysed pension funds as part of overall corporate finance theory. Their arguments, which drew on earlier work by academics such as Zvi Bodie of the Boston University School of Management in America, laid the foundations for a completely new actuarial school.
New wares to peddle
According to the new thinking:
•A pension fund should be seen as part of the sponsoring company's balance sheet and risk profile.
•Because funds have tax privileges, shareholders have an interest in wanting them to be fully funded, indeed in modest surplus, so as to maximise that benefit.
•When a company has a pension scheme and accrues liabilities to it, it is in effect issuing long-dated index-linked bonds.
•Assets are worth what the market will pay for them, so £100 worth of equities is worth no more than £100 of bonds.
•The natural assets for a pension scheme are deferred annuities.
One of the strongest arguments made by the new actuaries was to debunk the idea that holding equities somehow reduced a fund's liabilities. They used a simple analogy to show how nonsensical the original thinking had been. Imagine you borrow £1,000 from the bank (ie, a liability) and invest it in equities (ie, assets). Do you owe any less to the bank as a result? Further, do you think you could persuade the bank manager to allow you to make smaller or slower repayments on the grounds that your equities will produce returns in future that will make up the difference? Of course not, said the new actuaries. What a fund does with its assets has obvious consequences, they pointed out, but these do not include altering the value of its liabilities.
To the layman or to observers versed in finance, these ideas might seem obvious. But for actuaries they represented an entirely new way of thinking about pensions. Initial resistance to the new school crumbled amid tumbling equity markets after 2000. Supposedly healthy pension schemes suddenly had huge deficits, not just as a result of lower share prices, but also because falling real interest rates pushed up the net present value (but not the long-term costs) of their liabilities. Something had clearly been wrong with the actuarial status quo, and that opened the way for advice from a new generation of actuaries.
Lane Clark & Peacock (LCP), a firm of British actuaries, conducts an annual survey of the pension schemes of the biggest British companies. Ninety-two of the top 100 companies that make up the FTSE-100 share index have defined-benefit schemes, and these have mostly lurched into deficit in recent years (see chart one). New pension-fund accounting and valuation rules, known in Britain as FRS17, mean that these deficits are more comparable than they were. The headline deficit of £37 billion in July 2005 represents five months' worth of the companies' pre-tax 2004 profits, a year's worth of dividends, or 3% of the FTSE-100's market value. But LCP argues that the figure is not equivalent to the full extent of the challenge facing companies—add other factors and the total deficit might be as much as one-quarter bigger.
The reason why the reported FRS17 numbers could be much too small may, though, be another case of false precision. If a company tried to walk away from its pension liabilities then it must top up the assets so that the accrued benefits can be fully met by purchasing the appropriate annuities from an insurance company. Just now, this is an expensive option: if all the FTSE-100 companies with deficits went down this route, the shortfall would be nearer £150 billion. A recent estimate by Mercer, another firm of actuaries, put the buy-out costs at twice that—though the new school of actuaries would be the first to point out that this is just a snapshot. If real interest rates were to rise, then annuities would become cheaper and the cost of winding up a scheme would fall.
Actuaries, along with the rest of the pensions industry, have also been surprised by an unprecedented increase in the longevity of pension schemes' members, particularly of a cohort that is now in its 60s and 70s. Obviously the longer people live, the longer they will draw pensions, so this is a critical variable for schemes (as well as for governments trying to finance social-security systems). Greater longevity has also had another, more subtle, effect on pension schemes, because it has led insurers to model more carefully how long people might live and hence to charge a more accurate (ie, higher) price on the long-dated life policies and annuities they offer.
With such an array of pension problems, no wonder many companies developed an aversion to defined benefits. According to Britain's National Association of Pension Funds (NAPF), by mid-2005 about 70% of defined-benefit schemes had been closed to new members; some 9% had been closed to further accruals by members (a trend that has accelerated). Christine Farnish, the NAPF's chief executive, has said that she expects defined benefits to disappear from the private sector within five years.
The deterioration of a once flourishing sector led to political intervention and the introduction of a regulatory framework designed to shepherd pension schemes to safety. This includes a new Pension Protection Fund modelled loosely on America's Pension Benefit Guaranty Corporation. In its first full year it will levy £575m from Britain's pension schemes, as it begins to phase in risk-adjusted premiums that call on healthier funds to pay less than creaking ones. A Pensions Regulator has also given more powers to trustee boards to claw back deficits from scheme sponsors over shorter periods, or to ask for security over other assets such as properties.
That is one of several trends embraced by actuaries that have gradually encouraged pension schemes to become more conservative in the assumptions they make and the assets they hold. One landmark was the decision in 2000-01 by Boots, a retailer, to switch all of its £2.3 billion of assets into a portfolio of long-dated cashflow-matching bonds and to make a linked share buyback that benefited shareholders. The deal, which proved well-timed and has since had some imitators, was deemed so radical at the time that many actuaries balked at suggesting anything similar to other clients. Coming near the peak in share prices, it was dismissed by many companies as merely a trading strategy. In fact, the deal came after years of internal debate, between Boots' managers and their financial advisers, pension-fund trustees and, yes, actuaries, about how to apply new actuarial ideas.
Many schemes have since been lowering their exposure to equities, investing more in property, private equity, hedge funds and commodities, as well as buying more bonds. At the heart of this trend is a concept known in the pensions business as “de-risking”. At present this is being touted as effectively by investment banks eager for fees as it is by actuaries. The banks see an opportunity to use their financial-engineering expertise to create structured portfolios of assets that are suited to pension schemes' future cashflows. They point out that even though equities have performed well since the end of 2002, funds' health has worsened. The reason is that liabilities have grown even faster than assets. (The accusation that actuaries failed to warn of the growth in liabilities is implicit.)
The solution, argue the banks, is to look more closely at the risks embedded in liabilities and then to reduce funds' riskiness with “Liability Driven Investing” (LDI). The big financial risks relate to inflation and interest rates, while the biggest non-financial risk is changes in longevity. Using derivatives and swaps, the financial risks can be largely stripped out (for a fee, of course) so that funds can be much more certain about their ability to meet future cashflow requirements.
Two LDI pioneers have shown what is possible. Friends Provident, a life insurer, implemented a hedging programme with Merrill Lynch in late 2003. In September 2005 the pension-fund trustees of WH Smith sold all of the £870m ($1.6 billion) fund's assets and invested 94% of the proceeds in a portfolio of interest-rate and inflation swaps, with the balance invested in equity options designed to capture returns from shares over the next decade or so. The company was persuaded to embrace the plan when its advisers explained that the level of risk in the pension fund was so high that the group's solvency could be at stake if things deteriorated.
It is too expensive to reduce long-term risks entirely, so the idea behind LDI is to focus on the big risks and narrow the range of possible future outcomes, limiting the bad ones. LDI is a bit like a hedging programme that zaps the negative effects of interest-rate and inflation risk. There is a range of LDI strategies and structures. In a sense, Boots implemented an LDI programme, but one using bonds rather than snazzier derivatives.
A long squeeze
One problem with LDI is the constraints on the supply of the instruments it uses, particularly when a pension scheme needs to stretch at least 50 years into the future (which is the limit of long-term swaps and bonds). Last year Merrill Lynch pointed out, for example, that Britain has some £700 billion of defined-benefit liabilities, but a mere £7 billion of 35-year index-linked (ie, inflation-proofed) government bonds. As more funds switch their attention to reducing risks, these supply constraints are likely to worsen. In a recent technical squeeze in the market for 50-year gilts, prices have risen so high that real yields have collapsed to historically low levels. This week, for example, the latest auction of 50-year bonds was oversubscribed and offered a real yield of just 0.46%. Demand is coming from pension funds (and insurance companies) looking for very long-dated investments, but also from investment banks seeking to hedge their own LDI-related trading books.
LDI springs from the new actuarial thinking in that it puts the risks in a pension scheme in the context of the sponsoring company's overall risk profile. But actuaries have begun to point out that LDI is not the answer for every fund. Those with financially strong sponsors, or with sponsors prepared to give pledges or guarantees to their funds, might have no need for a transaction that can be expensive. Moreover, a fund that locks in security at today's high bond prices might come to regret it a decade hence if real interest rates revert to their long-run historical levels.
Even so, the insight that pension schemes need more security is becoming well established in Britain and in America. Ultimately, the old actuaries failed because they did not properly anticipate, calculate and communicate the rising costs of retirement provisions, especially once inflation slowed and real interest rates fell from the mid-1990s onwards. The promise of the new actuaries is that, as their ideas spread, such mispricing will never happen again. If that has come too late for many defined-benefit schemes, at least it might offer a bit more certainty when planning for the next generation's old age.
Monday, January 23, 2006
How Europe Can Age Gracefully
Business Week article
NEWS ANALYSIS
Natascha Gewaltig
How Europe Can Age Gracefully
Its graying population will put economic pressure on the euro zone soon. What's needed: the political will to implement reforms now
Will the graying of Europe be its economic undoing? In coming decades, a key challenge for countries in the euro zone -- those European nations that use the euro as their common currency -- is posed by an aging population. Even if labor participation rates rise and more women take jobs, economies will depend on immigration to sustain economic growth and fund pension-system liabilities. The next four years provide a window of opportunity for government to implement crucial changes before the demographic shift moves into high gear.
Low fertility rates and an increase in life expectancy will lead to a change in the structure of the euro zone population over the coming decades. Demographic estimates from the European Commission (EC) show that much of the increase in life expectancy will be due to a lower mortality rate in the older age brackets. That means that the average age of the population will increase, as the number of citizens older than 65 rises in relation to the working-age population.
CRIMPED LABOR SUPPLY. The share of the working-age population (15 to 64) will fall from around 66.9% in 2004 to just 56% in 2050. At the same time, the share of the population older than 65 will increase to 30% from 17%.
This development will have several effects. Foremost, the labor supply will decrease over the next few decades. The labor shortage will lead to an increase in wages and a likely attempt to substitute capital for labor.
Companies will need to find less labor-intensive production mechanisms as the availability of labor, especially in narrow fields of expertise, diminishes. As a result, the capital/labor ratio may rise, as will labor productivity and gross domestic product per capita.
WOMEN TO THE RESCUE? However, as the EC points out, some simulations suggest that the positive effect on economic growth of expanding the capital stock around each worker will be marginal compared with the projected drop in labor supply. Even if the euro zone economies are able to post a 14% rise in the capital-labor ratio, productivity would only increase by 3.3% per year until 2050, assuming a constant population structure.
So a greater increase in productivity will be needed to compensate for the loss in output resulting from a fall in the working-age population. Still, the EC estimates that potential growth of the euro zone economy, as gauged by GDP, will decrease to only around 1% in the long term as a result of the aging population.
One key issue for these projections: whether female labor participation rates increase, which would at least partially offset the effect of a decline in labor supply. Germany, for example, had a female participation rate of just under 60% in 2004, according to data from the Organization for Economic Cooperation & Development (OECD).
This compares to rates of 65.4% in the U.S. and 66.6% in Britain. Participation rates in France and Italy are even lower than in Germany. For the euro zone as a whole, the female employment rate was 56.5% in 2003, and the EU commission suggests that this could rise to 64.6% by 2050.
TAX PRESSURES. At the same time, the employment rates of older workers in the age bracket of 55 to 64 will have to be lifted from the 37.4% in 2003. High unemployment in major euro zone countries has meant that early retirement has become almost the norm. The demographic changes will mean that this is no longer a feasible option for the overall economy.
Nevertheless, a rising female participation rate will not be sufficient to compensate for the expected decline in the workforce over the period, so immigration will also have to play an increasingly important role. As the commission has pointed out, it's very important to ensure that the skill structure of migrants matches labor market needs. At the moment, unemployment rates among immigrants tend to be higher than those of natives in many EU countries, and better integration remains a key challenge.
The impact of these demographic changes on the budgetary situation will be important for financial markets. For one, the demographic changes will lead to a sharp increase in pension spending and other age-related expenditure. Without structural reforms, this would lead to a marked increase in taxes and social security contributions, which will also have an impact on GDP growth.
VICIOUS CYCLE. A rise in labor taxes to finance the additional cost could cause unemployment, and the decline in net wages could also have a further negative impact on labor supply.
The OECD stresses that raising taxes and levies to finance pensions reduces the total amount of physical capital that can be accumulated via the impact on aftertax income and associated availability of funds for private investment. The necessary tax increases will have a negative impact on productivity and wage levels.
A privatization of pension schemes, on the other hand, could more than double the long-run ratio of physical capital to labor, raising long-run wages by around 25%. Indeed, some studies even suggest that the current pay-as-you-go (PAYG) pension schemes have a negative impact on family formation, and thus have contributed to the problem of the aging population.
NO TIME TO WASTE. Still, relatively favorable demographic developments over the next 4 to 5 years mean the period until 2011 is a window of opportunity for governments to prepare their pension systems and labor markets for the upcoming challenges. Radical changes and reforms of the PAYG pension schemes in key countries will be necessary. Despite the life-expectancy increase, the entry level for pension schemes has remained widely unchanged -- but this will have to be increased for the plans to remain sustainable.
Nevertheless, the time spent in retirement is likely to increase in the long run, all else being equal, and the change in dependency ratios will make the current PAYG system unsustainable. Pension levels will have to be lowered, and private-pension provisions will need to become more important. If policymakers exert the political will to implement these changes now, the euro zone may weather the coming demographic shifts more easily.
NEWS ANALYSIS
Natascha Gewaltig
How Europe Can Age Gracefully
Its graying population will put economic pressure on the euro zone soon. What's needed: the political will to implement reforms now
Will the graying of Europe be its economic undoing? In coming decades, a key challenge for countries in the euro zone -- those European nations that use the euro as their common currency -- is posed by an aging population. Even if labor participation rates rise and more women take jobs, economies will depend on immigration to sustain economic growth and fund pension-system liabilities. The next four years provide a window of opportunity for government to implement crucial changes before the demographic shift moves into high gear.
Low fertility rates and an increase in life expectancy will lead to a change in the structure of the euro zone population over the coming decades. Demographic estimates from the European Commission (EC) show that much of the increase in life expectancy will be due to a lower mortality rate in the older age brackets. That means that the average age of the population will increase, as the number of citizens older than 65 rises in relation to the working-age population.
CRIMPED LABOR SUPPLY. The share of the working-age population (15 to 64) will fall from around 66.9% in 2004 to just 56% in 2050. At the same time, the share of the population older than 65 will increase to 30% from 17%.
This development will have several effects. Foremost, the labor supply will decrease over the next few decades. The labor shortage will lead to an increase in wages and a likely attempt to substitute capital for labor.
Companies will need to find less labor-intensive production mechanisms as the availability of labor, especially in narrow fields of expertise, diminishes. As a result, the capital/labor ratio may rise, as will labor productivity and gross domestic product per capita.
WOMEN TO THE RESCUE? However, as the EC points out, some simulations suggest that the positive effect on economic growth of expanding the capital stock around each worker will be marginal compared with the projected drop in labor supply. Even if the euro zone economies are able to post a 14% rise in the capital-labor ratio, productivity would only increase by 3.3% per year until 2050, assuming a constant population structure.
So a greater increase in productivity will be needed to compensate for the loss in output resulting from a fall in the working-age population. Still, the EC estimates that potential growth of the euro zone economy, as gauged by GDP, will decrease to only around 1% in the long term as a result of the aging population.
One key issue for these projections: whether female labor participation rates increase, which would at least partially offset the effect of a decline in labor supply. Germany, for example, had a female participation rate of just under 60% in 2004, according to data from the Organization for Economic Cooperation & Development (OECD).
This compares to rates of 65.4% in the U.S. and 66.6% in Britain. Participation rates in France and Italy are even lower than in Germany. For the euro zone as a whole, the female employment rate was 56.5% in 2003, and the EU commission suggests that this could rise to 64.6% by 2050.
TAX PRESSURES. At the same time, the employment rates of older workers in the age bracket of 55 to 64 will have to be lifted from the 37.4% in 2003. High unemployment in major euro zone countries has meant that early retirement has become almost the norm. The demographic changes will mean that this is no longer a feasible option for the overall economy.
Nevertheless, a rising female participation rate will not be sufficient to compensate for the expected decline in the workforce over the period, so immigration will also have to play an increasingly important role. As the commission has pointed out, it's very important to ensure that the skill structure of migrants matches labor market needs. At the moment, unemployment rates among immigrants tend to be higher than those of natives in many EU countries, and better integration remains a key challenge.
The impact of these demographic changes on the budgetary situation will be important for financial markets. For one, the demographic changes will lead to a sharp increase in pension spending and other age-related expenditure. Without structural reforms, this would lead to a marked increase in taxes and social security contributions, which will also have an impact on GDP growth.
VICIOUS CYCLE. A rise in labor taxes to finance the additional cost could cause unemployment, and the decline in net wages could also have a further negative impact on labor supply.
The OECD stresses that raising taxes and levies to finance pensions reduces the total amount of physical capital that can be accumulated via the impact on aftertax income and associated availability of funds for private investment. The necessary tax increases will have a negative impact on productivity and wage levels.
A privatization of pension schemes, on the other hand, could more than double the long-run ratio of physical capital to labor, raising long-run wages by around 25%. Indeed, some studies even suggest that the current pay-as-you-go (PAYG) pension schemes have a negative impact on family formation, and thus have contributed to the problem of the aging population.
NO TIME TO WASTE. Still, relatively favorable demographic developments over the next 4 to 5 years mean the period until 2011 is a window of opportunity for governments to prepare their pension systems and labor markets for the upcoming challenges. Radical changes and reforms of the PAYG pension schemes in key countries will be necessary. Despite the life-expectancy increase, the entry level for pension schemes has remained widely unchanged -- but this will have to be increased for the plans to remain sustainable.
Nevertheless, the time spent in retirement is likely to increase in the long run, all else being equal, and the change in dependency ratios will make the current PAYG system unsustainable. Pension levels will have to be lowered, and private-pension provisions will need to become more important. If policymakers exert the political will to implement these changes now, the euro zone may weather the coming demographic shifts more easily.
Saturday, January 07, 2006
India China to gain from ransfer of assets
Wharton, Business Standard
BS Regional Bureau January 07, 2006 04:35 IST
By the year 2050, there will be a situation where two-thirds of the world's capital will be owned by Asian countries like India and China, said Jeremy Siegel, the Russell E Palmer professor of Finance, on the first day of the Wharton Alumni Forum, held in Mumbai.
The demographic changes in developing countries such as India and the developed ones like the US and European countries will alter the capital ownership patterns across continents, he added.
Siegel said, "The US will see rising life expectancy. There will be fewer workers to produce goods, coupled with a lot more ageing population who will want to consume those goods."
Which, according to Siegel, raises two questions: Who will produce the goods that are required by a vast section of the older population? And, who will buy the assets owned by the older population?
This is because younger people provide goods and the older people transfer their assets -- be it in terms of physical assets or even intangibles such as knowledge and experience.
That's where the developing countries like India will have a key role to play, Siegel said. India can see more young people in the working age group and fewer outside the working age.
Siegel summarised: "Developed countries will have to buy these goods from India and, in turn, transfer their assets to the people from this nation."
This is in sync with the mindset prevalent in the developed economy whereby the older populace in certain developed locations in the states like Florida, for instance, which have sold assets to the young in exchange for imported goods from the other 49 states.
A large worker population will also mean larger production of goods and this will result in 'India and China cornering twice the GDP of the developed world.'
BS Regional Bureau January 07, 2006 04:35 IST
By the year 2050, there will be a situation where two-thirds of the world's capital will be owned by Asian countries like India and China, said Jeremy Siegel, the Russell E Palmer professor of Finance, on the first day of the Wharton Alumni Forum, held in Mumbai.
The demographic changes in developing countries such as India and the developed ones like the US and European countries will alter the capital ownership patterns across continents, he added.
Siegel said, "The US will see rising life expectancy. There will be fewer workers to produce goods, coupled with a lot more ageing population who will want to consume those goods."
Which, according to Siegel, raises two questions: Who will produce the goods that are required by a vast section of the older population? And, who will buy the assets owned by the older population?
This is because younger people provide goods and the older people transfer their assets -- be it in terms of physical assets or even intangibles such as knowledge and experience.
That's where the developing countries like India will have a key role to play, Siegel said. India can see more young people in the working age group and fewer outside the working age.
Siegel summarised: "Developed countries will have to buy these goods from India and, in turn, transfer their assets to the people from this nation."
This is in sync with the mindset prevalent in the developed economy whereby the older populace in certain developed locations in the states like Florida, for instance, which have sold assets to the young in exchange for imported goods from the other 49 states.
A large worker population will also mean larger production of goods and this will result in 'India and China cornering twice the GDP of the developed world.'
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