By Edward Chancellor at Breaking Views
The United States is not a “bubble economy”. That’s the official view of the Federal Reserve expressed by Chair Janet Yellen earlier this month. Yellen describes a bubble as a combination of “clearly overvalued” asset prices, strong credit growth and rising leverage. In other words, the type of financial fragility the central bank, with its vast research staff, failed to spot prior to the subprime crisis.
The Fed’s definition of a bubble is too narrow. Bubbles are, in essence, illusions of wealth. The last two great bubbles – internet stocks and U.S. real estate – involved inflated asset prices. The great current bubble is centered around liabilities, or promises to make future cash payments. The owners of these claims consider them part of their current wealth. But what if they cannot be paid?
These thoughts are provoked by a gloomy note on pensions by Andy Lees of the independent research outfit MacroStrategy Partnership. Lees is worried that the assumptions involved in calculating pensions are as flawed as the valuations prevalent during the dot-com bubble.
The present value of a pension is arrived at by discounting future cash payments. As interest rates have fallen, this discount rate has declined, increasing pension liabilities. As a result, many pensions find their liabilities exceed assets. In pensions-speak, they are “underfunded”.
For instance, the current deficits of U.S. corporate “defined benefit” pension plans are estimated at around $425 billion, by Citigroup. UK and European corporate pension plans also sport large deficits. The aggregate shortfall of American public-sector pension plans – state and local government – is somewhere between $1 trillion and $3 trillion, according to Citi.
The true extent of the mismatch between pension assets and liabilities is greater than reported. Let’s start with the assets. U.S. corporate pensions assume a return of 7.1 percent on plan assets. The assumed rate of return for American public pension plans is somewhat higher. The retirement industry will find it difficult, nay impossible, to achieve these returns.
The U.S. stock market is currently expensive by historic standards. GMO, the Boston-based asset manager (and my former employer), expects U.S. stocks to return minus 1.2 percent annualized over the next seven years.
Government bonds in developed economies, sporting minuscule and in some cases negative yields, won’t make up the difference. A traditional portfolio of 60 percent equities and 40 percent bonds is likely to return a mere 2 percent over the long run, according to MacroStrategy. Given that pension plans have a higher weighting to bonds their returns are likely to be even lower.
Then there’s an issue with the discount rate used to arrive at the present value of pension liabilities. American states and local governments apply an average discount rate of around 7.5 percent to value these liabilities. U.S. corporate pension plans use a 4 percent to 4.5 percent discount rate. By contrast, the current yield on the 10-year Treasury is less than 2 percent. These “discount rates are totally unrealistic”, says Lees. If realistic discount rates were applied, pension liabilities would balloon.
The adverse consequences of the pensions bubble are already evident. Several municipalities and towns, including Detroit and San Bernardino, have declared bankruptcy. The Pension Benefit Guaranty Corp, the quasi-state body which insures corporate pensions, has liabilities roughly twice the size of its assets and will run out of money in the next few years. Entitlements will have to be cut, taxes raised, and public services reduced. None of these actions will be popular.
Pensioners and taxpayers are not the only stakeholders in danger. Moody’s points to risks to U.S. municipal bonds should the pension crisis persist. Last year, the International Monetary Fund warned that the European life-insurance industry – which also applies above-market discount rates to its liabilities in order to maintain the appearance of solvency - poses a potential threat to financial stability.
Then there’s the impact on the real economy to consider. If corporate pension deficits increase, cash flow will have to be diverted away from investment. Uncertainty about future pension payouts may undermine consumer confidence.
Underfunded pensions are only the tip of the iceberg. The liabilities from unfunded government pensions dwarf everything else. Citi estimates that pension costs for 20 OECD countries will come to $78 trillion in current money, which is nearly twice their aggregate reported national debt.
Ben Bernanke, Yellen’s predecessor at the Fed, liked to talk about the global “savings glut”. In truth, there’s been a dearth of saving in the United States and the UK since the turn of the century. That should come as no surprise. Interest rates, after all, provide an inducement to save. Zero interest rates diminish that incentive.
Over the past decade, the net savings of Americans have averaged little more than 1 percent of gross domestic product. The collapse in the savings rate has been accompanied by declines in investment and productivity growth. All this means less money in the pot for tomorrow’s pensions. The gap between the belief in those pension promises and the ability to pay looks very much like a bubble.