Pension, a ‘handle with care’ product

July 21, 2017:  

There is a crisis in the US pension fund industry which can cause, at least, social unrest, and possibly another financial crisis. The State of Illinois, for example, is likely to be the first US State to be rated as junk. Why is this happening?

Promise & crisis

During the baby boom years, when it had a large, and expanding, young population, State governments felt emboldened enough about the future to offer defined benefits pension schemes, promising to look after retirees with ‘defined’ benefits.

Since then, a couple of unanticipated things happened. The 2008 financial crisis hit, and the population aged as Americans were not producing babies as rapidly as they did after the war. In order to come out of the 2008 global financial crisis, central banks pumped more money, hoping that extra money would be used by a) consumers to buy more which would spur consumption, which accounts for 70 per cent of US GDP, and b) companies, which would invest more, again spurring demand, and GDP.

Neither happened. The money went, instead, to those who could borrow cheaply, and was invested in assets. The balance sheets of four central banks of US, ECB, England and Japan grew over four times from $4 trillion in 2007 to $13 trillion now.

Lowering of interest rates

Interest rates were lowered to near zero, and this hurt savers. Savers included the pension funds; the calculations of these funds required a return of 8 per cent on their assets to meet their obligations, but they got around 1 per cent. The States were supposed to put in more funds to meet the deficit, but faced with lower tax revenue themselves, they were unable to do so.

Voila, a crisis is upon us. Moody’s has evaluated the unfunded pension liabilities at $3.5 trillion. If the rating of States is reduced to junk, they can’t borrow money and will have to default on the promised defined benefits. That will lead to social unrest on an unprecedented scale.

The US Federal Reserve Chair Janet Yellen needs to be a Goldilocks with interest rates, neither too hot (which discourage saving and investment) nor too cold (which discourage saving and create such problems). She has embarked on a journey to raise interest rates and reduce the size of the Fed balance sheet and has recently threatened to stay the course of rising rates.

Lose-lose situation

This would provide some relief to the pension funds, but would also cause grief. This is because pension funds have increased allocations to equity once fixed income returns fell; and a hike in rates by Yellen would cause stock markets to fall. So, it’s a lose-lose situation.

In India, the Central Bank has, thankfully, been more reticent in reducing interest rates and has done a Goldilocks with them. It has also been wary of permitting weapons of mass financial destruction (derivatives) which caused the 2008 crisis and can cause another.

India’s problem has been directed lending to select companies and the lugubrious pace of our judicial system which appears to lean towards those who break the law (granting adjournments whenever asked for) instead of the victims. The NCLT has now ruled shorter adjournments in bankruptcy cases; but why not in all?

(The writer is India Head — Finance, Asia/Haymarket. The views are personal.)

(This article was published on July 21, 2017)

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