I personally think that this is the most important bit of my three-part research, and this applies to every working human on earth apart from rentiers. Probably most of us would like to have dignified and peaceful life post-retirement. It seems like a feasible scenario but here comes the bad news, not everyone will have that opportunity. In a nutshell, the pension system is broken and negative rates even accelerated the process of breaking it. In this part, I will describe the current condition of the pension system in countries with negative rates, although similar problems apply to countries having a low-interest-rate environment. There will be also a paragraph talking about the impact of low rates on insurance companies and their clients.


PENSIONS

First, to get to know where the problem comes from we have to understand pension funds asset allocation, or what kind of assets they own the most. According to the JP Morgan survey as of March 31, defined benefit pension funds (a type of pension plan in which an employer promises a specified pension payment) in Japan holds 44.8% in bonds (18.1% domestic, 26.7% foreign). In the European Economic Area, the number of bonds held by pension funds in 2018 was 54% according to European Insurance and Occupational Pensions Authority, Financial Stability Report.

As you can see, the asset allocation to bonds is very high. As we have already learned in the previous article, the bond yields decline together with falling interest rates. This in effect decreases pension funds future returns and all despite increases in bonds’ prices (yields and prices have an inverse relationship). As if that was not enough, increasing average life expectancy exacerbates the problem (the longer the people live, the more pensions have to be paid). It has also to be emphasized that this is the issue on a global scale since the bond yields around the world have been declining for a few decades.

This trend is perfectly shown in the chart below.




According to Bank of America Merrill Lynch, since 2014 share of negative-yielding bonds in the global bond market has increased from 0% to more than 20% (black color). Once again, more than 20% of bonds around the world guarantee a LOSS if they are held to maturity. And yet, pension funds and insurance companies are long-term investors! They usually hold bonds to maturity.

In addition, roughly 20% of global bonds are yielding between 0-1%. So, we essentially have about 40% of bonds providing no return. These changes have had a disastrous effect on pension funds, especially for defined benefit plans which account for 90% of pension funds in Europe and more than 90% in Japan. They use investment-grade bond yields (high-quality bonds) to calculate their future liabilities. Therefore, if the yields tumble then liabilities increases. At this point, it is worth to recall that there are more than $11 trillion negative-yielding bonds in the financial system, which has even reached $17 trillion in August this year (see the chart).

source: zero hedge



It simply means that if you buy a -0.50% yielding bond with 10-year maturity for $100, after 10 years you will get back $99.5, 50 cents loss. However, the biggest financial institutions in the world buy these bonds using billions of dollars.

As you probably guessed the largest amount of negative-yielding debt is trading in the Eurozone and Japan. The graphic below breaks this down into details. It has to be emphasized that it was at the point when the negative-yielding debt has reached its all-time record ($17 trillion). However, the percentage share of each region has not significantly changed.


source: Bloomberg

Currently, more than 45% of negative-yielding bonds have been in Europe, whereas roughly 43% in Japan and almost 12% in the rest parts of the world.

Ros Altmann, a former United Kingdom pensions minister estimates show that a 1% drop in long-term interest rates will increase liabilities of an average pension scheme by roughly 20%, while their assets would only increase by approximately 10%. In effect, the funding status of a pension fund will drop forcing employers to increase their funding and/or pensions will be decreased. By the way, this is already happening in the Netherlands.

It sounds really scary. Let’s look then how big the shortages actually are.

In 2017 pension fund assets in Europe represented only 76% of liabilities. It means that to cover every $100 billion liabilities funds had only $76 billion assets or a $24 billion funding gap.


As I mentioned before, it is a global-scale issue, therefore it cannot surprise you that it has also been highlighted by the former policymakers. More specifically, by the prestigious Group of 30 (a private international body of leading financiers and academics) in a report covering 21 countries accounting for 90% of global GDP, including the USA, China, Japan, Germany, India, and Mexico. The report was overseen by former U.K. Financial Services Authority Chairman Adair Turner.


The report says that the pension funds funding gap of the aforementioned countries in 2018 was $1.2 trillion and is expected to increase to 15.8 trillion in 2050, and this is all adjusted for inflation. Therefore in nominal terms, it would be so much higher.

It is extremely worrying development and if nothing changes then a 10% cut in an average pension may be soon perceived as a really small punishment. Pension funds try to fight this by increasing their exposition in more risky assets and pass those risks to their customers. I will not go into details but as a courtesy of Bloomberg, you can see an example of reprehensible behavior of Denmark pension funds, the country where interest rates have been negative for longer than anywhere else.

“Regulators are increasingly worried that pension funds are shifting more risk over to their customers. In August, the head of the Danish financial regulator said there are signs that retail investors are being forced to accept more risk than they understand.”

If that is true, those people should have been fired and never allowed to work in the industry again.


INSURANCE COMPANIES

The next important participants of the financial system affected by the level of interest rates are insurance companies. They are engaged in the market by investing the money received from businesses and individuals (insurance premiums). They do it to ensure they have sufficient capital to pay future claims. Thus, if their returns are poor, the premium increases.

These companies usually invest in the so-called safe assets with relatively low returns and high liquidity just in case they would have to pay claims immediately. Again, we are going to deal with bonds. A notable example is that most European insurers are intensively involved in high-quality assets in Switzerland and Germany. Ironically, the bonds of these countries currently have the lowest yields around the world, which in effect does not provide sufficient expected returns (a consequence of negative interest rates).

To give you some reference about what numbers we are talking about. European Union insurance companies hold assets worth $11.2 trillion or equivalent of 58% EU GDP (Gross Domestic Product) while Japanese insurers manage $3.4 trillion assets or 62% of Japan GDP.

Insurer's job is to make long-term promises to policyholders, sometimes including return guarantees. Now imagine, that you have bought a life insurance or insured your home. It supposed to be full protection for both your family and yourself in case something unexpected happens. This premium you have put in the insurance company is invested in the market and your policy is supposed to last for 30 years. Now here comes the reality.

According to stress tests of European life insurers conducted in 2014, the whole insurance industry is expected to running serious cash-flow pressures in about 8-11 years. That was 5 years ago, so now I think that the problem is much bigger as we live in a world of negative interest rates.

Moreover, European Insurance and Occupational Pensions Authority said that more than half of European life insurers have been guaranteeing a return to investors that exceeds the yield on the local 10-year government bond. Again, it was 5 years ago when most bond yields have been positive.
Back then, guaranteed return on total policies in Germany was about 3.2% and has been reduced to 1.25% on new products, relative to a 10-year bond yield of about 0.3%. Nowadays, the 10-year German bond yield is -0.36%, up from -0,71%. Can you see the mismatch? You probably wonder now what does happen when guaranteed returns are to be lowered? Here comes the answer.
In Japan, it took more than 20 years and bankruptcy of eight insurers to lowers guaranteed returns for clients and bring some sort of normality. I wonder how many people have been harmed due to those circumstances.

In the case of Europe, however, no one exactly knows how it could play out as the governments will probably step out and try to rescue the system using taxpayers' money. Let’s, therefore, highlight the countries which are the most exposed. According to Moody’s, these are Germany, Netherlands, and Taiwan, where more longer-term and higher-value guaranteed returns were written in the past (and as we know expected returns have fallen dramatically due to low bond yields). The agency also says that Japan, South Korea, Sweden, and Switzerland have to be watched very closely.


CONCLUSION

The difficulties regarding pensions and insurances are much more extensive than one would think. Over 70% of bonds held by insurers and pension funds in the Eurozone now yield less than 1%. How on earth then can they get required returns of at least 4-5%?

Summarizing, the longer the negative rates will stay with us the more liabilities those companies will have to meet in the future, which of course will be not met. Nowadays, not many people realize the significance of the problem but when their pockets will substantially shrink then we will see not tens of thousands of striking people on the streets like in the Netherlands, but millions.

Protect yourself and take care.
Seb