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
2 Comments
Long term obviously a problem but not for a generation at least. Take note Pensions would have lot of long term debt in its portfolio (20-30 year maturity) even 5 years out. Unimaginable cap gains on the portfolio (assume you sell now, to traders/speculators). Look at Japan - greying population/ultra low interest rates for 20 bloody years no problem. Even for next generation Japan Pension funds found one solution (real estate) - see link.
ReplyDeletehttps://twitter.com/Determinedinvst/status/1208822859922952192
By the time problem actually comes to frution, all current politicians will have retired/died. There problem is solved at least.
I see your point, but why then there are already pension cuts? I dont call for a pension crisis now, but people are receiving less than they supposed to, that it was promised to them.
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