The 2008 Global Financial Crisis (GFC) was primarily driven by a huge accumulation of debt. A decade after the GFC, another large financial crisis is looming because of a lack of savings: the pension crisis. Although not a traditional or catalyst-driven crisis, this pension crisis will have significant effects for economies.

Our observations

  • Life expectancies increased significantly during the 20th century, putting pressure on traditional public pension provisions. For example, when the U.S. Social Security Act was enacted in 1935, U.S. citizens born at the time had a lower life expectancy at birth (61.7 years) than the current retirement age (66 years). American life expectancy has increased to 79 years, implying an average thirteen years of public pension assistance.
  • Simultaneously with rising life expectancies, fertility rates have decreased. The combination of more elderly people with fewer people born means that the dependency ratio – the ratio of those in the labor force and paying for retirees out of the labor force – will rise significantly and put more pressure on the affordability of public pension provisions. The United Nations estimates that the worldwide dependency ratio will double between 2015 and 2050 (although with wide regional differences based on demographic differences).
  • A decade of ultra-low interest rates in response to the GFC has deteriorated pension funds’ and corporate pension schemes’ balances sheets, as their future liabilities have lower discount rates. As a result, many corporate pension schemes in the U.S. and Eurozone have become underfunded in recent years. Pension funds in particular have been hit, as they are required to invest for a large part in safe assets (e.g. government bonds), that are sensitive to long-term interest rates.
  • Furthermore, ultra-low interest rates have hurt frugal savers and made credit cheap. In the S. and Eurozone, consumer debt is now at a record high, already above their levels before the GFC. As a result, personal saving rates have decreased significantly in the U.S. and the Eurozone in recent years.
  • A 2014 survey on financial literacy by S&P asked respondents four questions about basic financial concepts (risk, inflation, interest rates, and compound interest rates). The study found that on average, 52% of respondents from the EU are financially illiterate. Although there is a positive relationship between GDP per capita and financial literacy, at least 30% of the population in all major economies are financially illiterate.
  • The World Economic Forum estimated that in 2015, the retirement savings gap (the amount of pension income to maintain 70% of pre-retirement purchasing power) in eight countries – the U.S., U.K., the Netherlands, Australia, Canada, India, and Japan – amounted to $70 trillion. Underfunded government pension schemes account for 75% of this gap. This total gap will increase to $400 trillion ceteris paribus by 2050. Likewise, Citigroup estimates that the 20 biggest OECD economies face public pension debt of $78 trillion, or 190% of their GDP.

Connecting the dots

In traditional societies, people have children at least partly as insurance against falling into poverty and lack of resources when they would not be able to work anymore. Modern societies have set up formal social security systems and pension schemes to provide a structural solution to this problem, and to distribute individual risk across societies. When defined as being able to maintain a reasonable degree of pre-retirement purchasing power, many people around the world still face insufficient funds when they stop working. In emerging markets, this is primarily because social security systems are non-existent, such as in Africa or India, or largely underdeveloped hence unable to maintain citizens’ lifestyles and consumption patterns, as in China. However, many citizens in the West are also facing a significant retirement savings gap.
Most modern pension systems consist of three pillars: public pension provisions by governments (generally in the form of a “senior basic income”), corporate, work-related pension schemes, and individual savings and pension products. The first two pillars have become significantly underfunded in recent years. With worsening demographic trends (i.e. ageing societies with lower natural population growth, hence rising dependency ratios), governments will become pressured to spend more on public pension provisions. However, public debt has risen significantly after the GFC, so that governments have less fiscal space to do so. Furthermore, the increased number of workers in the informal and gig economy and self-employed entrepreneurs add to the problem, as they often don’t enroll in corporate pension schemes (the second pillar) and remain primarily dependent on government-provided pensions (the first pillar). However, consumer savings, the third pillar, are not sufficient to make up for these shortcomings either, as indebted consumer balances show few signs of preparation.

This problem is compounded by the fact that many citizens are financially illiterate: they lack the financial knowledge and skills required to save up for their senior days. At best, this means that citizens find it difficult to independently set up and maintain a liquid, solvent and secure long-term private balance sheet; at worst, that they are largely ignorant of their darkening financial future. With all three pillars failing to deal with the structural problems of low interest rates and demographic headwinds, significant retirement savings gaps emerge.
This looming pension crisis will have consequences on many levels. Governments will have to spend more on pension provisions, forcing them to reallocate their government spending from other sources. Likewise, private corporations will face increased costs of their pension liabilities, hence deteriorating their balance sheets and limiting free cash flows. In addition, consumers will take a hit as well. Although retiring baby boomers may unleash a new wave of wealth into economies, there will also be a number of senior consumers that are not included in this “silver economy”, but who will see their disposable income shrink and will be forced to adopt more frugal consumption habits. However, as this crisis unfolds gradually, without a clear catalyst (unlike the GFC with the fall of Lehman Brothers), this looming pension crisis is not a “sexy” topic for either lawmakers or shareholders, making it easier for them to pass the buck. Consequently, it will have gradual but long-lasting effects on consumers, corporates and public finances, hence on consumption, corporate earnings and governments’ fiscal capacity. This will further sustain post-crisis deflationary forces and keep interest rates low for longer. Solutions will have to break this status quo and redefine the context of work, pensions and life after retirement, something we will explore next week.

Implications

  • Corporate pension liabilities, which, as this note argues, will increase in the long-term, are often booked off-balance sheets. Therefore, corporate defining benefit pension plans will become a more important variable for assessing corporate financial health.
  • The retirement savings gap and subsequent reallocation of government, corporate and consumer spending also provide opportunities. First, consumer staples might outperform consumer discretionary aimed at low-income seniors, as well as segments that benefit from structurally lower interest rates (i.e. food and retail over financials). Second, at a geographic level, countries with favorable demographics (e.g. France or the U.S.) will face fewer problems than countries with a large bulk of workers retiring in combination with low fertility rates (e.g. Germany or Japan). Export countries and sectors with high exposure to emerging markets, which generally have more favorable demographics, will likewise remain unaffected by this pension crisis in the West.
  • We have written before that sovereign wealth funds (SWFs) are suitable vehicles for investing in opportunities with a long-term horizon and illiquid assets. Furthermore, they are also interesting for government and corporates when it comes to tackling their pension problems. Pension funds and schemes generally use the risk-free interest rate (i.e. financial yield curve) as their discount rate, which is determined by volatile financial markets. SWFs, on the other hand, can use the real economic growth forecast, corrected for demographic changes, as their discount rate. This gives them an incentive to invest in and increase the earning power and long-term productivity of their home economies and company. This reduces pressure on public finances in the long-term and benefits workers’ corporate pension schemes.