The looming pensions crisis

This is an amended version of a piece published in the Irish examiner

In addition to the banking crisis the government also face a series of crises in relation to pensions.

There are at least three separate but related crisis around the issue of pensions. Firstly we have a situation where the state is paying pensions, both for public servants and for others, but of current income. Secondly we have a situation where the vast majority of defined benefit schemes in commercial organizations, so my statement was, are underwater. The third is the experience of the last number of years in relation to investments cannot but have heard it chilling effect upon the people’s willingness to engage with financial services, including pensions.

At present Ireland is in the lucky position that has a young population. Approximately 17% of the populations are in the elderly category. CSO projections suggest that this could rise to as high as 25% by 2021 and rise to as high as 46% in 2041. All of these persons will be dependent, at least in theory, a pension. From any of them, if the past is any guide to go by, this will primarily be displayed old-age pension.

A proportion of these persons will also be the retirees from civil and public service employment, and at least in the medium-term the majority of these will be on the “old-style” pension arrangements, where the pension is tied to the final retiring salary.

As of 2009 this liability, according to the Comptroller and Auditor General (p12 and generally here) for public sector pensions alone, was €116 billion. In other words were the state to have to go out, purchase on the open market an annuity the yield on which would be equivalent over the period to the pension to be paid to these public servants this would cost €116 billion. It is inconceivable that this liability can be allowed to continue to grow. Unchanged, the public sector pension bill could reach €5b per annum. The recent changes announced by the government in relation to pensions for public servants being based on a lifetime average will help to reduce the growth of this pension liability. It is entirely probable however that faced with the need to cut both immediate and future expenditure the state will have to move to reduce the actual amount of expenditure on public sector pensions in the near term. The proposed new arrangements would also it appears be applicable, in certain circumstances, to existing pensions. This might mean that public servants find that while their existing built-up pension entitlements stay as they are future pension entitlements might conceivably be linked not to final pay but instead either to average pay or to the consumer price index. Another possibility might be the imposition of additional taxes on lump sums, or indeed full retrospection of the average lifetime he provision. Public sector employees, existing and future, will need to be aware of the fact that pension provision, coming out as it does and will of current taxation, is going to be reduced.

Private sector pensions are not in much better shape. Up to 80% of defined benefit schemes may well find themselves in actuarial deficit. Persons paying into Defined contribution schemes have been very badly hammered, especially those coming up to the last number of years before retirement. All of this will serve to throw additional strain on the public purse.

Government does have a good plan in the automatic opting in of new employees into a defined contribution scheme. This is soundly based on research, and is to be welcomed. Personally I would prefer to have seen a situation where persons were not easily able to opt back out after a number of years, as is the case. However this will over time results in the building up of very large defined contribution schemes, which will in itself pose problems.

For instance, one could easily conceive of a situation whereby faced with pension pots of tens of billions and a government fiscal position that becomes Strained there is a temptation for said government to either engage in financial repression, or to direct pension savings away from market towards government assets. The experience of countries such as Chile and Poland is that strong controls need to be put in place to ensure that management fees of state-mandated pension pots are kept at the absolute lowest level possible. We must also take cognizance of the lessons from behavioural finance, such as a general tendency to overconfidence, loss aversion the tendency of people to over diversify, difficulties in people making decisions when faced with a large number of choices, and other heuristics and rules of thumb which might together resulted in individuals making significantly sub optimal choices in how they allocate their pensions savings. There is a wealth of research from behavioural economics which can guide this , if drawn upon. See here, for issues on individual choice; here for some Australian experience; here for a study of individual issues in dc investing; here for a more general survey. There is a nice piece in business and finance from the Geary institute also worth reading.

In an environment where there seems to be no such thing as a risk-free asset, where even sovereign bonds are now exposed to the possibility of major losses, where equities may be facing into a secular bear market, and where investors have been badly burned, the appetite for the risk required to grow defined contribution schemes to an adequately large amount of money sufficient to pay the pensions of the contributors is likely to be muted. That would be a pity, as taking risk is the inevitable requirement to ensuring that a decent return is obtained.

If we want to provide a decent level of income for ourselves when we retire then we have only two choices. Either We save it ourselves, or we pay for it through taxes. Either way there is a high probability that in the near term we are going to start to pay more. This will result in further withdrawals of money from an already fragile domestic economy. However, there is no choice.