Public pension pressure

March 2015  |  FEATURE  |  PENSIONS

Financier Worldwide Magazine

March 2015 Issue

March 2015 Issue


The issue of pension funding has made headline news in recent years. Notable municipal bankruptcies in Stockton, California, and in Detroit, Michigan have helped to shape the discourse around public pensions. Though both public and private pension schemes have faced considerable difficulties, public pensions are likely to face the toughest time ahead. Events in Stockton and Detroit have been well documented. Although both cities are now on the road to recovery, their bankruptcy processes had a hugely damaging effect – both from an economic standpoint, as well as in terms of public perception.

In the US, many cities and states are facing monumental budget shortfalls. These deficits follow years of guaranteeing the pensions and healthcare benefits of thousands of municipal employees. However, local governments are finally acknowledging that they do not have the savings in place to meet these obligations. According to a 2013 report from the Pew Charitable Trusts, a number of cities in the US had only 50 percent of the funding required to cover their pension obligations.

But public pension pressures have not been confined to the US. Efforts are underway in China to unify the country’s existing dual pension system. Under plans for China’s revised pension scheme, the country’s 40 million public sector employees stand to lose their exemption from paying into the state pension system. The move by the Chinese government has been designed to counteract public discontent over the excess benefits enjoyed by the country’s civil servants.

Recent research published by the Organisation for Economic Co-operation and Development (OECD), in its ‘Pension Outlook 2014’ found that the current economic environment, characterised by low returns on investment, low growth and historic low interest rates, has led to a general reduction in the government revenues required to finance retirement promises – a development which has had a detrimental effect on public confidence in government bodies in a number of countries.

Population age

For many local and national governments, when it comes to their pension shortfalls, the situation is likely to get worse before it gets any better. In the coming years, aging populations will continue to exert considerable pressure, not only on the general economy but most tellingly on pension systems. The biggest potential impact is related to the changing relationship between what workers put into their respective pension pots, and what they take out. Though retirement ages have generally remained the same in recent years, life expectancy has begun to creep up. As the baby boomers begin to enter retirement in the coming years, pressure will ramp up on the wider pension system, as those employees will be replaced by a significantly smaller demographic, who in turn will pay much less into the system.

For Pay-As-You-Go (PAYG) public pension schemes, much like with the 401k, an aging population will have a particularly detrimental effect on the wider public pension system. PAYG financed public pension schemes will likely experience considerable sustainability issues. According to the OECD report, public pension expenditure is due to increase by 8 to 10 percentage points of GDP as a result of aging populations between 2010 and 2060.

To address the challenge of pension funding, on an individual basis, employees should be encouraged to contribute more toward their pensions, and these contributions should be made over a longer period of time. Furthermore, postponing retirement may be an option for some, and would enable more people to make greater contributions to the system. Higher contributions over a longer time period will go some way to addressing the potential for underfunded plans in the years to come. This solution need not apply only to public pensions; it could also be applied to complementary funded private pensions.

A number of other options should be considered in attempts to redress current and future pension funding problems, according to the OECD. One of the most prudent relates to diversifying sources to finance retirement while ensuring that more steps are taken to encourage and assist older workers to find and hold down jobs in their later years.

Reform

As has been well documented, the financial crisis had a wide range of implications for countries around the world. For states both within and outside the OECD, severe macroeconomic pressures have led to increased levels of government debt in recent years. From 73 percent of GDP in 2007, governmental debt increased on average to around 110 percent in 2013. This has had a detrimental effect on many pensions systems and helped to accelerate the implementation of pension reforms. However, in many respects these reforms have not gone far enough to address the real problems still facing future retirees. Many of the measures implemented by countries in the immediate aftermath of the financial crisis were designed to counteract short term fiscal problems, rather than address long term issues with pension systems and funding.

In many respects these reforms have not gone far enough to address the real problems still facing future retirees.

Accordingly, there have been increasing calls for more wide ranging pension reforms. In Detroit, the city’s nearly 13,000 active public employees now receive considerably smaller annual salaries as the city attempts to claw its way back from bankruptcy. The city’s workers will contribute up to 8 percent of their current pay toward the municipal pension program under a new deal worked out between city officials and union representatives. Detroit, which had been struggling with an insurmountable $18bn debt load, will remove around $7bn of liabilities by reducing its employee pension obligations by around 4.5 percent.

The OECD believes that further efforts should be made to strengthen the regulatory framework surrounding pension schemes. By making changes to their regulatory infrastructure, countries will be able to assist pension funds and annuity providers, helping them to deal with the uncertainty around future improvements in mortality and life expectancy. Failures to account for future improvements in life expectancy can result in a shortfall of provisions of well over 10 percent of the pension and annuity liabilities. Pablo Antolin, Principal Economist and Head of the Private Pension Unit at the OECD, notes that “The compounding pressure on governments’ finances and increased longevity is undermining the sustainability of pension systems across the OECD countries. Although many members have begun in-depth reforms, this is still work in progress. It will take many years to embed the changes and further measure will be required to strengthen private pensions, increase coverage and contributions, and reinstate public trust.”

Recent efforts have been made to reform existing pension regimes in China. Under the new scheme, China’s 40 million public sector workers will lose their exemption from paying into the state pension system. Previously, China had employed a dual-track urban pension system which saw private sector employees obliged to contribute 8 percent of their annual salary to the country’s pension system whereas governmental staff were not required to contribute at all. This scheme has been at the heart of much discussion and disagreement within China; however, steps are finally being taken to redress the imbalance. Under the new scheme, employers will contribute the equivalent of 20 percent of an employee’s salary to the scheme. Prior to the reform there was no dedicated revenue source for public sector pensions in China, as the government was responsible for paying retiree benefits out of general fiscal revenue. Given China’s recent economic stagnation and its aging population, the move is not a massive surprise. With the number of Chinese people aged 65 and above due to increase from around 132 million in 2015 to 331 million by 2050, a tremendous strain will be placed on the country’s pension schemes. The country’s funding shortfall for its urban pension system between 2012 and 2050 is expected to be around $6.3 trillion, so the Chinese government has been under pressure to act for some time. Its pension obligations have long been a cause of consternation within the country, as the availability of good or meaningful pension coverage is still remarkably low. Whether the Chinese reforms will be enough to make a significant dent in the country’s underfunded pensions seems doubtful, although the move is at least a step in the right direction.

Pension reforms have been slated in a number of other jurisdictions, including the UK, Canada and the US. In Quebec, Canada, draft legislation in the form of Bill 3 has been designed to help restructure a number of pension plans. The Bill, which applies to 170 pension plans covering around 50,000 retirees and 122,000 active employees, has been designed to restructure defined benefit pension plans for municipal employees in an attempt to improve their wider financial health and ensure their sustainability in the future. The move has met considerable opposition from unionised employees in a number of Quebec’s larger cities.

Realities

Retirement benefits will remain a key issue moving forward. Employees must ensure that their financial situation is in order before they reach retirement age, but governments need to deal with the additional strain brought about by increased longevity and life expectancy. For cities such as Chicago, which leads the US in unfunded pension obligations, some of the pension reforms implemented in Detroit could provide much needed answers. Pension reductions will never be popular, but for many municipal governments, they may be the only available response.

In their attempts to safeguard the financial security of their cities, a number of governments have made pension scheme enrolments mandatory. Though this may help to a certain extent, auto enrolment is by no means a panacea. Arguably, the best approach involves governments and employers encouraging employees to commit additional funds to their pension schemes over a sustained period of time. Contributing more, and for a longer period, will go some way towards addressing concerns – though it is unlikely to be the answer to municipal government prayers.

The financial industry is still striving to repair much of the damage caused by the financial crisis. Confidence in financial institutions, as well as pension schemes, is at an all time low. Reforming the regulatory framework is an important step, but efforts must also be made to rebuild trust if governments are to safeguard the sustainability of their pension schemes.

© Financier Worldwide


BY

Richard Summerfield


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