The pension panic is coming

If you know something is going to happen in the future, when do you react to it?

More importantly for the purpose of making money in financial markets, when is everyone else going to react? Because that’s when prices move.

One of the core theories about markets is that they can anticipate. They look to the future and prices react accordingly. The year’s weather forecast affects crop prices on the Chicago exchange many months in advance of planting, for example.

But how far ahead do markets look when they establish prices?

An academic will smile dismissively if you ask that question. The markets discount the future in a way that gives more weight to the immediate future, and barely any weight to what’ll happen many years from now. This means the price is always a reflection of what’s going to happen in a balanced and theoretically perfect way.

There’s some truth to that. The further into the future you go, the more uncertain it is, so the less it should weigh on your estimation of a fair price.

The problem is when humans get involved. Especially humans who are incentivised on a quarterly basis, or the election cycle. For example, many traders are quite happy to pick up pennies in front of a steamroller. Writing options is very lucrative until you blow up. Everyone knows it’s going to happen, but some still make the mistake.

Let me ask the same question a little differently. If you know a crisis is going to happen in 12 years’ time, when do you react?

The pension panic is coming

The Government Actuary’s Department calculated the National Insurance Fund (NIF) will run out of cash by the mid-2030s. That’ll put the state pension and other benefits squarely on the government budget’s expenses column.

Think about the momentum of the change here. We used to build up the value of assets in the NIF by contributing more than withdrawals. Then we started to draw down the assets. Which means a bigger outflow than inflow.

When the assets hit 0, in the 2030s, the size of the change will be vast. Suddenly, a huge bill will hit the government budget each year which was previously not there at all. It’s not a gradual change. It’s a total shift.

Adding such a huge expense is something even politicians can’t ignore. So what’s going to give? The pension age, the size of the benefit, taxes…?

Probably all three given the size of the problem. The valuation of unfunded state pension liabilities is more than double UK GDP.

Baroness Ros Altmann, Tory pensions minister from 2015 to 2016, explains:

“The current provision for state pension payments is not enough to meet the cost of future pensions. Changes will be required if forecasts are right. There is a potential issue on inter-generational fairness if these forecasts are right as younger workers face paying more to secure their state pension.”

Which is of course rubbish. The pension uses a so-called “pay as you go” method where money is transferred from the young to the retired each year. If you pay into the system, you are not going to secure your state pension, you’re going to pay someone else’s.

The scary part is that the UK is already paying a comparatively low pension. According to the OECD, our state pension is one of the lowest in the developed world as a percentage of average earnings. That’s a bit misleading because we use alternatives to the state pension to supplement income. So let’s look at private pensions next.

I have to say, relying on a company you worked for to pay your pension strikes me as a uniquely bad idea to begin with. Companies fail. Especially when they’re saddled with vast pension liabilities.

About two thirds of the ÂŁ2.3 trillion in corporate liabilities is unfunded. That same shift to the expenses column is going to occur at companies too. Good luck competing on a global stage with that hanging around your neck.

Political consequences of overpromising

The solution to keep the state pension going is about ÂŁ1,000 more per year per worker, assuming the pension age rises to 70.

The battleground is clear. Will young people agree to pay and will retirees agree to cuts?

Supposedly it’s political suicide to meddle with pensions. But the impact on pension costs if we don’t raise the pension age or cut benefits is huge.

Meanwhile, the politics of pitching an increase in taxes on the young to pay for the state pensions of the old is a bit iffy. People used to be persuaded by the idea that they’re adding to a pool of assets that the NIF invests and will then pay out to you when you retire. It looks like you’re supporting yourself.

If the NIF runs out of money, it won’t be a fund anymore, it’ll be a transfer. Without the illusion of adding to an asset pile to save for your future, will the premise of this form of welfare hold up politically? Imagine asking all those boomerang kids to support their parents…

Sure, the political power of the pensioner will be immense. And they’ll be politically active. Especially given they laboured their working life under the illusion they were contributing to a vast fund of assets that’d be waiting for them in retirement. When that fund runs dry in 12 years, they’ll be furious.

But think about how this intergenerational claim subverts society. It constitutes a rather large breach of a social contract both ways. Hopefully it’ll be politicians who cop the blame. Especially given the size of their pensions!

My biggest fear isn’t for the state pension, the company pension or the political fallout. My greatest fear is for financial markets. Because even those of us who think we’ve prepared for this debacle by saving and investing outside the government system could be caught up in the collapse.

Retirees will sink financial markets

None of the above is a big secret. In fact, the government itself is aware of the problem. It’s just that the solution is politically unfeasible, so nobody is terribly concerned about dealing with it.

As usual, the political solution to a failing system is a new system. That of private pensions and retirement savings. People should prepare for their own retirement with the help of tax incentives and a heavily regulated selection of retirement products.

These are much better than the government system because they use the power of financial markets to magically raise returns. The money you save multiplies in value, which is how saving for a long retirement becomes plausible.

In other words, the government has turned financial markets into a retirement scheme. But taking the long-term returns of financial markets as an assumption strikes me as a rather big mistake.

Not just because financial markets don’t deliver decent returns during regular and lengthy bear markets like the last 18 years. But because the effect of turning financial markets into retirement systems could undermine them altogether.

Consider this simple question: if the state pension system isn’t sustainable because there aren’t enough young taxpayers to pay out the claims of retirees, then why are financial markets going to be any different?

If there aren’t enough young buyers paying into the stockmarket, how will retirees be able to sell out at decent prices? Who will buy their stocks? If there aren’t enough people to pay taxes for state pensions, there aren’t enough stock buyers either.

Politicians have moved the pension problem to the financial markets, not solved it. And they could sink those financial markets in the process as retirees sell out en masse while the younger generation boycott.

But that only brings us to the question we began with. If we know all this is coming, when do you react to it? Because that’s when it all goes wrong.

Until next time,

Nick Hubble
Capital & Conflict

Category: Economics

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