The term “lost decade,” a familiar metaphor for economic stagnation, is back in vogue as commentators consider the future of Europe. And when we consider the country most often associated with that famous phrase — Japan — we can only wonder if we are really looking at retirement's lost decade in Europe and beyond.
Indeed, the similarity to the bursting of Japan's credit/property bubble and the rise of its large public sector debt, all of which began in the 1990s, is hard to avoid when we look at the Western economies, especially when we consider the demographic drivers of the retirement crisis, with its preponderance of older workers. Since economic growth requires some combination of increasing working populations and productivity, the prospects for long-term retirement adequacy are troubling.
From the U.S. to the U.K. and Europe, social security programs represent a large additional debt burden for governments that is not incorporated in their national debt figures. These social security debts can be substantial. In France, for example, a study by Freiburg University commissioned by the European Central Bank estimated the additional liabilities as 3.6 times gross domestic product.
Thus, in the eurozone, governments are raising the retirement age for social security in an attempt to control costs (incidentally, the Japanese did the same, in addition to raising contributions), while company-provided pension funds are seen as a potential source of additional tax revenue. In the U.S., the debate over such solutions is heating up, given that it's an election year.
Of greater concern perhaps is what might happen to the fuel in the retirement engine — that is, assets and equities in particular. Continuing sluggish economic growth might well mean lower returns for at least a part of the decade ahead. If asset returns can no longer do the heavy lifting in terms of financing existing arrangements, then what will?
With monetary policy options running out, quantitative easing has become a solution, as we've seen with the U.S. Federal Reserve and other central banks. Simply put, they are providing liquidity by purchasing longer-dated securities in the market; as a consequence, the price of these securities is driven up and the yield is driven down. The fact that these are the very bonds best suited to match pension liabilities means that an indirect consequence of quantitative easing is the liabilities of pension funds go up.
Positive signs for U.S. DB plans
But the news is not all bad. The aggregate deficit in pension plans sponsored by S&P 1500 companies fell to $336 billion as of March 31, a decrease of $147 billion from year-end 2011, according to new figures from Mercer. This deficit corresponds to an aggregate funding ratio of 82% as of March 31, compared to a funding ratio of 79% as of Feb. 29, and 75% at year-end 2011.
The increase in funded status in March was primarily because of positive asset performance during the month. U.S. equity markets were up approximately 3% for the month. Interest rates on high-quality corporate bonds, which are used to measure the pension liability, also rose 15 basis points during the month, helping to lower the liability.
In addition to investment performance, assets have also grown because of contributions. During fiscal years ending in 2011, S&P 1500 plan sponsors contributed more than $70 billion to their plans, which is $20 billion more than they had expected at this time last year. Financial disclosures indicate expected contributions of $54 billion during fiscal 2012.
With funded status improving, financial statements indicate a continued shift in asset allocation for plan sponsors. The weighted average allocation to fixed income investments increased to 40% at the end of 2011 from 37% at the end of 2010. This shift in plan sponsor investment philosophy is expected to dampen funded status volatility moving forward, but also indicates a decrease in expected returns: The average disclosed expected return on assets dropped to 7.56% for fiscal years ending in 2011 from 7.78% for fiscal years ending in 2010.
However, there are still large amounts of dollars at risk. Mercer estimates that if equities remain flat, and interest rates fall 50 basis points, the aggregate S&P 1500 deficit would increase about $100 billion (to $436 billion). Likewise if rates rose 50 basis points, the aggregate deficit would decrease $100 billion (to $236 billion).
Amid all this, the euro crisis casts a long shadow, with volatility in euro bond yields resulting in volatility in discount rates — all of it hard to predict, and concerns about inflation always in the air. Multinational companies with eurozone pension liabilities, or those lacking a robust approach to their year-end accounting, must take a strategic view, perhaps engaging global actuarial services to stay ahead of volatility as much as possible, with forecasting, funded status monitoring and risk consulting.
Challenges for DC plans
As for employers who have eluded defined benefit related problems through the implementation of defined contribution plans, they still face challenges. Many of their older employees won't want to retire because they cannot afford to, although this will represent an opportunity to keep key talent around longer. However, to succeed at this, retirement plans will need to be tweaked to deal with the unique needs of this older cadre.
Meanwhile, the euro crisis also affects the DC world, as DB plan deficits and funding strains lead to the freezing or closing of DB plans and reviews of DC plan design, along with legislative changes. Employers feeling the financial pinch have a reduced appetite to match or pay DC contributions, while employees tend to contribute less — a case of short-term thinking about savings and investment. Current plans might therefore be inadequate for the long-term good of the workforce. Thus, companies need to assess their DC plans globally, regionally and locally. DC executives should measure adequacy, capture data and provide risk modeling. Additionally, sponsors should educate employees on the nature of the DC plan's investments, risks and options.
In fact, there's no overstating the risks that fall to employers if they have inadequate DC outcomes. There's the potential impact on recruitment, especially if a DC plan is below market, along with the issue of employees being unable to afford to retire, staying in the workforce beyond normal retirement age, blocking promotion opportunities for younger talent, and affecting productivity. Employees may also be litigious with regard to how DC plans have fared for them and how well employers have communicated about plan risks and requirements.
Obviously, the specter of a lost decade for retirement is a complex scenario that needs to be taken very seriously — but by no means without hope. It's a challenging time for actuaries and financial leadership, as their appetite for risk might drop but low bond yields make it difficult to reduce risk. Companies that actively address the issues — with regular funding updates, scenario analyses and good stakeholder communications — will be well-positioned to continuously improve their retirement programs. The result can be a productive, engaged workforce that will ultimately find its way to retirement security.
Fergal McGuinness is a Mercer senior partner based in Zurich. He is a member of the European Leadership team for the Retirement, Risk and Finance Consulting business with responsibilities for strategy, growth and innovation in the region. Tony Pugh is a Mercer senior partner and head of EMEA DC Consulting, based in London. References to Mercer shall be construed to include Mercer LLC and/or its associated companies.