‘It’s tough to make predictions, especially about the future.’ – Yogi Berra
When you’re in the predicting business, you really do appreciate the irony in that quote.
However, there are times when some predictions are far easier to make than others.
A little over 12 months ago, I wrote:
‘In my home state of Queensland, the government — with a serious spending problem — is planning to raid the Government Employees Defined Benefit Super Fund.
‘For the uninitiated, a Defined Benefit Fund pays its members a guaranteed multiple (based on years of service) of their final average (last three years) salary (FAS). Let’s say a member with 40 years’ service is paid a multiple of 10 times their FAS of $100,000.
‘The government must guarantee the $1 million is there to pay them. That example is simple enough. Now add into the mix thousands of employees of different ages, with varying lengths of service and differing salaries. How do you ensure each member’s entitlement is properly accounted for?
‘Enter the actuaries…the number crunchers. They put all the variables into their models — including a guesstimate on future earnings — and tell the government whether they need to tip money into the fund or not.
‘The Queensland government has identified an apparent surplus of $11 billion in the Government Employees fund…which, under law, they are entitled to withdraw from the fund. How convenient for a government with a spending problem. The debate rages over whether the surplus is real or not…
‘Well, the answer to that depends on whether the actuaries dial the future performance numbers up or down.
‘If the actuaries plug an earning rate of 7% per annum into their forecasting model, then there’s $11 billion ripe for picking.
‘However, if you adopt a more conservative 3% per annum return (which is probably more in line with the low growth, low return environment that Future Fund Chairman Peter Costello warned about recently), then there’s not a brass razoo to spare. No money is available to be withdrawn.
‘Call me silly, but I’m thinking our Treasurer, Curtis (Money) Pitt will opt to go with the 7% rate, netting him a big fat cheque for $11 billion.
‘Guess what’s going to happen in a few years’ time?
‘OK, you guessed it.
‘The Courier Mail (the local rag in Brisbane) headline is going to be ‘Government Define Benefit fund in the red’. Queenslanders will be forced to pony up more money (via increased taxes of course) to make up the shortfall.
‘No crystal ball needed for making this prediction. It is a sad repeat of what politicians all around the world are doing.
‘They are perennial over-promisers, under deliverers, and raiders of any money box, drawer or pantry to compensate for their profligate ways.
‘It saddens me that, as a society, we do not possess foresight that extends beyond the next offering of political silver pieces.
‘While I lament a lack of leadership in the political realm, it’s also a sad reflection on our community. We have allowed ourselves, within the space of one generation, to become increasingly more dependent on a socialist model that’s destined to bankrupt; one that will leave our children, and their children, with a legacy none of us can be proud of.’
Front-page article in The Australian on 18 July 2017:
‘Raided Queensland public service super fund risks deficit’
Right prediction: But it was an easy one to make…the words ‘inept’ and ‘treasurer’ go together like ‘horse’ and ‘carriage’.
Wrong headline: The Courier Mail didn’t break the story.
Shorter timeframe: I thought it’d take a few years, not 12 months, for the risk to be identified.
This is an extract from that article:
‘The Queensland public service superannuation scheme that was stripped of $4 billion last year by the Palaszczuk government has “no scope’’ for any more raids and could even need an emergency top-up in the next few years.
‘At the time, Mr Pitt argued the scheme was heavily in surplus.
‘The scheme has an “actuarial surplus’’ of $6.17bn in excess funds as at June 30, 2016 if all costs and member’s benefits were paid out.
‘The “actuarial surplus’’ is based on a projected 5 per cent annual return on the scheme’s investment into the future.
‘But on the more stringent Australian “accounting basis” — using a projected 1.9 per cent return on investment — the scheme was $3.078bn in deficit when it was raided.’
Was the fund in surplus or not? Well, that depends on what future rate of return you use.
The more optimistic the rate, the better the projected outcome. But is that forecast rate correct? When you’re a treasurer in need of a short-term budget fix, the answer is ‘who cares, it’s not going to be my problem…’
In principle, think of the problem confronting defined benefit funds as that facing a pending retiree with $1 million. The prospective retiree wants $50,000 per annum to live off.
One planner projects a return of 7% per annum (delivering $70,000) and declares there’s a ‘surplus’ of retirement income.
Another planner projects 2% per annum (returning $20,000). You require a capital base of $2.5 million at 2% to achieve a return of $50,000. Therefore, your retirement capital is in ‘deficit’ to the tune of $1.5 million.
The reality is that no one knows what future returns are likely to be. But common sense dictates it’s better to err on the side of caution…especially when you’re dealing with the retirement hopes and dreams of millions of people.
But the shortfall confronting Queensland taxpayers is not unique.
Defined benefit funds the world over are in trouble.
Bloomberg published this article on 21 June 2017:
[Click to enlarge]
Even if the bean counters use an overly-optimistic outlook for returns, they still cannot turn a chronic deficit into a surplus. From Bloomberg:
‘A “best case” scenario of a cumulative 25% investment return during the 2017-2019 period will not offer a respite for chronically underfunded U.S. public pension plans, according to a Moody’s Investors Service report.’
How bad is the shortfall in US state and local government pension plans?
[Click to enlarge]
Take a close look at this chart, and you’ll see it tells a tale. Prior to 1995, the funds were neither in surplus nor deficit. There was sufficient capital to meet obligations. Why? Because, back then, US government bonds paid a decent rate of return.
After 1995, the funds actually went into surplus…peaking at US$500 billion in 1999.
How was this achieved? Competitive pressures meant the funds — to keep up with the Joneses — gradually increased their weightings away from the boring old government bonds and into tech stocks. This went well…until it didn’t.
In the early 2000s (when the tech bubble burst), there was a US$1 trillion turnaround in fortunes — a US$500 billion surplus transformed into a US$500 billion deficit.
The high returns achieved in the boom of 2003 to 2007 held the situation steady. But they did not make any substantive inroads into the deficit.
The 2008/09 crisis then sent the deficit soaring…another US$1 trillion gap opened up.
Even the Dow’s record-breaking performance over the past eight years has not changed the trend.
What happens when the next crisis hits? (And it will…with a vengeance.)
In Europe, Deutsche Welle ran this headline on 1 July 2017:
To quote the article (emphasis mine):
‘The core problem of the German economy and society is miserable demography. A positive development, namely the increasing longevity of the population, is an extremely negative groundbreaking, namely a small number of children. This is reflected in one of the lowest birth rates in the world — and this has been the case for decades. The record-breaking birth rate is by no means rooted in a biological, but in deeper social causes and inadequate policies at different stages. One consequence is a pension system that is not sustainably financed, because the ratio of contributors and receivers will drastically deteriorate.’
American economist Herb Stein famously said that ‘If something cannot go on forever, it will stop.’
The next crisis — delivering massive losses to portfolios weighted heavily in shares — is likely to be the tipping point of this pension charade.
Something must give.
Benefits must be reduced OR taxpayers must be asked to pay more to fund the deficits OR a combination of both.
That’s NOT a prediction; it’s a statement of mathematical fact.
Whatever the solution to this problem is, the outcome will be deflationary.
Members receiving lower benefits will have less spending power. Taxpayers with less after-tax income will have less spending power (and borrowing capacity).
In pushing interest rates so low to stimulate growth (via more debt accumulation), the central bankers have starved pension funds of decent returns that aren’t burdened by onerous risk. Therefore, the funds have had to increase exposure to assets offering higher returns, but which also come with higher risk.
There are no free lunches. At some point the markets are going to remind investors of the price to be paid for chasing higher returns.
With pension funds highly exposed to market forces, what we have is a disaster of biblical proportions lying in wait.
On a global basis, hundreds of millions of lives are going to be impacted by the cumulative decisions of inept central bankers and treasurers.
The cruel twist is that the pension plans of these incompetents running the show are not under threat.
Editor, Markets & Money