Aspiring copywriters are told that “guarantee” is one of the most dangerous words in their lexicon. Even when not used in a strict legal sense, the word is so laden with expectations that, if not deftly handled, it can later ensnare its user.
Politicians and plan sponsors know the problem all too well. Even when not explicitly guaranteed – and many explicit guarantees have been made – past pension promises have returned to bite governments and corporations. Such commitments were originally intended to buy social harmony or quell industrial action by unionists demanding the same perks as management. Today they have grown to be significant burdens on states and overwhelm struggling companies.
Governments have responded with reforms that ratcheted back state pension “promises.” Calculations in 2009 show lifetime benefits paid in the 16 OECD countries that introduced the most wide-ranging reforms have now been cut on average by 22% for men and 25% for women (
, 2009). Filling the Pension Gap
But it was the financial crisis that underlined the stress that funded pension provisioning systems are under. At year-end 2008, global pension assets stood at €20 trillion; down by roughly 15% from year-end 2007 (€23.2 trillion). Towers Watson reported in January 2013 that global pension fund assets have recovered and reached a new high of $30 trillion. Yet, this is little consolation for individual workers, particularly in the United States, who watched their pension fund portfolios shrivel from 2007 to mid-2009.
While younger workers will recover assets over their working life, the decline was traumatic for employees within striking distance of retirement. With little time to make up withered savings, they have either retired with substantially less than planned, or delayed retirement.
A fragile existence
Afghanistan’s Krygyz nomads survive in one of the most remote, high-altitude, bewitching landscapes on Earth. It’s a heavenly life – and a living hell – with little security.
Given events, it is understandable that clients, both individuals and institutional, seek some hard assurance that pension assets will be protected. Yet, what they are likely to get is softer guarantees, not harder. The desire for certainty comes at a time when states and corporations are withdrawing from providing guarantees – that dangerous word again – on the amounts they will contribute towards an individual’s retirement income.
However, this does not mean clients are left alone and exposed to capital market volatility. Consumer protection laws and regulations exist to shield clients by specifying where and how entities can invest their assets. In particular, the introduction of fair-trade principles is seen as bringing greater transparency and consistency to financial statements. These principles require companies (such as insurers) and institutions (such as pension funds) to measure and report assets and liabilities (generally financial instruments) at estimates of the prices they would sell or pay for the assets if they were relieved of the liabilities.
Under fair-value accounting, also known as “mark-tomarket,” losses are reported when the values of assets decrease or liabilities increase. With a common valuation applied across companies, it is argued that investors and consumers gain better information on the financial state of various institutions.
Fair valuation is at the core of risk-based funding and solvency regulations in many countries as they relate to pension funds. More regulations are also being considered, specifically in the form of the Solvency II framework for European insurers.
With little time to make up withered savings, they have either retired with substantially less than planned, or delayed retirement
Critics of fair value argue that, among other points, reported losses can adversely affect prices, resulting in greater volatility that increases the overall risk of the financial system. This was seen during the financial crisis of 2008-2009 when write-downs lead to a rapid spiraling down of value as assets were sold at ‘fire sale’ prices. This in turn lead to contagion as many entities competed to offload assets at ever lower prices.
These claims are often flung around with little evidence, so they may be overstated. However, what is beyond dispute is the fact that changes in funding regulations and accounting standards have driven employers to minimize their pension promises. They have insured away obligations, realigned investment portfolios and passed-the-buck in terms of retirement income onto employees with the move from defined benefit to defined contribution pensions.
Amongst insurers, the introduction of risk-based solvency rules in Switzerland is seen as a key factor behind the significant move away from equity allocations into government bonds in the last decade. A similar development was seen in Japan in 2006 after the introduction of asset liability management (ALM) strategies amongst life insurers.
Other factors are also at play, notably a lessening in risk appetite after the financial crisis. However, it is feared further risk-based solvency rules will indirectly hasten the demise of guarantees in favor of promises and products based on payoffs based on market events.
Much of the concern about retirement asset protection is focused on the accumulation phase of life. Notably less attention is being paid to the decumulation phase and this is the big bind about protection. Protection is no great help if its implementation means savers will fall short of their ultimate goal: an adequate retirement income.
If governments seeking to protect savers restrict investment risks, or make changes that will restrict investment risk, they could actually be exposing savers to the biggest risk of all: inadequate retirement assets. While experience shows that the average person would be naïve to expect capital markets to benignly provide for them, it should not be forgotten that risk pays a premium.
This premium could potentially generate funds individuals need to help bridge the retirement shortfall. After all, the same market dynamics responsible for destroying so much savings in 2007-2009 also created much of that wealth in the decade previously.
It seems, then, the notion of retirement needs a rethink, particularly concerning how pensions, guarantees and risk mesh together. With demographic trends running against developed countries and strong volatility of capital markets a given, we seem to be entering an era where fewer, not more, guarantees could be expected. But if guarantees are not the answer, what is? Perhaps it is the indexing approach adopted by the Netherlands, traditionally one of the developed world’s foremost pension thinkers.
Oxford university professor
Gordon L. Clark suggests the word “guarantee” itself could be redefined so the underlying pension contract would become less binding. Instead, changing conditions should be taken into account and future guarantees would allow for rolling variations of guaranteed returns.
Walter White believes guarantees still have a genuine place in any individual’s retirement strategy through annuities. Risk can be reduced and guarantees locked in, if financial professionals leverage the ‘Transition Period’ – the five to 10 years prior to the retirement date – to secure income streams and help reduce the risk losses shortly before retirement.
That is one approach.
Don Ezra and Keith Ambachtsheer make a similar point in the Conference Call about how pools of retirement savings should be treated differently during different phases of an individual’s lifecycle. Perhaps this will eventually morph into an approach that examines all asset sources: private, state and occupational, and allow a similar investment approach to portfolio assets. And, of course, education and well-designed default options have a part to play.
None of these approaches alone will provide a single silver bullet to solve the problems plaguing retirement. Combined, they could still ensure the millions of individuals can still expect adequate, safe and sustainable retirements in the decades to come – even if it is not exactly guaranteed.