Monday, 4 November 2013

Pension Systems in Declining Populations

Pension Funds
The global asset management industry has been booming over the past decade. Only in 2012 assets under management were up by 9% reaching $87.2 trillion. Of that, approximately 40%, or $33.9 trillion, were held by pension funds. To get a grasp of the size these funds the graph on the right indicates their sizes relative to GDP. As one can easily observe, pension fund assets in the UK and the US exceed 110% of GDP while they account for approximately 50% of the world's GDP.
Figure 1
Although many countries (according to the OECD) are still mainly funded through public pay-as-you-go (PAYG) systems (Pillar I), a shift towards mandatory private pension funds (Pillar II) and voluntary ones (Pillar III) is observed. The increased popularity of privately-held pension funds can be attributed to a more "free-market" view of the world; the private sector can do it just as well as the public sector so why not let the former do all the job? The private sector has done its job excellently so far: pension funds usually focus on relatively conservative investment strategies (a comment from someone in the industry was "we are playing with people's retirement so we focus on low-risk products") and although their allocation has been increasingly focused on bonds and bills as the following graph shows, their returns have been relatively good for the 3-year average (see the OECD publication for details).
Figure 2
Although the fact that the private sector is doing its job very well may suffice as an excuse on the tremendous growth of  pension funds, reality offers additional justification: people are expected to live much longer than they did half a century ago thus they require more money to preserve a decent standard of living for longer (FlipChartRick has an excellent article on Pieria concerning the changes in distribution of the UK population since the 1900's). Additionally, the growing population of the elderly increases fears of PAYG systems facing trouble with funding. Compliment that with a slight need humans have to earn more and more (commonly known as greed) and the need for pension funds is increased.

Yet, what we have failed to observe is that focusing purely on the private sector to provide funding has its own issues. The PAYG system mainly took contributions from workers and passed them on to pensioners, investing the rest in government bonds. This basically means that nothing in the economy changes by much: what contributors lose, pensioners get and the remainder is returned to the people via government spending. Government spending can (and does) increase consumption, yet as David Ricardo noted "In point of economy there is no real difference in either of the modes, for 20 millions in one payment, 1 million per annum for ever, or £1,200,000 for forty-five years are precisely of the same value". In essence, although an increase in government spending can produce short-term increase in consumption, the government will eventually have to lower consumption to repay for the loan. (obviously this does not take into account multiplier effects which propagate the increased consumption shock and, with the assistance of the private sector make the shock last longer. Yet, if we strictly look at just government spending the above holds)

As Figure 2 shows, private pensions, just like PAYG, take contributions, pay out the pensioners and use the rest to invest. Yet, the investment strategy is much different: although both invest in bonds and bills, pension funds also invest in property, equity, derivatives and hold a significant amount in cash. Although funds hold about 20% of their assets in equities, the sheer number of that investment is astonishing if one remembers the total size of the market. As stated before a protracted period of increasing prices rises the money supply in the economy. In addition, as property is becoming more and more important given its "safety", more funds are allocated there, resulting in increased demand and higher prices. The following two graphs are indicative of the correlations of pension funds and housing:
Figure 3 Case-Shiller Housing Price Index
Figure 4
Although Figure 3 dates from the 1890's, the sharp drop in 2007-2008 can easily be seen, just like the one Figure 4. The drop would have been more visible in Figure 4 had I been able to find assets in dollars and not as a percentage of GDP. The reason is that US GDP also fell drastically during that period and thus although assets took a tumble the result is much less steeper than it should have been.

In general, it seems that private pension funds are actually contributing to inflation by increasing property, equity and bond prices (while reducing their yields). As the quest for safe assets becomes more and more intense, with pensioners increasing every year, the need to invest money in order to obtain a return which would make the fund sustainable makes bonds and property more valuable than ever before. This, as mentioned before, increases prices (and lowers bond yields) thus making money supply increase. 

As Charles Hugh Smith notes if yields are falling how will pension funds continue to exist, especially if the elderly population increases? The answer will most probably be through property and equity, which will create a short-term boost to their returns. Will this be permanent though?

Declining Population
Suppose that we have 100 units of currency in a population of 100 people, each person owning a unit. Suppose now that in a few year's time, the population is decreased to 80, now with each person owning 1.2 units if money is stable. Would that mean that consumption is decreased? The answer is that it depends. If people tend to spend more than before then consumption might not be reduced. Yet, even if consumption per capita increases it will occur at a diminishing rate. It has long been the case (Kuznets, 1955) that people spend less of their income as their income rises. In simple terms, even you are making a million a year you will probably not be buying a new TV every 2 months to compensate for the lack of demand. 

In this scenario, superabundance is rapidly reached: more than enough goods for every human being, yet with declining demand. Declining population will have many interesting side-effects: as already mentioned long-term rates are greatly affected by the rate of population growth. Yet, if population growth is zero or negative it will mean that these rates will also become negative or zero. My guess is that they will fluctuate on slightly positive ground if population is stable due to liquidity preferences and they will be less negative than the rate of change of the population if it is negative, for the same reason. Whether this is enough to compensate for the increased percentage of the elderly in total population and the increased need for safe assets which will make bond yields even more negative is to be seen.

Interestingly enough, in such a scenario inflation is not out of the picture. As the elderly consist of a growing part of the population and long-term bond yields tend to zero or negative, more investment in real estate and equity will occur, resulting in a rise of property and stock prices thus creating a boost in money supply. This will lead to an environment of short-term inflation due to money supply increases either through private actions like the ones described here or through public ones, i.e. printing. In such an environment banks will have a diminished role: less demand for lending will essentially mean less bank-created money.

If one thinks of a yield curve in this scenario then it would have to be an inverted, gradual-sloped one, at times resembling a fixed curve. Rates should be slightly positive in the short-run due to inflation persistence, while in the long run they should be more prone to negative values due to a decrease in population (even though the decrease in population would equal the long-run rates as already stated).

A suitable question is why shouldn't the long-run rates be positive given that we have inflation in the short run. The answer is that if population will continue to fall then the above-mentioned inflation, driven by property and equity, cannot persist for much longer. As the number of people on the planet is reduces, demand for property is also reduced and more land is available, forcing prices to fall. If this is the case, and no government intervention occurs, then the (very) long-term trend of inflation will be negative. Even at that, the short-term rates will be higher than the long-term ones. As inflation reaches approximately zero, short-term rates will reflect just that, with expectations of inflation being that the trend will stabilize. At that time, long-term rates will continue to be negative and follow the trend of population growth.

What is most likely is this environment is that markets will basically break as nobody would wish to invest in an asset which is losing its value. With working population shrinking, the only remedy I can currently think of is an increase in the retirement age, just like it is being done in most Western countries. Yet, even this has important considerations in the long-run: our bodies are not designed to work until their late 70's (unless we are talking about non-intensive work in which again productivity is reduced) and we cannot view this increase in retirement as a panacea. If abundance through automation is not achieved times might just get more difficult, with inequality rising to new heights.

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