The most difficult task for pension fund managers is to properly calibrate risk and return to make sure that pensioners earn a steady income after retirement. Today, this tradeoff is harder than ever. Since 1980, the average person’s life expectancy at retirement has increased by about four years, or one year per decade. This has resulted in greater liabilities for pension funds. In addition, bond yields have decreased to rock-bottom levels, which means that the dollars we save no longer grow as fast as they once did.
How do we ensure a sustainable retirement system in these difficult conditions? We can either force future retirees to increase their level of contributions accordingly, or we can find ways to invest capital more efficiently and take on more risk with the objective of earning higher return.
This tradeoff presents a rock-and-a-hard-place situation for pension plan managers, regulators and policymakers. Any restriction placed on pension plans to take on risk results in bigger contributions from future retirees to ensure there is sufficient capital in the pot to pay the pensions.
For example, take the case of solvency requirements in Canada. These requirements are designed to protect pensioners by requiring pension plans to always have sufficient assets to safely cover pension liabilities. If a plan experiences a sudden drop in assets resulting in a deficit, the plan must eliminate the shortfall by making a special contribution. This is costly and therefore discourages risk-taking.
The following example illustrates why the risk-return tradeoff has become a real challenge for pension fund managers. Consider a 45-year-old worker who will retire at age 65 and earn a pension that pays $50,000 annually. She expects to live until age 80. If the capital is invested only in bonds that yield six per cent per year, the capital lump sum that needs to be invested today to pay the $50,000 annually is $151,416.
Now imagine that this worker expects to live an additional five years and that bonds yield only two per cent per year. The capital required today to finance the same pension jumps to $550,202. Put differently, if the worker used to put aside 10 per cent of her annual income for a pension, she must now contribute 36 per cent.
The good news is there are ways for pension funds to become more efficient in delivering higher returns while keeping the risks under control. The key is that pension funds have a distinct advantage over other investors, such as mutual funds, because they have a long-term horizon.
The long-term horizon comes from the fact that pension funds have a large proportion of their liabilities that are not due until 20-plus years from now. There’s also a fair amount of predictability in the contributions received each year. Because of this, pension funds are not subject to sudden redemption runs the same way that mutual funds can be.
A long-term horizon has many other advantages. For one, long-term investors are better able to weather short-term fluctuations in financial markets because they can afford to wait. This means long-term investors can take contrarian positions in bad times and purchase assets at depressed prices. This is precisely the type of investment strategy that delivers high returns over the long run.
As long-term investors, pension funds can afford to give more attention to the long-term profitability outlook of firms. This is valuable because most stock analysts tend to focus on a stock’s short-term profitability, leaving good deals on the table for investors who can afford to buy and hold an investment over a long period.
Long-term investors can also be more active and successful on the environmental front. The long-run performance of their investments is intrinsically tied to their resilience to climate change over the next 30 to 50 years. In other words, pension funds can better internalize the long-run impact of climate change on their investments.
A research study that I recently published together with a team from CEM Benchmarking shows that large public Canadian pension plans, which are not subject to strict solvency requirements, are able to perform strongly in the long term. Over the past 20 years, these funds have generated approximately an eight per cent annual rate of return. The high returns have allowed the plans to stay well-funded without necessarily requiring high contributions from future retirees.
In spite of the benefits, it is hard for most pension funds to be a long-term investor in the current environment. Managers and board members of the funds must have the patience and ability to manage short-term pressures.
Pension plan members must also be realistic and understand that while there will inevitably be bad years, ultimately, the funds have the capacity to withstand short-term fluctuations. A solid risk-management framework must be set in place. The regulatory environment must also allow for reasonable levels of risk-taking by pension funds for pensions to be realistically sustainable.
To be clear, long-term policymaking for pension funds does not imply that we should forget about short-term fluctuations in the funds’ solvency ratios. These fluctuations should continue to be monitored closely as they may be informative about structural deficiencies in the pension fund strategy.
But we should not necessarily rush to punish a pension fund as soon as it faces a bad year, either by requiring immediate contributions or by forcing the fund to de-risk. Bearing short-term risks is a necessity if we hope to reap large investment gains over the long-term and in turn ensure successful pension outcomes while keeping costs under control.