Photo by Stefano Pollio on Unsplash
Hello,
Welcome to Known Unknowns, a pension risk newsletter in a world where risk has no meaning anymore.
Are US Pensions in trouble?
Perhaps, though not in the same way UK pensions were, as I explain in my Bloomberg column.
But first, we need to talk about bonds. Bond prices rule the economy. High-quality fixed income is the market’s risk-free asset. And risk free is the entire foundation of financial markets. It is how we measure and gauge risk and determines how much risk people take. Predicting what will happen to bond prices is also very difficult because the long end of the yield curve is something of a mystery. Many commentators in the financial media and people in industry are convinced that the expectations hypothesis (EH) holds up. EH is the theory that long rates are based on expectations of future short rates, or long rates are based on future Fed policy. The data does not support the expectations hypothesis at all. That’s because the term premium is an elusive beast. It is hard to measure and contains risk premiums (liquidity risk, inflation risk, rate risk) that are poorly understood. What I am trying to say here is that the Fed does not have total control of the yield curve.
Or so I thought. After the first few rounds of quantitative easing (QE) and my read on Operation Twist, it seemed the yield curve was still doing its own thing, despite the Fed’s best efforts. But now I am not so sure. The Fed bought SOOOO many bonds in the last few years. So many that we didn’t notice foreign governments and pensions weren’t buying as much anymore. There also has been regulatory policies that forces financial firms to hold lots of safe debt. So what do long-term yields even mean anymore? The market is so distorted. And since long-term bonds are the risk-free rate for anyone with a long-term liability (future retirees, pension funds, insurance companies), measuring economic risk becomes equally squishy.
Today inflation is high. Expected inflation and the inflation risk premium are big components of the term premium—so it will be bigger. Oh, and we are also losing an enormous, captive buyer of bonds in the form of quantitative tightening (QT). I expect the yield to keep rising (they are still negative when you account for inflation)—even if the Fed gets cold feet and stops increasing rates. And when rates go up, we will discover where all the bodies are buried. After all, a zero-rate world makes it pretty easy to hide lots of bodies.
And I worry many of them are resting in US pension funds. I am not so worried about corporate plans (though you never know). Public sector plans may appear less exposed; they don’t even use the treasury as their discount rate (though they should). But low rates meant they bulked up on risk, especially private equity (which also suffers in a low-rate environment). So, who knows how it will shake out? Chasing yield and not accounting for risk usually goes poorly.
UK pensions are actually solvent; they have never been better funded. We can’t say the same for public sector pensions.
Lots of people convinced themselves that zero rates were the new normal. It does seem rates have trended downward over time as the world has become less risky. But there have been so many distortions in the risk-free rate in the last 30 years; who knows what risk-free is worth, and the corollary is—what is risk worth? We’ll soon find out.
When will Fed policy start to work?
Past research suggests that it takes a year or more for rising rates to lower inflation. People set wages and leases and make investment decisions for a year or more in advance. These things take time to work through the economy. But just like the yield curve, we don’t know much about how long it takes for monetary policy to work or even how it works.
It seems expectations are important. And if they are well anchored, it can take a long time for monetary policy to impact the economy because people make plans around a certain inflation rate. But if people don’t know what to expect, lag times can be much shorter because people don’t make the same long-term commitments to prices and wages.
But unanchored expectation with an inflation target sounds to me like the Fed has no credibility. And that is a big problem since believing the Fed can lower inflation is what gives it the actual power to lower inflation. This is why they keep insisting they will keep rates high until inflation falls.
But will they? Talk is cheap when unemployment is low and real rates are still negative. Restoring credibility will take making some hard, unpopular choices.
Will Social Security be there in the future?
I’d bet on it being there.
Social Security recipients will be getting a very large cost-of-living adjustment (COLA) increase this year, 8.7%. Many retirees live on a fixed income and will surely need it. But since wages are not rising as fast, this may speed up the doom year when Social Security can no longer pay full benefits.
I always thought it weird that many people think Social Security will disappear. Nearly 50% of Americans don’t expect to see any benefits at all! Worst-case scenario, there’s a 20% across-the-board benefit cut. But even that is highly unlikely; governments will default on bondholders before anyone gets a big pension cut.
Yet, it is political kryptonite to put Social Security on firm financial footing.
Riddle me this: everyone loves the program, and many fear it will disappear, but no one wants it to change.
But the fact is, the sooner reform happens, the cheaper it will be—for taxpayers and beneficiaries. Promising you won’t touch social security is living in a fantasy land that makes retirement planning much harder for everyone.
In other news
I debated whether unions work for the economy for Intelligence Squared. At a famous comedy club! There was some comedy before and after the debate, even if the debate—while interesting—was not very funny.
Until next time, Pension Geeks!
Allison
The incoherent political discussion on Social Security is baffling to me. It is mainly Republicans who keep threatening to disembowel it, yet a fairly high percentage of their voters are or will be largely reliant on it. Maybe those voters don't understand yet that they are not the ones reading the menu, but will be on the menu instead.
Social Security has been a very valuable social and economic tool that provides a major amount of financial security to a large percentage of the population. If it were to vanish quickly, I don't think people have even attempted to process the economic impacts of having workers dramatically increasing savings rate (reducing consumption) and retired people making major changes to their spending during recessions and market downturns if they are largely reliant on their own savings. Social Security is currently a significant economic flywheel where checks get sent out every month and spent within 30 days. This helps smooth out consumption during booms and recessions, so is anti-cyclical while eliminating it would be pro-cyclical and the amplitudes and frequency of economic booms and busts and market booms and busts would likely increase which is what we saw in the century before the New Deal. People living to 85 instead of 65 would amplify the economic impact beyond what we saw before the New Deal.
It will probably take a couple of more years to sort out the next 15 years of Social Security as mortality, especially among seniors, increased dramatically over the past two years while employment and inflation has been on a roller coaster. I have thought for a while that having a quarter to a third of the Trust fund in the stock market (using a simple total US stock market index approach) would make sense. The duration of the end of the Trust Fund is rapidly moving to a point where the risk would outweigh the benefits. The duration of stock investments is close to 20 years while the end of the Trust fund is only about 12 years out. 2023 would likely be a very good year to make a shift of some 2030s bonds into stocks but the incoherent political atmosphere makes that highly unlikely. It will probably happen when it would either be irrelevant or stupid.
The make-up of the Trust Fund is here: https://www.ssa.gov/cgi-bin/investheld.cgi Basically, it is bonds with maturities from now through mid-2030s with average interest rates of 2.3%. I think their maturity selection is based on actuarial analysis of need for the bonds maturing at specific times. Selling these bonds to invest in stocks in 2023-24 while the Fed is going through QT would probably be an additional stress on the 10-year T-bond market, so I doubt the Fed or Treasury are pushing for such a move.
Personally, I think Social Security will be around in something like its present form 20 years from now. But the inability of our society and politicians to address both Social Security and healthcare costs means that I am targeting saving an extra $500k in retirement accounts. This accounts for the potential for Social Security only paying out 75 cents on the dollar of promises and exorbitant US healthcare costs. That has been requiring significant savings rates and reduced consumption during our late career working years. If politicians truly threaten the existence of Social Security so it could to zero at some point, then we would significantly slash consumption during retirement. That loss of spending power would be unpleasant for us but catastrophic to many households. It would likely severely impact GDP, particularly during recessions. The small business owners complaining about paying FICA taxes would suddenly wonder why their customers went away.
The incoherent political discussion on Social Security is baffling to me. It is mainly Republicans who keep threatening to disembowel it, yet a fairly high percentage of their voters are or will be largely reliant on it. Maybe those voters don't understand yet that they are not the ones reading the menu, but will be on the menu instead.
Social Security has been a very valuable social and economic tool that provides a major amount of financial security to a large percentage of the population. If it were to vanish quickly, I don't think people have even attempted to process the economic impacts of having workers dramatically increasing savings rate (reducing consumption) and retired people making major changes to their spending during recessions and market downturns if they are largely reliant on their own savings. Social Security is currently a significant economic flywheel where checks get sent out every month and spent within 30 days. This helps smooth out consumption during booms and recessions, so is anti-cyclical while eliminating it would be pro-cyclical and the amplitudes and frequency of economic booms and busts and market booms and busts would likely increase which is what we saw in the century before the New Deal. People living to 85 instead of 65 would amplify the economic impact beyond what we saw before the New Deal.
It will probably take a couple of more years to sort out the next 15 years of Social Security as mortality, especially among seniors, increased dramatically over the past two years while employment and inflation has been on a roller coaster. I have thought for a while that having a quarter to a third of the Trust fund in the stock market (using a simple total US stock market index approach) would make sense. The duration of the end of the Trust Fund is rapidly moving to a point where the risk would outweigh the benefits. The duration of stock investments is close to 20 years while the end of the Trust fund is only about 12 years out. 2023 would likely be a very good year to make a shift of some 2030s bonds into stocks but the incoherent political atmosphere makes that highly unlikely. It will probably happen when it would either be irrelevant or stupid.
The make-up of the Trust Fund is here: https://www.ssa.gov/cgi-bin/investheld.cgi Basically, it is bonds with maturities from now through mid-2030s with average interest rates of 2.3%. I think their maturity selection is based on actuarial analysis of need for the bonds maturing at specific times. Selling these bonds to invest in stocks in 2023-24 while the Fed is going through QT would probably be an additional stress on the 10-year T-bond market, so I doubt the Fed or Treasury are pushing for such a move.
Personally, I think Social Security will be around in something like its present form 20 years from now. But the inability of our society and politicians to address both Social Security and healthcare costs means that I am targeting saving an extra $500k in retirement accounts. This accounts for the potential for Social Security only paying out 75 cents on the dollar of promises and exorbitant US healthcare costs. That has been requiring significant savings rates and reduced consumption during our late career working years. If politicians truly threaten the existence of Social Security so it could go to zero at some point, then we would significantly slash consumption during retirement. That loss of spending power would be unpleasant for us but catastrophic to many households. It would likely severely impact GDP, particularly during recessions. The small business owners complaining about paying FICA taxes would suddenly wonder why their customers went away.