My Take On "The Looming Pension Disaster"

I could give you a list of a thousand problems on this topic.  I won't.  I'll pick one, maybe two.  I wrote a while back about the problem in New Jersey.  New Jersey hardly has a monopoly on pension problems.  Here's another nice one by Alan Sloan at Fortune.

In the FT today, there's a piece about securitizing pension risks. Before I tell you what the heck this means, I'll tell you it cannot work.  Too many regulatory problems.  The risk cannot be unloaded or hedged.  This all ties back to my moving and storage piece, (which, by the way, I will continue to link as frequently as possible, because if you haven't read it, you don't get half of what I'm saying!)

Securitizing pension risks means figuring out a way for another party to hold the risk that people live longer than expected.  Put another way, construct a security that allows large groups of people to hedge the risk that they live longer than expected.  Let's think about buyers of this security.

The world economy has four different types of entities set up to efficiently buy and hold securities, or store risk: insurance companies (primarily life), pension plans (both public and private), investment companies (by this I mean mutual funds, money market funds, and UCITs in Europe, etc.) and sovereign wealth funds.  Virtually all other financial institutions seek to convert from storage companies into moving companies: They source risk and lay it off on others, they don't hold it well.

Working backwards, sovereign wealth funds, while receiving much attention, don't have much assets.  Sovereign wealth funds seek to protect the population of the sovereign state from financial ruin (typically) when the population outlives natural resources within the country.  For example, sell the oil and diversify the economy with the proceeds because the oil needs to support the country long after the oil is gone.

Investment companies, while very large in aggregate, have substantially all their assets from individuals or institutions saving and investing for retirement purposes.  You and I already face the risk that we individually live too long.  (Living too long means you run out of money before you die, in this context.)  Quite possibly the last investment you should consider with your retirement money would be a risk that you lose money if other people live too long.  Why?  Because if you live too long, there's a good chance they do to!

Pension plans carry one single overwhelming liability risk: People live too long.  Pension plans (in the classic sense, called defined benefit plans) pay out fixed benefits in retirement for as long as someone lives.  When life expectancies rise, pension plans' liabilities (obligations to make future payments) rise.

So, our first three buckets of assets more or less carry the same liability risk: people living too long.

Next, we come to life insurance companies.  Most obviously, life insurers carry the risk that people die too soon--before they pay enough premiums to cover the payouts.  That's why life insurers need massive diversification.  Also, their risk really falls to young people who die too soon, (because they haven't paid enough premium) versus old people who live too long for the pensions.

[Interesting side note here: Life insurance companies worry far more about pandemics that strike young healthy people than those striking elderly, feeble people.  Catastrophe modelers for pandemic carefully differentiate between the two.]

Back to securitizing pension risk.  What does it mean?  Making life expectancy into a risk that someone can trade.  Goldman Sachs had a product that got at this idea.  It failed.  It had the catchy name Qxx.  That's worse than iPad.  It failed because no one will logically buy this risk.  I'll also add that if some entity were willing to buy the security, you really couldn't trust their ability to pay in the extreme because, ultimately, this is their risk too.

So, where does this leave us?  Life expectancy cannot be hedged, for the most part.  Everyone who could provide protection against the risk already has the risk.  You can shove it around a lot.  You can try to hide it.  You can't make it go away.   I hate to be too self-referential, but I previously discussed why we cannot hedge financial market disasters because that's a systematic risk.  Life expectancy poses the same problem: Every single person on Earth faces the same risk, that they live longer than their resources can support them.  Sure, there are isolated cases of individuals, (Bill Gates comes to mind,) but in the aggregate, it can't be done.

What does that mean for the looming pension crisis?  Unless life expectancy starts to fall, which would be truly catastrophic, our only hope is that productivity and growth outpace life expectancy advances.