How to future-proof your pension against the global retirement crisis

Under pressure

Enter the words “pension,” “retirement,” and “crisis,” and a myriad of reports outlining the dire state of many pension funds around the world spring onto your screen. They all point out that a toxic mixture of aging populations, economic conditions, and government policies (often well-intentioned but misguided) have left much of the global population facing a dire outlook in terms of their retirement finances.

Hard data underlines the difficulties that lie ahead:

Over the period from 2020 to 2050, the number of retirees per 100 working people will increase from 28.4 to 40.4 in the US, from 18.5 to 47.5 in China, from 36.5 to 58.1 in Germany, and from 52.0 to 80.7 in Japan. Similar trends can be seen in advanced and emerging economies across the planet.[1]
At the same time, many pension funds now find themselves unable to meet their liabilities. In the US, for example, most state and municipal public pension funds are distressed or fragile, with funded ratios of less than 90%, according to the Equable Institute’s State of Pensions 2023 report.[2]

Although funding improved in 2023, Anthony Randazzo, the executive director of the Equable Institute, a bipartisan nonprofit that provides public pension education, research and solutions for employees, labor, communities, and policymakers, expressed disappointment.

Randazzo explained that more than 15 years on from the financial crisis, and having experienced a bull market fueled by zero interest rates, “the national average funded ratio is tepid with little sign that a strong recovery is on the horizon.”

At the end of fiscal 2023, the average funded ratio for public pension funds in the US stood at 78.1%, up from 74.9% in fiscal 2022. Yet the overall funding status is still down from a high of 94.4% in 2001.

Moreover, the true state of affairs may be much worse than the headline figure, according to recent research. It estimates that unfunded pension liabilities—the gap between promised benefits and the assets set aside to pay for them—are actually closer to $5.1 trillion, which translates to an overall funding ratio of less than 50%.[3]

The problem, according to Stanford Business School, is “that future pension obligations are being grossly undervalued—and the discrepancies are adding up. Over the nine-year span of the study, unfunded liabilities grew by 50%, even as stocks surged and state and local budgets contributed more to pension plans.”

Troublingly, pension funds have responded by adopting higher leverage, making riskier bets, or both. The collapse of the ill-fated Truss administration in the UK in October 2022 highlighted the dangers lurking in the global pension system.

Back in the early 2000s, many UK pension funds adopted a liability-driven investment (LDI) approach to match their assets to future pension payments. That seemed an entirely sensible strategy. The problem is that while these funds initially switched from equities into bonds, they then sought out riskier and riskier instruments—including volatile financial derivatives—as interest rates and bond yields fell.

The UK’s pension funds used derivatives to protect themselves from potential swings in interest rates, gaining large exposures through small amounts of capital. But that also meant that if the derivative became loss-making for the pension fund because of a change in underlying asset prices, the fund could be called on for more money, sometimes at short notice.

That’s what happened after the UK’s September “mini-budget” triggered a jump in UK government bond yields, driving pension funds to race to raise cash to prop up their LDI hedges. The scale of the crisis was such that the Bank of England had to step in to buy bonds.

And it’s not just derivatives that pose a threat. Pension funds have even been investing in wildly volatile instruments such as cryptocurrencies. A CFA Institute survey in April 2022 found that 94% of state and government pension-plan sponsors reported investing in crypto.[4]

The Canadian pension-fund manager Caisse de dépôt et placement du Québec, for example, invested US$150 million into the crypto lender Celsius in October 2021. Celsius filed for bankruptcy less than a year later as crypto prices plummeted.[5]

The trend of moving into relatively exotic areas of the financial market is worrying for observers, as it increases the possibility of underperformance even further. As early as 2019, the Boston Federal Reserve commented, “Risk-taking behavior is most pronounced among funds with sponsors with the least ability to bear additional risk.”[6] It is important to differentiate these exotic assets from alternative assets. Alternative assets, such as those offered by professional firms, are carefully vetted and managed to ensure that the risk is rewarded, unlike the high-risk investments in cryptocurrencies that some pension funds have pursued.

Deeper challenges

The troubled macro-environment looks set to continue. High inflation and market volatility will likely persist in the coming years, as the geopolitical world rebalances.

But even assuming a positive economic environment, there are fundamental pressures on traditional pension schemes that have not been addressed.

Aging populations and falling birth rates will mean lower contributions to workplace pension schemes, just as the number of retirees is growing. Furthermore, more people than ever are living into old age, meaning longer retirements with higher funding requirements.[7]

The shift from Defined Benefit (DB) to Defined Contribution (DC) schemes means that there is no longer a guaranteed sufficient lifelong income for these individuals, and those with barely sufficient assets are at the mercy of the markets.

Working longer is one way to address these issues. However, studies have shown that even those who aspire to work longer often retire sooner than planned, owing to ill health, redundancy, or another change of circumstances, such as needing to care for a spouse.[8]

Seeking a more secure future?

The challenges facing institutional pension funds are clear. In response, many prudent investors are supplementing their pension plans by taking greater control of their retirement finances with personalized investment strategies. By building additional funds alongside their traditional pension contributions, individuals can create a more robust financial foundation for retirement.

Working with a professional portfolio manager or, better still, an experienced firm can be a way to bypass the turmoil engulfing the pension industry.

This approach allows individuals to take control of their retirement finances and seek out higher returns in non-public opportunities, such as private debt, private equity, and real estate. That avenue also has diversification benefits as it brings exposure to assets not available in public markets. Moreover, private assets tend to be less volatile than their public counterparts. While sourcing and evaluating such deals requires expertise, it provides an effective way to future-proof your portfolio.

Petiole Asset Management specializes in private-market investments as a means of outperforming the traditional options open to investors. As the world transitions to the next phase in financial markets, this new approach may become the new normal.

Key takeaways

Aging populations, economic conditions, and government policies have left much of the global population facing a dire outlook in terms of their retirement finances.
Consequently, individuals are increasingly looking to construct their own retirement finances independent of traditional structures.
By working with a professional portfolio manager or an experienced firm, individuals can bypass the turmoil engulfing the global pension industry.

[6]Institutional investor

[7]Brookings

[8]CNBC