The World Economic Forum, in conjunction with Mercers (the actuaries) recently estimated that the combined pension deficit currently stands at $66.9tr for eight countries, rising to $427.8tr in 2050. The eight countries are Australia, Canada, China, India, Japan, Netherlands, UK and US. Of the 2016 figure, $50.5tr is unfunded government and public employee pension promises.
Yes, we are now talking in hundreds of trillions. Other welfare-providing states missing from the list have deficits that are additional to these estimates.i
$66.9tr is roughly 1.5 times the GDP of the eight countries combined, and $427.8tr is nearly ten times. Furthermore, if we take out the non-productive government element, the figures relative to the private sector tax-paying base are closer to twice productive GDP today, and thirteen times greater in 2050. That 2050 deficit assumes a 5% compound annual growth rate. This is a linear projection, but the deterioration in finances for unfunded government pensions may turn out to be exponential, in line with the accelerated increase in the broad money quantity since the great financial crisis.
The problem is mainly in the welfare states, so we know that the welfare states are in big trouble. Governments routinely offer inflation-protected pensions to state employees, funded out of current taxation. The planners in government treasury departments are coming alive to the scale of the problem, though the politicians would rather ignore it. Government finances are already being subverted by both unfunded pension obligations, and by additional rising healthcare costs for aging populations.
Furthermore, people are living longer. Someone born in Japan ten years ago who retires at 60 can expect to live to 107, leaving the state picking up a forty-seven-year welfare and pensions bill. And it’s not much less expensive in other countries, with 50% of North American and European babies born in 2007 expected to live to 103.
The global dependency ratio, those in work relative to those in retirement, is expected to deteriorate from 8:1 to 4:1 by 2050. When most people retire, they stop paying income tax and become a burden on the state welfare system. Therefore, retirement ages must rise. Not only must they rise, but they must rise by enough to pay for those who are otherwise fit but mentally incapacitated by dementia, Alzheimer’s and Parkinson’s, set to spend the last decades of their lives expensively kept.
That is the background to a global problem. But we shall just say “poor taxpayers”, and move on. Instead, this article focuses not on the problems of funding state pensions (which is admittedly 75% of the problem), but is an overview on why the current low growth, low interest rate environment is so detrimental to private sector pensions.
Forty years’ servitude, and what do you get?
In the last millennium, one of the benefits of working for a company was a company pension scheme. There were intended to garner enough savings during their working lives for employees to retire on up to 70% of final salary. Nearly all but the smaller companies offered a pension scheme, of this defined benefit type. Since then, many of these schemes have been replaced by defined contribution schemes. Both types of pension are based on how much you and the company have contributed. Where possible, defined benefit pensions are being wound up, because mounting deficits on these pensions can threaten the survival of the contributing companies, and are being replaced by defined contribution schemes, where any shortfall merely reduces the pensioner’s pension.
Irrespective of whether a pension scheme is a defined benefit or defined contribution scheme, this system of saving for retirement is failing. Besides rising life expectancy, the principal variables that affect a pension’s benefits are how well the pension’s investments perform, and the ability of the funds in the pension plan to cover the pension payments over the expected lifespan of the retirees. Investment returns are forecast based on current bond yields for government securities, and a long-run assessment of equity markets, including dividends.
This gives rise a problem, brought about by central bank interest rate policies. By suppressing interest rates and bond yields, central banks force pension trustees to increase their estimates of the amount of capital required to cover pension payment streams over the expected life of the pensioners. For example, let us assume a pension fund has an income from its investments of 5% and has no deficit. If that income is slashed to 2 ½ per cent, the income falls by 50%. Simple arithmetic tells us the amount of capital required to maintain the original payment stream doubles.
In practice, the calculation is much more complicated, but clearly, current interest rate policies are giving rise to substantial actuarial shortfalls. Another source of deficits is lower than expected investment returns on the inflation hedges that are expected to benefit from artificially cheapened money. These are principally listed equities, and unlisted property.
By way of illustrating how investment returns on bonds and equities have fallen over the years, Table 1 shows the annual compound returns on US Treasuries, US equities and gold for comparison priced in dollars, taken over the last forty years (a working life), as well as since the start of the current century.
Table 1. Compound annual returns - US$
US 10-year Treasury bond (coupons reinvested)
US 30-year Treasury bond (coupons reinvested)
S&P 500-Index (dividends reinvested)
Gold (physical, incl. 12-month gold lease rate)
Sources: Goldmoney research
The reason for including gold in the table will become apparent later in this article.
While a diversified pension fund is likely to invest in a wider range of asset classes, the core of its portfolio is government bonds and equities, which with dividends reinvested have demonstrated superior returns to bonds since the 1950s. Bonds are bought with the intention of holding them to redemption, and ideally, a pension fund manager will seek an average maturity in excess of ten years, which is why Table 1 includes return outcomes for both 10-year and 30-year maturities. Today, 10-year USTs yield only 2.2%, and 30-year USTs 2.8%. In Europe and Japan, the situation for pensions is much worse, with zero and even negative yields. At these rates, capital requirements in a pension fund soar towards infinity.ii
With the long-term trend in interest rates having declined from their peak in 1980-81, it is hardly surprising that portfolio allocations in favour of bonds have been reduced. Furthermore, the superior performance of equities in the second half of the last century threw up actuarial surpluses, allowing many companies to take contribution holidays, and this in turn has encouraged the trend towards increasing exposure to equities.
Equity diversification worked well for pension funds for a while. Thirty years ago, US equities paid decent dividends, and stock prices rose, even though there were some unsettling bear markets. Since 2000, dividend yields have declined significantly, leaving pension schemes more dependent on rising stock prices for total returns. Furthermore, the outturn of 4.45% for the S&P since 2000 has been in practice difficult to achieve, with active managers mostly underperforming the index.
Equities were meant to be a hedge against inflation. But since 2000, taking management performance and costs into account, any improvement on a portfolio of bonds has been marginal, or sometimes entirely absent, considering the increased investment risk relative to government bonds. This is the worst of everything: the conditions whereby fiat money loses purchasing power over time are not leading to higher nominal bond yields, nor a compensating outperformance of equities.
Hard money versus soft – the implications
The crisis in pensions is very real. The 30-year bond now yielding less than 3% and price inflation measured by the CPI likely to exceed it soon. The crisis faced by pension trustees could get considerably worse, with the 10-year T-bond yielding less than the official rate of inflation already. Central banks have now bought an estimated one third of government bonds in issue, driving prices up and yields down. They may be saving government finances, but they are killing pensions.
Essentially, managing a pension by offsetting the falling purchasing power of unsound money with conventional inflation-hedging investments no longer works. Furthermore, if central banks were to properly face up to the problems of unsound money, it’s hard to envisage this being done without undermining financial markets. While pension liabilities would fall because of rising interest rates, the assets in the fund would also fall in value, and many equity investments might not even survive.
It is unlikely that such a financial crisis would be contemplated as a deliberate act of monetary policy, but it is a significant and growing risk that governments will lose control of markets, despite their interventions. It is on this basis that a pension fund investing in physical gold makes sense.
As with equities, the period chosen for historical performance comparisons can make a significant difference, and this is reflected in the figures for gold in Table 1. Critics of gold as a pension asset are sure to point out that since 2000 gold has enjoyed a decent bull market, while the equity market started from the peak of the dot-com crisis. This criticism has a point to it, but it ignores the consolidation of the dollar price of gold that’s lasted over one third of that time, losing one third of its value.
Historical performance, as they say, is no guarantee of future performance. The reasons for allocating pension money into gold must therefore be based on an understanding of the relationship between sound and unsound money, as well as an in-depth understanding of the relationship between money generally and asset prices. This is particularly true when inflation hedges, such as equity and property investment, are being considered. Furthermore, a responsible analyst must take account of the variable time lags between monetary policy affecting asset prices and eventually consumer prices. Inevitably, before monetary policy affects the price of gold, there can be considerable variation in time differences. For example, the unprecedented global expansion of central bank balance sheets and the expansion of bank credit following the great financial crisis had a significant impact on the price of gold between 2009 and 2012. Since then, monetary and credit expansion has continued, but the gold price has declined.iii However, the value to a pension fund is essentially long-term, and must look through these intertemporal effects.
The chart below shows how the purchasing power of the four major paper currencies, measured in gold, has declined since the end of the Bretton Woods Agreement (the Nixon shock). It is indexed to gold from 1969, when gold was officially $35 per ounce.
The degree of losses suffered by the major currencies relative to gold is clearly seen in this chart. In less than fifty years, the dollar has lost 97% of its purchasing power measured in gold, while the purchasing power of the dollar measured by the official CPI has only fallen 75%. Prices for goods measured in gold have therefore fallen (i.e. gold’s purchasing power has risen), which is what we would expect from our understanding of sound money.
When money is sound, its purchasing power increases over time, reflecting the improvements in technology and manufacturing processes brought about by competition between manufacturers. We saw this over the course of the nineteenth century in Britain when the gold standard applied. Therefore, savings not only earned modest interest, but their value increased over time, rewarding thrift. Ordinary people had a strong incentive to put some money aside for their own welfare and that of their families, savings that could accumulate over generations.
Saving in gold in a sound-money environment produces the best long-run returns. In these circumstances, government bonds pay coupons that are a gold substitute, and are a genuine basis for all saving. When national currencies were unconditionally exchangeable for gold, government bonds were as good as gold. That, obviously, is no longer true.
There is another important difference between fiat currencies and gold in the context of providing a pension. In the early days of retirement, the average person will obtain part-time employment, because new retirees tend to be fit, able and sociable. Their need for a pension is as low as it is likely to be in their retirement. However, as the pensioner ages, the ability and desire to work diminishes, and the cost of healthcare becomes an increasing burden. The cost of living, particularly regarding healthcare, is at its highest for the very old.
A pension distributed in fiat money works the other way around. The purchasing power of a fiat currency diminishes over time relative to sound money, as the chart above dramatically illustrates. That chart covers forty-eight years. An American born today can be expected to face unsound money progressively eroding his pension for thirty-seven years. His pension in unsound money will become progressively worth less as he ages, leaving him with very little when he needs it most for his escalating healthcare costs.
Gold behaves differently. Its purchasing power increases over time, so that in a pensioner’s later years, it buys more of the things needed, including healthcare. Since gold is the best preserver of purchasing power, increasing over time, it seems extraordinary that the pensions industry spends virtually no effort trying to understand the benefits sound money brings to pensions.
Ignorance on this point is mostly a modern Western phenomenon, the consequence of a Keynesian drive to remove gold from the monetary scene and of the state discouraging Keynes’s pet hate, saving. Instead, most pensioners, including those who have saved assiduously for all their working lives, are forced to fall back on state-provided welfare.
The failure of private pension schemes will simply increase the burden on the state. If you think the WEF report referenced at the beginning of this article is alarmist, think again. The pensions crisis will not only bankrupt the private sector savings schemes that define their benefits, but they will bankrupt governments as well.
Asians in the old world, for whom all this savings mess is barely relevant, are more fortunate, understanding that government money is to be spent before it loses its purchasing power, reserving gold for saving. The disparity in performance between investments that supposedly give protection against price inflation, and gold, is more marked than shown in Table 1 for the dollar, or as indicated by the loss of the dollar’s purchasing power of 97% since 1969, illustrated in the chart above. The next chart shows how selected Asian currencies have fared against gold, which has been considerably worse than against the dollar, euro, pound and yen.
No inflation-compensating investment has matched gold in these currencies, which is one good reason why in all these countries the family savings are composed either entirely or mostly of physical gold. Note that the Turkish lira suffered a one million to one consolidation on 1 January 2005, the original 1969 lira to all intents being worthless today. An ounce of gold in Indonesian rupiah has risen from IDR11,500 in 1969 to IDR15,500,000. No wonder the Indonesians and Turks prefer to save in gold.
It is clear, on investigation, that conventional inflation hedges, such as equities and property, are failing to protect pensions adequately. Central bank suppression of interest rates plus quantitative easing have resulted in negative real yields on government bonds. The annual average return on equities, after costs and underperformance, is barely keeping level with price inflation.
There appears to be a negative relationship between the rate at which a currency loses purchasing power, and the ability of a conventional inflation-hedge to protect pensions. This is the message from Asian currencies, where the trend is more marked. Given the acceleration of monetary inflation since the great financial crisis, it is likely that the loss of purchasing power for the major paper currencies will in turn accelerate in the coming years. Inflation is always a monetary phenomenon. In this event, the gap between the increase in nominal values for inflation hedges and the loss of a currency’s purchasing-power seems set to widen further.
If we add to the mix increasing longevity for pensioners, pensions as currently constituted are failing to deliver the security pensioners expect for their retirement. An allocation into physical gold is the best insurance against underperformance, based on empirical evidence and monetary economic analysis. However, pension funds rarely hold physical gold as an asset, the managers having yet to discover it as the natural antidote to unsound money.
Even if a pension fund manager takes the decision to invest in gold bullion, the manager would have to overcome a systemic and regulatory bias against what is designated an unregulated investment. The alternatives are regulated derivatives and investments in gold mines, which being in themselves ephemeral and having counterparty risk, are not the same thing.
Eventually, the financial system will be forced to abandon unsound money. We are already seeing that the financing of economic activity by the expansion of unbacked credit no longer delivers the economic benefits expected, and there is an increasing awareness that the welfare-driven democracies are heading for a financial crisis. The WEF report on pensions is only part of that realisation.
It would be too optimistic to think we will simply move from a world of unsound money to a realisation that the abandonment of sound money was a mistake. Changes in the way savings are recycled will have to be so fundamental that the current financial system faces nothing less than destruction. Politics and vested interests can be expected to strongly resist such radical change, principally by sacrificing the purchasing power of paper money to buy yet more time.
The strong likelihood that the destruction of the major fiat currencies will accelerate in a vain attempt to buy off the financial system’s demise, merely strengthens the case for gold in a pension fund. The dynamics are plain to see. As your currency bites the dust, the prices of all investments expressed in it will underperform relative to gold. The greater the effect, the greater the underperformance.
Yet, the pensions industry, the custodians of our future welfare, seems hardly aware of what is happening. Pension funds will be well on the way to being redundant before realisation dawns, and we savers will be the victims. Instead, we must take a leaf out of the Asian’s book, short-circuit the financial system and accumulate physical gold for ourselves, if we are to preserve any of our savings for retirement.
iSee WEF White Paper: We’ll Live To 100 – How Can We Afford It? Figure A3 pp 22.
ii In practice, deficits arising from suppressed interest rates are often concealed by over-optimistic forecasts for equity market performance. For this reason, the situation is probably worse than stated.
iii The decline in gold prices since September 2011 has had much to do with central bank intervention, particularly in the wake of the Cyprus banking crisis, which accelerated capital flight in the EU. It should be noted that the bullion banks are systemically short of physical gold, and a significant price rise would cause them problems. For this reason, there is a bias in favour of using derivatives to control the price.
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