The US is not a “bubble economy”. That’s the view of the Federal Reserve, expressed by its chair Janet Yellen this month. Yellen describes a bubble as a combination of “clearly overvalued” asset prices, strong credit growth and rising leverage. However, the Fed’s definition of a bubble is too narrow.
Bubbles are illusions of wealth. The last two great bubbles – internet stocks and US real estate – involved inflated asset prices. The great current bubble is centred around liabilities – specifically pensions. Today’s workers count the pensions they are promised as part of their wealth. But a look at the position of many pension schemes makes it clear that not all these claims can be paid.
Pension deficits are soaring
The present value of a pension is arrived at by discounting future cash payments. As interest rates have fallen, this discount rate has declined, increasing pension liabilities. As a result, many pensions find their liabilities exceed assets. For instance, the current deficits of US corporate pension plans are around $425bn, estimates Citigroup. UK and European corporate pension plans also have large deficits. The aggregate shortfall of American public-sector pension plans is somewhere between $1trn and $3trn, according to Citigroup.
However, the true mismatch between pension assets and liabilities is even greater. Let’s start with the assets. American corporate pensions assume an annual return of 7.1%, but will find it impossible to achieve this. The USstockmarket is expensive by historic standards. Government bonds in developed economies sport minuscule, and in some cases negative, yields. So a traditional portfolio of 60% equities and 40% bonds is likely to return a mere 2% over the long run, according to Andy Lees of MacroStrategy Partnership, an independent research outfit.
On the liabilities side, assumptions are also “totally unrealistic”, says Lees. US public-sector plans use an average discount rate of around 7.5% to value their liabilities. US corporate pension plans use a 4%-4.5% discount rate. Yet the current yield on the ten-year Treasury is less than 2%. If realistic discount rates were used, liabilities would balloon.
The consequences of the pensions bubble are already evident. Several USmunicipalities and towns have declared bankruptcy. The Pension Benefits Guarantee Corporation, the quasi-state body that insures American corporate pensions, has liabilities roughly twice the size of its assets and will run out of money in the next few years. Entitlements will have to be cut, taxes raised, and public services reduced. None of these actions will be popular.
Systematic risks
The risks are far-reaching. Last year, the IMF warned that the European life-insurance industry – which also applies above-market discount rates to its liabilities in order to maintain the appearance of solvency – poses a potential threat to financial stability. Then there’s the possible impact on the economy. If corporate pension deficits increase, cash to fund them will have to be diverted away from investment.
Yet underfunded corporate pensions are only the tip of the iceberg. The liabilities from unfunded government pensions dwarf everything else. Citigroup estimates that pension costs for 20 OECD countries will come to $78trn in today’s money, nearly twice their reported national debt. Ben Bernanke, Yellen’s predecessor at the Fed, liked to talk about the global “savings glut”. In truth, there’s been a dearth of saving in America and the UK since the turn of the century.
Over the past decade, US net savings have averaged little more than 1% of GDP. The collapse in the savings rate has been accompanied by declines in investment and productivity growth. All this means less money in the pot for tomorrow’s pensions. The gap between the belief in those pension promises and the ability to pay looks very much like a bubble.