ED HARRISON: One of the things that I'm excited to think about is, you mentioned before off
camera, you have at MacKenzie Investments, a model in terms of the way to think about
it, a framing of four different things that are relevant to thinking about this.
Can you talk about that a little bit?
KONSTANTIN BOEHMER: Sure.
The whole pension crisis, what we're doing here is we're looking at the whole industry
or the whole country, it is a little bit unfair to overgeneralize a lot of those things.
There are phenomenal pension funds and countries which are extremely well prepared and individuals
who are doing exactly the right thing.
What we do is we try to generalize in order to get a more broad view of what is actually
going on.
The way that we look at it is that there are four design flaws within pension funds in
general.
Those four design flaws are demographics, then the underlying assumptions based on discount
rate and return expectations is a big design flaw, then what we have in addition to that
is the vested interests, so who are the people who make the decisions?
Fourthly we have a conundrum where we have extremely high return expectations of those
pension funds to hit their targets and that is actually driving the asset allocation.
It is not really possibly sometimes the best asset allocation that is possible in that
moment.
It is more that the return targets that a lot of pension funds have are driving the
asset allocation.
ED HARRISON: Let's go into that one by one.
KONSTANTIN BOEHMER: The first design flaw, I think it's pretty obvious.
Pension funds were developed a long time ago and really got into prominence after World
War II and you saw a major pickup in corporations, but also local governments and federal governments,
but during that time, we had vastly different demographics.
Those times we actually had a pyramid where we had lots of workers and very little retirees.
The models at that time to determine a sustainable framework for the welfare state were based
on the data that they had available at that time and they build those models and came
up with different features.
Back in the days, in the '60s, people only had to account for roughly 13, 14 years of
retirement, so when people worked up until they were 60s, in the 60s.
Then you only had to finance on average 13, 14 years in the developed world.
If we fast forward to today, yes, the average age or average retirement age has inched up
a little bit, but the years in retirement have exploded.
ED HARRISON: Let me guess, 20.
KONSTANTIN BOEHMER: 20.
It's roughly 20, that's right.
ED HARRISON: Yeah, that was pretty good.
KONSTANTIN BOEHMER: Excellent.
That's a 50% increase from 13 and a half roughly to 20.
For any financial model, it is extremely hard to adjust for such a major change, because
that means that at least, they will need 50% more money relative to what their expectations
were at the very beginning.
ED HARRISON: How do they get that more money?
Some of that probably goes into the other design flaws, but in general, from a demographic
perspective, how do you deal with that, like what are the facets that get you that more
money?
KONSTANTIN BOEHMER: That's the changes that pension funds need to do that is definitely
raised the retirement age, then there needs to be some kind of increased contributions
to adjust for the new reality.
Then there might also have to be a conversation on maybe the payouts, whether those assumptions
or whether the plan that was originally come up with, that's still relevant.
Those are all not nice conversations to have and that goes to the vested interests that
is another design flaw where we say, look, nobody's really interested in uncovering all
the mess that has been created and has basically festered over those years and only tiny little
changes have happened.
The really big changes are still to be made.
ED HARRISON: What about, I don't know if you'd go into this, but I would imagine the first
thing that came to mind when you talked about the demographics, and you talked about savings
to disinvesting, I thought immediately of spending and GDP changes.
What impact does that change in demographics have on the velocity of the pace of GDP growth?
Does it have any that you've seen?
KONSTANTIN BOEHMER: In general, the super big picture for me would be that we have overspent
because we had the security of the welfare state, made people feel a lot more confident
about the future, and about the increasing living standards that people were more willing
to spend money.
Now, the realization phase is kicking in where that security and safety that we obtained
since the '60s and '70s is being questioned, and that would probably mean that there will
be less spending going forward and slightly slower growth because we also have a massive
amount of unaccounted for debt.
Debt levels are in general extremely high, but on top of that, we also have those unaccounted
debt levels coming from the pension funds.
ED HARRISON: Now, what about the second part of the design flaw?
KONSTANTIN BOEHMER: Yeah, that's my favorite.
The second part are the financial assumptions.
It is, for any model that you build, it is okay to put in assumptions for stuff that
you don't know, or where you don't have a really good handle of what you put in, what
your input factor is.
For a lot of those pension funds, and I would say the most prominent cases for that would
be US states, that would be public pension funds, let's say the teachers, firefighters,
police officers, and so on.
Those US state pension funds, they have still ridiculous assumptions embedded in their calculations.
What we've done is we reverse engineered that whole formula to see, look, what is your assumption?
What would be a realistic assumption?
The assumption that is still embedded and prevalent in the US states is that they think
that they can discount future obligations at 7.1% and that their assets will grow every
single year at 7.6%.
To put that into perspective, what does it mean to have a discount rate of 7.1%?
That basically means if I had an obligation of $100, so I need to pay somebody $100 in
20 years' time, it is basically enough if I have $25 right now in my pocket, that would
be considered fully funded.
I don't need to have $100 right now, I just need to have $25 and I would be fully funded.
I don't think that's fair.
I don't think that is the right calculation.
That is not the right assumption, because let's say the time value of money should be
significantly lower.
ED HARRISON: Well, given the fact that interest rates are so low right now, and to the degree
that that persists for a longer period of time, it would suggest that those discount
rates are going to be lower and they're not going to be able to discount at that level
of in perpetuity.
Let's say you have like a 6% discount rate.
What happened to that $25 to $100?
How does that change?
KONSTANTIN BOEHMER: It is dramatic.
That discount factor has an oversized impact on the sustainability of a pension fund.
What we did in our models is we said, look, why don't we just use 4%?
I would say 4% is not even really fair, because you want to give the impression that it is
safe money.
Because I want to give the impression that is safe money, I think maybe the US government
equivalent yield would be a fairly decent proxy but let's just say we use 4%, which
is significantly above what the US-- ED HARRISON: More than double.
KONSTANTIN BOEHMER: Exactly, yeah.
If we go to 4%, all of a sudden, just for the US states alone, the deficit that the
pension funds have would go from $1.3 trillion to $4.3 trillion.
That is a big difference.
That also means that the funding status, right now pension funds are saying we have a funded
status of, let's say, 74% or so.
If we use a discount rate of 4%, all of a sudden, that switches to 47%.
That is a dramatic difference in terms of how funded, how able those pension funds are
actually to meet their future obligations.
ED HARRISON: The other side of that you said was the 7.6% asset increase assumption.
We've already just said, I looked at treasuries today, the 10-year was yielding at 1.8 fours
or there about, how do you get to 7.6% in that environment?
KONSTANTIN BOEHMER: It's difficult.
I am a fixed income manager so for me, those numbers are completely out of reach.
Just to give you an idea of what 7.6% would mean maybe in the sovereign bond space, if
you buy a Ukrainian bond, a 20-year Ukrainian bond, you're not even getting to 7.6% yield.
It is pretty aggressive.
Of course, they have a very diversified portfolio and there are higher returning assets, let's
say the property in the private equity space and infrastructure, equities, of course, and
other assets, but still, achieving or trying to achieve and trying to hit 7.6% every single
year is extremely ambitious, because it doesn't account for market variability.
It doesn't account for that we had record highs in almost any asset class.
We are at record highs in equities, in fixed income, in real assets.
At some point, we'll have a few years where we don't hit those 7.6%.
ED HARRISON: That gets back to the risk and that's part four that you're going to talk
about in a second, but what's the third flaw that you've-- talk to me a little bit about
that.
KONSTANTIN BOEHMER: The third one would be, let's say vested interests.
ED HARRISON: I think of it as an agency problem.
KONSTANTIN BOEHMER: Exactly.
Here it is, just nobody wants to uncover what's really going on.
Even it hits the pensioners themselves, it's tricky to ask the difficult questions and
to demand answers on is my pension sustainable because, in a way, like one sleeps better,
believing that one is safe than to ask and put all that effort into those probing questions
and making sure that you get those right answers.
ED HARRISON: The media say that let's say you're a US state and you're underfunded by
53%, that's 47% that you said versus 26%, then suddenly, you're going to have to cough
up a lot of money and from a budgetary perspective, that doesn't look good for you as someone
who needs to be elected in a year or two years.
It's a lot easier not to make that decision and let someone else make the decision like
five, 10 years later.
KONSTANTIN BOEHMER: It's better to pretend because the real consequences of this would
be for states to pony up a lot more money.
Who wants to do that?
Everyone wants to get reelected?
Do you really want to-- and you have two choices where you can either reduce expenditure, or
you can increase revenues, taxes.
Both of them are not really vote winners.
It is difficult to make that decision now.
It's better to just say, let's let somebody else deal with it, or let's just put some
lipstick on it and hope nobody will take another critical look at it.
ED HARRISON: Well, the other option is to roll the dice.
This goes to the fourth structural flaw, you could move out the risk curve, you could move
out the duration curve, which you could tilt your asset allocation.
Tell me about that.
KONSTANTIN BOEHMER: I think that is what's going on.
The pension funds half that stick a target of we need to achieve a significant return
on assets, which is good.
Yes, it is good to be ambitious, it is good to have certain goals that you want to hit
but if that is going to the extreme that it actually influences how you make your asset
allocation decision, it might tilt you away from what is actually a sensible asset allocation
to something that is overly aggressive.
I would put it into the context of all those pension funds on maturity.
It is just like us, when we're young, we should have a high tilt towards risky assets, towards
also illiquid assets in order to gain that extra return, that extra liquidity premia
for example.
It makes sense in our early days of our personal career or personal lives to have a very high
exposure to those higher potential assets.
As we progress, as we get older, of course, we need to adjust how we're positioned because
the sequencing of returns will become much more important.
If you are in the payout phase for a pension fund, then you cannot really have drawdowns,
which are significant, because that will really compromise your ability to pay back.
If you have that drawdown early on in your career, there's a high chance that you will
recover from that.
Later on, it will be difficult, which is why a lot of pensioners will get the advice from
financial advisors to reduce their risk, put more money in fixed income and cash and so