THE FUTURE OF (PARTIALLY) FUNDED PENSION SYSTEMS

THE FUTURE OF (PARTIALLY) FUNDED PENSION SYSTEMS Presentation at OECD, 21 June 2017 Joshua D. Rauh Ormond Family Professor of Finance, Stanford GSB Senior Fellow, Hoover Institution Senior Fellow, Stanford Institute for Economic Policy Research

INTRODUCTION Solvency of defined benefit (DB) pension systems around the world has weakened Wide heterogeneity in Accounting regimes Regulatory regimes Newer models Defined Contribution (DC): individual/pooled, mandatory/voluntary Defined Ambition (DA): pooling of some risks, employers act as trustees but no longer as insurers What will happen to the (partially) funded DB systems and their participants?

ANSWER VARIES WITH PENSION RIGHTS Where pension rights are weak, underfunded DB plans will in essence become DC (or DA) systems Dutch experience with conditional indexation, then DA Canada Pension Plan if returns fall short indexation can be suspended if necessary stewards have full rights to cut benefits to maintain sustainability Where pension rights are strong, the underfunded DB plans will continue to place heavy financial pressure on sponsors, even bankruptcy US cities and states

AGENDA I. Key factors affecting DB solvency and sustainability of the model II. III. New analysis: 20 year history of 15 major DB systems in US, Canada, UK, Netherlands, and Germany Over 30 million members, $1.6T in assets Conclusions

KEY FACTORS AFFECTING SOLVENCY OF DB SYSTEMS There are many, but I emphasize two 1. Longevity improvements not matched by rising retirement ages 2. Long-term decline in interest rates

1. RETIREMENT AGES ARE RISING Sources: Pensions at a Glance 2011, Retirement Income Systems in OECD and G20 Countries, OECD Publication

BUT NOT AS FAST AS LONGEVITY Sources: Pensions at a Glance 2011, Retirement Income Systems in OECD and G20 Countries, OECD Publication

Percent 2. DECLINE IN SOVEREIGN YIELDS, NON-EU 18 16 14 12 10 8 6 4 2 0-2 10-Year Sovereign Yield, 1980 - Present Australia Canada Switzerland UK Japan USA Sources: OECD, BoC, BoJ, BoE, Fed 8

Percent DECLINE IN SOVEREIGN YIELDS, EU 20 10-Year Sovereign Yield, 1980 - Present 15 10 5 0-5 Germany Spain France UK Italy Netherlands Sweden Sources: OECD, Deutsche Bundesbank 9

WHY ARE FALLING RATES SO BAD? Public finances of a small, hypothetical city with AAA rated finances 10

BOND AGREEMENT The city enters into following bond agreement with creditors Installment payments of $100,000 per year over 30 years will repay the debt Long-term interest rate r=5% Prepayable any time, 50bp call premium How much will city be able to borrow under this agreement? The NPV of 30 years of $100,000 payments at 5.5% = $1.453M Year =1 Year =2 Year =3 Year =4 Year =30 $100,000 $100,000 $100,000 $100,000 $100,000 11

PENSION AGREEMENT At the same time, the city also must pay a pension to its mayor who is 59 years old and is planning to retire at age 60. This obligation is unfunded. The mayor is entitled to a pension of $100,000 per year, lasting for 30 years.* How much is this debt to the mayor worth? Contract Value Today? Year =1 Year =2 Year =3 Year =4 Year =30 $100,000 $100,000 $100,000 $100,000 $100,000 Only difference with bond is that the discount rate is 5%, no call premium: $1.537M * If the mayor dies before the 30 years are up, the payment must be made to the mayor s heirs. 12

IMPACT OF RATE CHANGE ON PENSION OBLIGATION VALUE City s liabilities at market value (r=5%) Bond Debt Pension Obligations $1.453M $1.537M Now, what if rates fall from 5% to 2%? The city can immediately refinance its bonds Assuming strong pension rights, however, it cannot renegotiate the pension to the mayor City s liabilities at market value (r=2%) Bond Debt Pension Obligations $1.453M $2.240M Effects could have been avoided if city had funded the pension obligations with duration-matched fixed income assets city had bought a receiver swaption (for 50bp) to mimic the call feature in the bond 13

WHY FUNDED DB ISN T SUSTAINABLE Any guaranteed pension promise has a financial cost/value that can be determined using markets for deferred annuities and bonds However, essentially no system funds the promise fully with durationmatched bonds and deferred annuities Instead, they fund with an amount of risky assets that is less than the present value of the defined benefit promise They hope that the risky assets will generate a return sufficient to pay the promise Many systems around the world do not mark liabilities to fixed income markets, but rather view liability value as related to expected return on assets (a fallacy) Even those that do mark liabilities to fixed income markets still rely on the hope of good returns to deliver on DB promises

20 YEAR SIMULATION OF 7% EXPECTED RETURN (RF = 1%, BETA = 1.0, MRP = 6%)

20 YEAR SIMULATION OF 7% EXPECTED RETURN (RF = 1%, BETA = 1.2, MRP = 5%)

III. STUDY OF 15 SYSTEMS (1997-2017) Start of a broader effort to track employer-based and funded pension systems internationally Dutch Occupational: ABP, PFZW US Corporate: General Motors (domestic and foreign), General Electric US Union: Teamsters Central States Pension Fund US Public Sector: CalPERS, CalSTRS, Illinois Teachers, Chicago Police European Corporate: Lufthansa, British Airways (old and new) Canadian Public: Canada Pension Plan Canadian Occupational: Ontario Teachers

SCORECARDS Tracking the following variables 1. Funding Status (Assets / Liabilities) 2. Demographics Active / Retired Participants Active / Total Participants 3. Assets per Participant 4. Contributions / Pension Payouts, with decomposition Pensions / Retiree Contributions / Active

Dutch Occupational 1. FUNDING STATUS (ASSETS/LIABILITIES) Latest 2009 2006 2002 1997 Latest 2009 2006 2002 1997 US Union 1 ABP 0.97 1.03 1.35 1.18 1.11 1 Central States 0.33 0.39 0.47 0.46 0.71 2 PFZW 0.95 1.07 1.34 1.00 n/a US Occupational Public Canadian Public 2 CalPERS 0.73 0.61 0.93 0.87 0.94 3 CPP 0.24 n/a n/a n/a 0.08 3 CalSTRS 0.70 0.64 0.96 0.80 1.39 4 Ontario Teachers 0.93 0.73 0.96 0.90 1.23 4 Illinois TRS 0.38 0.39 0.62 0.52 0.65 US Corporate 5 Chicago Police 0.25 0.38 0.53 0.50 0.70 5 GM - US 0.90 0.83 1.19 0.76 0.98 6 GM - Non US 0.54 0.58 0.51 0.50 0.62 7 GE 0.64 0.87 1.26 1.14 1.50 European Corporate 8 Lufthansa 0.61 0.64 0.33 0.02 0.00 9 BA Pension (APS) 0.95 0.85 1.00 n/a n/a 10 BA New Pension (NAPS) 0.87 0.69 0.74 n/a n/a Sources: Author s calculations

1. FUNDING STATUS (ASSETS/LIABILITIES) US Occupational Public & Union All Other 1.6 1.4 2.5 2 1.2 1 0.8 0.6 1.5 1 0.5 0.4 0.2 0 0 ABP PFZW CPP Ontario Teachers GM - US GM - Non US CalPERS CalSTRS Illinois TRS Chicago Police Central States GE BA Pension (APS) Lufthansa BA New Pension (NAPS) Sources: Author s calculations

Dutch Occupational 2A. DEMOGRAPHICS: ACTIVE / RETIRED Latest 2009 2006 2002 1997 Latest 2009 2006 2002 1997 US Union 1 ABP 1.30 1.60 1.50 1.68 1.68 1 Central States 0.31 0.39 0.74 0.81 1.07 2 PFZW 2.80 4.00 4.49 6.54 n/a US Occupational Public Canadian Public 2 CalPERS 1.35 1.67 1.80 2.05 1.96 3 CPP 1.95 2.27 2.35 2.42 2.64 3 CalSTRS 1.55 1.97 2.18 2.38 2.37 4 Ontario Teachers 1.34 n/a n/a n/a n/a 4 Illinois TRS 1.36 1.79 1.87 2.30 2.29 US Corporate 5 Chicago Police 0.91 1.08 1.14 1.21 1.36 5 GM - US 0.15 n/a 0.22 0.38 0.75 6 GM - Non US n/a n/a n/a n/a n/a 7 GE 0.26 0.56 1.00 0.68 0.71 European Corporate 8 Lufthansa n/a n/a n/a n/a n/a 9 BA Pension (APS) 0.02 0.05 0.09 0.15 n/a 10 BA New Pension (NAPS) 0.79 1.52 2.17 3.43 n/a Sources: Author s calculations

2A. DEMOGRAPHICS: ACTIVE / RETIRED US Occupational Public & Union All Others 3 2.5 2 1.5 1 0.5 8 7 6 5 4 3 2 1 0 0 CalPERS CalSTRS Illinois TRS Chicago Police Central States ABP PFZW CPP Ontario Teachers GM - US GM - Non US GE Lufthansa Sources: Author s BA Pension (APS) BA New Pension (NAPS) calculations

Dutch Occupational 2B. DEMOGRAPHICS: ACTIVE / TOTAL MEMBERS Latest 2009 2006 2002 1997 Latest 2009 2006 2002 1997 US Union 1 ABP 0.38 0.42 0.42 0.45 0.43 1 Central States 0.16 0.19 0.34 0.37 0.44 2 PFZW 0.44 0.53 0.55 0.58 n/a US Occupational Public Canadian Public 2 CalPERS 0.47 0.50 0.54 0.58 0.59 3 CPP 0.66 0.69 0.70 0.71 0.73 3 CalSTRS 0.48 0.54 0.57 0.62 0.63 4 Ontario Teachers 0.47 n/a n/a n/a n/a 4 Illinois TRS 0.39 0.46 0.49 0.54 0.70 US Corporate 5 Chicago Police 0.47 0.51 0.52 0.55 0.58 5 GM - US 0.12 n/a 0.16 0.25 0.38 6 GM - Non US n/a n/a n/a n/a n/a 7 GE 0.13 0.22 0.35 0.27 0.28 European Corporate 8 Lufthansa n/a n/a n/a n/a n/a 9 BA Pension (APS) 0.02 0.05 0.07 0.11 n/a 10 BA New Pension (NAPS) 0.29 0.41 0.48 0.60 n/a Sources: Author s calculations

2B. DEMOGRAPHICS: ACTIVE / TOTAL MEMBERS 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 US Occupational Public & Union 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 All Others CalPERS CalSTRS Illinois TRS Chicago Police Central States ABP CPP GM - US GE BA Pension (APS) PFZW Ontario Teachers GM - Non US Lufthansa BA New Pension (NAPS) Sources: Author s calculations

3. ASSETS / PARTICIPANT Dutch Occupational ( '000s) Latest 2009 2006 2002 1997 Latest 2009 2006 2002 1997 US Union (US$ '000s) 1 ABP 132.2 75.6 79.5 55.0 58.2 1 Central States 41.3 46.3 45.8 34.3 36.2 2 PFZW 70.4 38.3 40.0 26.4 n/a US Occupational Public (US$ '000s) Canadian Public (C$ '000s) 2 CalPERS 160.6 110.0 141.1 104.2 94.5 3 CPP 14.1 7.0 6.6 3.6 2.6 3 CalSTRS 211.8 139.7 181.4 141.0 168.0 4 Ontario Teachers 453.7 n/a n/a n/a n/a 4 Illinois TRS 111.2 78.0 112.4 76.9 89.0 US Corporate (US$ '000s) 5 Chicago Police 118.1 128.2 159.0 128.6 142.0 5 GM - US 127.6 n/a 154.2 86.2 89.5 6 GM - Non US n/a n/a n/a n/a n/a 7 GE 98.3 78.7 90.5 74.4 83.1 European Corporate ( '000s) 8 Lufthansa n/a n/a n/a n/a n/a 9 BA Pension (APS) 265.4 185.4 196.0 164.6 n/a 10 BA New Pension (NAPS) 196.7 88.5 84.1 53.2 n/a Sources: Author s calculations

3. ASSETS / PARTICIPANT US Occupational Public / Union All Others 250 200 150 100 50 500 450 400 350 300 250 200 150 100 50 0 0 CalPERS CalSTRS Illinois TRS Chicago Police Central States ABP PFZW CPP Ontario Teachers GM - US GM - Non US GE Lufthansa BA Pension (APS) BA New Pension (NAPS) Sources: Author s calculations

Dutch Occupational 4. CONTRIBUTIONS / PENSION PAYOUTS Latest 2009 2006 2002 1997 Latest 2009 2006 2002 1997 US Union 1 ABP 0.75 1.06 1.07 0.76 0.69 1 Central States 0.21 0.21 0.53 0.50 0.62 2 PFZW 1.63 1.80 1.87 1.17 n/a US Occupational Public Canadian Public 2 CalPERS 0.74 0.88 0.96 0.45 0.79 3 CPP 1.08 1.21 1.19 1.15 0.69 3 CalSTRS 0.63 0.75 0.82 1.02 1.15 4 Ontario Teachers 0.59 0.62 0.43 0.44 0.66 4 Illinois TRS 0.82 0.68 0.48 0.86 0.69 US Corporate 5 Chicago Police 1.01 0.52 0.53 0.63 0.76 5 GM - US 0.37 0.01 0.01 0.77 0.30 6 GM - Non US 0.70 3.26 0.80 0.43 0.28 7 GE 0.20 0.12 0.11 0.12 0.11 European Corporate 8 Lufthansa 0.45 1.53 3.26 1.00 1.00 9 BA Pension (APS) 0.23 0.07 0.10 0.06 n/a 10 BA New Pension (NAPS) 0.91 1.89 1.83 1.51 n/a Sources: Author s calculations

4. CONTRIBUTIONS / PENSION PAYOUTS US Occupational Public & Union All Others 1.4 1.2 1 0.8 0.6 0.4 0.2 9 8 7 6 5 4 3 2 1 0 0 CalPERS CalSTRS Illinois TRS Chicago Police Central States ABP CPP GM - US GE BA Pension (APS) PFZW Ontario Teachers GM - Non US Lufthansa BA New Pension (NAPS) Sources: Author s calculations

4A. PENSIONS / RETIREE Dutch Occupational ( '000s) Latest 2009 2006 2002 1997 Latest 2009 2006 2002 1997 US Union (US$ '000s) 1 ABP 12.10 9.59 8.28 7.29 6.76 1 Central States 13.98 13.04 12.39 10.83 8.51 2 PFZW 7.70 8.13 7.83 9.14 n/a US Occupational Public (US$ '000s) Canadian Public (C$ '000s) 2 CalPERS 30.98 24.78 21.40 17.10 13.00 3 CPP 6.06 5.60 5.09 4.76 4.49 3 CalSTRS 45.64 35.12 31.91 25.84 19.38 4 Ontario Teachers 42.06 n/a n/a n/a n/a 4 Illinois TRS 50.41 39.26 34.49 26.47 19.93 US Corporate (US$ '000s) 5 Chicago Police 51.95 42.35 38.09 30.85 23.15 5 GM - US 14.96 n/a 14.39 13.91 12.98 6 GM - Non US n/a n/a n/a n/a n/a 7 GE 14.23 13.15 11.77 10.93 9.22 European Corporate ( '000s) 8 Lufthansa n/a n/a n/a n/a n/a 9 BA Pension (APS) 15.69 14.04 12.65 10.33 n/a 10 BA New Pension (NAPS) 23.11 12.21 10.77 9.84 n/a Sources: Author s calculations

4A. PENSIONS / RETIREE US Occupational Public & Union All Others 60 50 40 30 20 10 45 40 35 30 25 20 15 10 5 0 0 CalPERS CalSTRS Illinois TRS Chicago Police Central States ABP PFZW CPP Ontario Teachers GM - US GM - Non US GE Lufthansa Sources: Author s BA Pension (APS) BA New Pension (NAPS) calculations

4B. CONTRIBUTIONS / ACTIVE Dutch Occupational ( '000s) Latest 2009 2006 2002 1997 Latest 2009 2006 2002 1997 US Union (US$ '000s) 1 ABP 7.03 6.36 5.91 3.30 2.77 1 Central States 9.30 7.27 8.77 6.66 4.92 2 PFZW 4.50 3.65 3.26 1.63 n/a US Occupational Public (US$ '000s) Canadian Public (C$ '000s) 2 CalPERS 17.08 13.15 11.36 3.71 5.25 3 CPP 3.37 2.99 2.58 2.26 1.18 3 CalSTRS 15.09 13.30 12.03 11.09 9.40 4 Ontario Teachers 18.46 n/a n/a n/a n/a 4 Illinois TRS 30.31 14.96 8.89 9.96 6.00 US Corporate (US$ '000s) 5 Chicago Police 57.20 20.16 17.65 16.12 12.85 5 GM - US 1.66 n/a 0.93 28.34 5.16 6 GM - Non US n/a n/a n/a n/a n/a 7 GE 10.93 2.79 1.35 1.86 1.39 European Corporate ( '000s) 8 Lufthansa n/a n/a n/a n/a n/a 9 BA Pension (APS) 164.93 18.14 14.47 4.18 n/a 10 BA New Pension (NAPS) 26.60 15.10 9.06 4.34 n/a Sources: Author s calculations

4B. CONTRIBUTIONS / ACTIVE US Occupational Public & Union 70 180 60 160 140 50 120 40 100 30 80 60 20 40 10 20 0 0 All Others CalPERS CalSTRS Illinois TRS Chicago Police Central States ABP CPP GM - US GE BA Pension (APS) PFZW Ontario Teachers GM - Non US Lufthansa BA New Pension (NAPS) Sources: Author s calculations

FACTORS Pension rights of participants in solvency (and bankruptcy) Workforce demographics and labor market structure Asset investment strategies and returns Funding discipline and governance

STATE CONTRIBUTIONS ACTUAL VS. REQUIRED WORST 10 Sources: Hidden Debt, Hidden Deficits: 2017 Edition

CITY CONTRIBUTIONS ACTUAL VS. REQUIRED WORST 10 Sources: Hidden Debt, Hidden Deficits: 2017 Edition

CONCLUSION OF STUDY Where pension rights are weak, solvency has been maintained through benefit reductions Systems have essentially become collective DC Where pension rights are strong, solvency has deteriorated Current resources going to pay out current retirees as systems have gone from mostly funded to partially funded This trend will continue to place immense financial pressure on DB sponsors in strong-rights regimes

IMPLICATIONS FOR PENSION DESIGN Transition from DB to DC Paying out resources to make good on hard promises while future generations are harmed vs Creating something sustainable for the future DC design Guidance based on expected returns is problematic Important to communicate distribution of outcomes Remove expectation of a guaranteed pension at a given age, or at a minimum make the guaranteed age much older Annuities as longevity insurance

BOTTOM LINE Where pension rights are weak, rights of workers and pension beneficiaries are being eroded Will face most pressure from the side of labor demand More mobile workforce may prefer (at least notionally) their own accounts Where pension rights are strong, companies and states are buckling under the burden of delivering Even new tiers are difficult because of connection between nature of benefit and cash inflow to the legacy system Once the sponsor is insolvent, it is the beneficiaries, creditors, and higher levels of government that will bear the burden