The looming pensions dilemma

Can pension funds cope with a perfect storm of demographic changes and market volatility through riskier investments?


Angry Parisians, heaps of uncollected rubbish, clashes with the police. While being a traditional French pastime, demonstrations also carry a symbolic meaning, capturing the zeitgeist of the time. If the May 1968 riots were the product of a bored youth, this spring’s protests over pension reform convey another message that reverberates beyond France: the coming pension crisis. The protests were sparked by the rise of the pension age from 62 to 64, bringing France in line with the European average. The reason, the French government argued, was that the system would collapse if the status quo remained intact.

Anger over the delay of a well-deserved right after decades of toil is rippling across the globe. Pensions are becoming a hot-button issue for governments, not just because they are important for older voters, but also because their allocation is underscored by deeply-held beliefs in social justice and intergenerational solidarity.

Under pressure
Pension systems face a crisis due to a combination of demographic trends, economic conditions and government policies. Populations in developed countries are ageing fast, with rising numbers of retirees putting pressure on pension systems. By 2050, the ratio of pensioners to working-age citizens in the developed world is expected to rise to 1:2 from the current 1:3 (see Fig 1). The pandemic accelerated this trend by pushing older workers to retire. Pension systems in eight of the world’s largest economies will face a staggering shortfall of $400trn by 2050, estimates the World Economic Forum.

Governments have sought to alleviate these pressures, but reforms are at best half-baked solutions and often create new problems. Systems have generally shifted from defined benefit (DB) pension plans, where retirees receive fixed benefits, to defined contribution (DC) plans that tie benefits to contributions. This places responsibility on workers to manage their retirement savings, which increases risks for those lacking financial literacy. Many are not saving enough, creating a vicious cycle that can strain pension system sustainability.

Policymakers hope that pension funds can fill funding gaps through smart investment, but their performance has been marred by market instability. Fifteen years of low interest rates pushed pension funds to turn to risky alternative assets that offer higher returns. Last year, Ontario Teachers’ Pension Plan, one of Canada’s largest funds, was forced to write down the $95m it had invested in FTX, a crypto exchange that went bust. The recent surge in interest rates has improved funding levels, enabling funds to earn hefty returns on bonds. Pension plans controlled by the UK’s Pension Protection Fund reported a surplus of £431bn last spring, compared to a £132bn deficit in 2020. However, higher interest rates have also exposed vulnerabilities in little-known corners of the financial world, such as ‘liability-driven investment,’ a derivative investment strategy used by UK pension funds that sparked a crisis in the government bond market in September 2022.

While policymakers have known for decades that reforms are necessary, progress has been slow. France may be an outlier among its European peers for raising the retirement age too late, but nearly half of OECD members face similar problems; Parisian riots demonstrate why such policies can be politically explosive. The UK government has delayed plans to raise the state pension age, fearing reactions from older voters. Pension reform can also cause generational conflicts, with younger workers fearing that pension systems operate as Ponzi schemes that may collapse before they retire. In the UK, the system’s sustainability is undermined by the ‘triple lock’ rule, which ensures that the state pension increases annually by the highest of price inflation, earnings growth or 2.5 percent; a report by the Institute for Fiscal Studies found that the rule has increased annual pension spending by £11bn. “The UK state pension is relatively poor compared to many other countries, so something needs to be done about that,” says Iain Clacher, an expert on pensions at Leeds University Business School, adding: “Longer-term, much more generous limits on private sector accumulation will have to be the solution. With much noise made about annual and lifetime allowances, this will ultimately cap the pension that accrues, and so the state pension will always be a bigger component of someone’s overall retirement income.”

While policymakers have known for decades that reforms are necessary, progress has been slow

Across the Atlantic, many US pension funds struggle to provide retirement benefits, with state pension debt reaching $1.3trn. Last spring, legislators from Illinois and New Jersey requested a federal bailout of their states’ public pension systems. A 2022 study by the insurance company Milliman found that among the country’s 100 biggest public pension plans, one in four were below the 60 percent funding threshold. Critics point out that pension administrators eagerly spend profits from good years, while making over-optimistic economic assumptions about future returns. Although most public retirement systems are not in immediate danger of insolvency, “many need some notable improvements to ensure they aren’t vulnerable to economic downturns or investment risks,” says Jon Moody, Vice President of Research at the Equable Institute, a US think-tank that studies retirement policies, adding: “If there is a sustainability crisis, it will be related to how costs influence decisions related to future benefit values or government programme cuts.”

Others, like Teresa Ghilarducci, a retirement expert at the New School for Social Research, call for a shift to a government-backed social safety net for pensioners. “There is a US retirement crisis, but no pension crisis. The public employees’ pension funds are not the problem, in fact they are part of the reason the crisis is not worse,” says Ghilarducci. “The crisis is nearly half of middle class workers going into retirement without a pension and only the basic Social Security benefit. Millions more elders will be poor in the next 10 years.”

Risky business
Aiming to raise funding levels, governments push pension funds to adopt riskier investment strategies that could contribute to capital formation and economic development. The UK Chancellor Jeremy Hunt has set out a plan encouraging defined contribution pension plans to invest five percent of their assets in private equity, venture capital and start-ups. The government believes this could boost investment in high-growth companies by £50bn by 2030, while expecting the typical pension to increase by over £1,000 annually. Some experts, however, have raised concerns over transition costs and liquidity. “The types of investments the reforms focus on are by their nature illiquid, whereas DC members can switch their asset allocation just by logging into their provider and changing their fund,” says Clacher.

Critics have also pointed out that the reform fails to push funds to support UK companies. Currently, DC pension funds invest just 0.5 percent of their assets in unlisted UK companies. UK pension and insurance funds reduced their holdings of UK-listed companies to four percent last year from around 50 percent in 2000, while fixed-income holdings grew to 72 percent. If invested in the UK, pension fund assets could increase productivity and wages and eventually generate additional pension contributions, says David Blake, an expert on pensions teaching at City, University of London: “This could have given the UK the highest productivity rates in Europe. Instead, over the last 25 years, pension contributions have been invested in international equities and bonds which have done nothing to improve UK productive investment and productivity. The reforms are an attempt to change this, but they are in danger of being too little too late.” Others point out that investment should be diverted toward firms active in high-growth areas and tackling global challenges, such as climate change. “It’s imperative that the Chancellor allows pension funds to invest only in venture capital (VC) firms that are committed to mitigating the associated risks,” says Thea Messel, co-founder of Unconventional Ventures, a VC firm, adding that investment in start-ups that develop solutions to long-term issues, such as global warming, health and transport, will help pension funds yield steadily high returns over longer periods.

One of the plan’s goals is to build economies of scale by consolidating smaller funds. However, long-term investment has to come from smaller DC schemes, given that private DB schemes are closed to new members and are gradually being offloaded to insurers. “Unless there is a plan to consolidate these schemes, it will be difficult to achieve the scale needed to invest in the big infrastructure investments the government wants to see,” Blake says.

The perils of investing in risky assets became clear in 2021 when the Pennsylvania teachers’ pension fund discovered chronic misreporting of its investment returns, resulting in higher member contributions to fill the gap. The scheme’s funding levels had dropped to just 60 percent due to rising pension benefits and a costly investment programme that included underperforming private equity and high-risk holdings such as loans financing Iraqi oil fields. Another problem is the lack of transparency, as private equity managers often guard their activities as ‘trade secrets.’ In some cases, crucial details are not shared with pension fund officials, many of whom lack financial training, while private equity valuations are often inflated by managers. “The opaqueness around how private equities are valued can contribute to the growth of unfunded liabilities,” says Moody from the Equable Institute, adding: “In cases where they are over-valued, required contribution rates can be set too low, which would result in unfunded liabilities purely because of an error in how the assets are valued.”

Performance is also questionable, despite the hefty fees involved; a 2021 JP Morgan study found that private equity only marginally outperforms stocks. Cases of over-reliance on private equity returns in the US can serve as a cautionary tale for UK pension funds whose previous dalliance with private equity was hampered by similar problems, according to Blake: “Unless the issues of poor transparency, high charges and the difficulties in accessing the true performance of private equity firms are resolved, there is likely to be a repeat of what happened 30 years ago.”