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 on.