Back to November 2019

A time bomb

By Joseph Cherian and Emma Yan*  
  • Asia
  • Global
  • Malaysia
  • USA
Low birth rates, longevity put pressure on pension systems

When individuals overextend themselves by borrowing beyond their means and don’t have enough assets or income to meet their debt obligations, they usually file for personal bankruptcy. It’s the same with companies.

Could this happen to defined-benefit (DB) pension plans? Well, it already has in the US. Various US public and private pension plans had to either freeze, eliminate or convert their DB plans. These plans had corporations or governments promising employees a set of life annuity payments upon retirement, which is usually a function of an employee’s years of service, age and last drawn salary. Private sector examples include IBM and a few legacy airlines, while public sector failures include many California municipalities.

A recent World Economic Forum report looked at life expectancy and retirement savings across six major world economies. It confirmed that people will outlive their retirement savings, on average by between eight to 20 years, with the highest burden falling on women.

The case of Malaysia

The Malaysian government, during Prime Minister Dr. Mahathir Mohamad’s recent visit to Japan, announced that it will continue the current pension scheme for civil servants until a new mechanism is devised to alleviate the burden, which now stands at 28 billion ringgit (US$7 billion) annually. That’s around one-third of Malaysia’s 2019 budget. It has become a huge financial drain on the national coffers.

But Malaysia isn’t alone in its pension predicament. It highlights the imminent retirement savings sustainability issues faced by both developing and developed nations, namely the precarious funding status of their private and public pensions, and the difficulty in implementing reforms to solve the issue.

In the US, if a private sector pension plan fails to deliver on its promises, a government agency called the Pension Benefit Guaranty Corporation (PBGC) steps in to make some, but not all, the promised pension payments to retirees. Unfortunately, the PBGC has had so many private DB plan failures on its hands over the years that it is itself now grossly underfunded.

It’s been estimated that the PBGC’s liabilities exceeded its assets by as much as $51 billion at the end of 2018.

When it rains, it pours

General Electric recently announced that the company is freezing its pension plan for approximately 20,000 salaried employees, and supplementary pension benefits for approximately 700 employees who became executives before 2011 in the US. The changes will become effective in January 2021. The company had already closed its pension plan to new entrants in 2012.

In China, a comprehensive Pension Fund Actuarial Report released this year by the Centre for International Social Security Studies (CISSS) indicated that the accumulated surplus of the pension fund could possibly be used up by 2035, absent any government action.

Meanwhile, Japan’s public pension liabilities amount to around 165% of the country’s gross domestic product!

Drivers of pension liabilities

Factors that contribute to a pension plan’s ballooning deficit include demographics, increased life expectancy, and inflation, among other things. In the case of public pensions, where benefits are funded by taxes and other state-provisioned income, the so-called support ratio, or the share of workers to retirees, is an important determinant as well. As birth rates drop and retirees live longer, the support ratio declines and underfunding is bound to happen.

This is also true in Asia. In most Asian developing countries, including Malaysia and China, the retirement age is fixed, birth rates are falling, and retirees are living longer.

In Malaysia, the retirement benefits of government pensioners are growing dramatically. That’s because the benefits are not only adjusted annually for cost of living, they are also extended to the dependents of a civil servant who passes away while still working in government or after retiring.

In China, the CISSS report indicates that the payer-to-retiree ratio will decline from 2:1 in 2019 to 1:1 in 2020.

Taiwan, meanwhile, had to prudently reform its public pension system in order to prevent pension funds from going bankrupt. The pension system has moved from an unsustainable scheme that was completely financed by the government to one where employees and the government jointly contribute their fair share towards future benefits. Changes were also made to the savings and payout rates, retirement age, and overall benefits.

The solution

How do Asian countries with ballooning pension liabilities address the issue? First, they should take a leaf from the US experience and redesign and optimise risk sharing by converting DB plans into defined-contribution plans, like Malaysia’s Employees Provident Fund and Singapore’s Central Provident Fund (CPF). Both have prudent contribution programmes, asset-liability management or liability-driven investing schemes, and in the case of the CPF, a government-administered life annuity income payout programme upon retirement.

Second, extend the retirement age so that people not only live longer but also work longer. Third, establish policies and incentives which encourage people to start saving earlier and save more. These policies should also discourage people from raiding their retirement plans for education, housing, leisure and other interim needs during their working-age savings or accumulation period.

Fourth, since many government-administered retirement plans provide massive subsidies and transfers that can be costly, policymakers should allow for supplementary tax-deferred, or better yet tax-free, retirement programmes managed by the private sector so that those who wish to save more for retirement can do so.

There should also be a government-mandated mechanism where only prudent, well-diversified investment products – such as lifecycle funds – with low institutional-level fee structures, easy online on-boarding schemes devoid of sales charges and commissions, and independent, for-fee advice schemes acting on a fiduciary basis, are allowed on such platforms.

It certainly won’t be easy to transform or reform traditional pension plans overnight. The first step is for people to realise that current DB schemes in Asia lack adequacy, sustainability, and perhaps even integrity. This should go hand-in-hand with appropriate top-down behavioural nudges, temporary financial subsidies, and simple financial education.

Ultimately, the answer lies less in underlying demographic realities such as longer life expectancies and lower mortality rates, and more on the adoption of proactive policies and systems, as well as vigilant cooperation among all stakeholders, be it federal and state, or employers and employees. Hopefully, we can all eventually get there.

* Joseph Cherian is practice professor of finance at the National University of Singapore Business School. Emma Yan is an adviser at Endowus, an independent financial advisory firm based in Singapore.