KONSTANTIN BOEHMER: 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. 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: Ed Harrison here for Real Vision. I am talking to Konstantin Boehmer of MacKenzie Investments. He is the global fixed income portfolio manager there. Thanks for talking to us.
KONSTANTIN BOEHMER: Thank you, Ed.
ED HARRISON: Beforehand, I was telling you, the reason that we're talking is we're going to have a pension week coming up going forward, where we're going to be talking about something, I think a lot of people are talking about as the retirement crisis. I think this is a good place to start off the conversation, the concept of a retirement crisis. The question, it begs the question, why would anyone be thinking there's a crisis in retirement and what would pensions have to do with that?
KONSTANTIN BOEHMER: I would like to start probably with the background why we started to look into this and why this is such an important topic for us at MacKenzie, and for me personally. I work in the asset management industry. Obviously, there's a lot of interaction with retirement because what we have to do as asset managers is we have to provide financial security for also our clients. That is a big part of why retirement is a key component here. It's also that it is we've seen a massive growth in assets under management and that is partly because so many pension funds have increased their assets, but also individuals had to start saving more and more for the individual security later in their life cycle.
We now have the baby boomer generation, which was the dominant generation starting after World War II, that massive part of the population is now shifting towards retirement. Those are crucial moments when a big part of the population is shifting from saving and starting to divest and starting to draw out money out of the system. Those are a lot of things which are making it extremely important for us. For me personally as a fixed income manager, it is important for me because I like to look at data, I like to look at what is happening in financial markets, and I see that there are clear connections, and I've built over my life, multiple models to help me understand the world a little bit better.
I've built models on how to look at different countries, how credit worthy they are, also to look at ESG to see which countries are well prepared, which countries are ill prepared. That started also the process into building models looking into countries, how well are countries prepared or how ill are they prepared and to take it into next step looking at US states, also US corporations to see how well is somebody prepared?
ED HARRISON: Very interesting. Yeah, I'm excited to get into some of that data later on. Actually, 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. Yeah. So it is, that's a 50% increase right? 13 and a half, roughly two to 24. 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 based or 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