This is part one of a two-part series
In recent months, bond yields have touched generational lows and yet interest in securities that provide a cash yield, continues unabated. This article aims to explain, from a demographic perspective, why this seemingly irrational pursuit for yield will continue for the next several years. The demographics of North America have been shaped for the past 60 years by the baby boomers. The political presence of the early baby boomers (those born prior to 1955) was felt in the 1960s as young people gathered to protest war in Asia and put greater emphasis on freedom and individualism. Their financial presence was felt in the 1980s and 1990s as the generation of baby boomers reached high-earning positions and found discretionary income with which to increase personal consumption. But the greatest impact of baby boomers is being felt in this decade as they head into retirement.
When social pensions were created, such as the Canada Pension Plan (CPP,) they were setup as pay-as-you-go plans, meaning that current contributions were used to offset benefit payments to current retirees. If the group of retirees increases at a faster pace than that of contributors, additional financial stress is placed on the working cohort to increase contributions. But there is a limit to the ability of a pension fund to ask members for increased contribution rates.
The same is true of public and private DB plans. Although they are not structured as pay-as-you-go plans, the decrease in bond yields has elevated liability values at a time when corporations and public institutions can ill-afford to contribute further to these plans.
This chart demonstrates the current demographic issue based on historical statistics and projections from the UN population division in the Department of Economic and Social Affairs. The projections are based on a medium-growth scenario.
The proportion of the population over age 65 continues to increase for the next several decades, while the working population (ages 20 to 65) percentage started decreasing about five years ago, coinciding with the period when the first baby boomers retired.
The OTPP example
One of the major public pension plans, Ontario Teachers’ Pension Plan Board (OTPP), is transparent about the demographic shift in its member population and, no doubt, other pension plans are facing a similar challenge.
In 1970, there were 10 active teachers for every retiree and by 2011 that ratio had dwindled to 1.5 active teachers for every retiree. OTPP even translates this ratio into the implication for the plan members and sponsors in an adverse investment environment; in 1970, a 10% decline in assets required a 0.6% increase in contribution rates, while in 2011 a similar decline in assets would require an increase of 4.4% (as per its annual report).
Thus far, we have demonstrated that pension plan benefit payouts will increase over time and that the current working population will be unable to shoulder the burden of unrealistic increases to contribution rates should assets decrease in value. The end result is the current search for yield that helps solve the problem from two fronts:
- the yield from investments provides cash, which can be used toward benefit payments and reduces the reliance on cash contributions to pay for benefits, and
- investment yield tends to mitigate investment losses in years when assets perform poorly, thus reducing asset volatility. Yield will reduce the likelihood of requiring increases to contribution rates by putting cash back into a pension plan.
In the next article, I will examine what alternatives exist for a pension plan searching for yield and the risks of such investments.