Pensions Are Searching Everywhere for Yield, Including Cryptocurrencies
Pension funds are increasingly piling on more risk in the face of prolonged interest rate malaise and that includes highly volatile assets such as cryptocurrencies.
Mark De Vries looks out over his modest garden in his humble cottage house a forty-minute drive outside of Amsterdam. The former supervisor in the metal industry has a worried look drawn across his face.
Having saved diligently into a pension during his working life, his plans for his retirement have hit the skids after receiving a notice from his retirement scheme, one for the Netherlands's biggest industry-sector funds, of plans to cut his pension by up to a tenth.
The news came to him like a punch to the gut.
De Vries had planned a comfortable retirement, with holidays to Spain in the summer and trips with his grandchildren, but all these plans have come under threat due to his reducing pension income and threats that this is only the first of successive rounds of cuts.
Millions of pensioners and savers around the world are facing the same retirement insecurity as De Vries as low interest rates over the past decade after the financial crisis wreak havoc on the funding of once generous pensions.
And the problem is not specific to any one corner of the world either.
From the United States to Russia, Japan and Brazil, pensions are now more likely to be underfunded than ever in their history.
A Perfect Pension Storm
With increasing life expectancy, pensions are struggling as they get squeezed between the rise in the number of retirees drawing down on their pensions against the backdrop of falling yields.
U.S. industrial giant General Electric recently announced that it is joining a growing list of companies that are ending guaranteed “final salary”-style pension schemes, affecting around 20,000 current workers at the company.
The main culprit of course in this global upheaval has been diminishing bond yields.
Bonds, have historically provided a simple match for the cash flows needed to be paid out to pension members such as De Vries.
But decades of declining bond yields have made it far harder for pension funds to buy an income for their members, pushing them more and more into stocks and other riskier, illiquid investments, including real estate, private equity and cryptocurrencies.
To be sure, much of that exposure by pension funds has been indirect, through both hedge funds and private equity funds, but the effort to goose returns is undeniable and in many cases a failure to do so could create long term existential issues for members’ pensions.
For now at least, buoyant financial markets have ensured robust investment gains for pension plans based on existing holdings, but because pensions plans have far longer-term liabilities, the dimming outlook for future gains means that there is an immediate need to clock higher returns and that usually means taking on more risk.
And this danger to pension funds is not only something that will affect individuals like De Vries, who have seen the value of their pensions hit, but it could also have a wider impact on the economy.
Where Will You Yield?
With the specter of a recession looming over the horizon, historically low rates don’t have much room to go any lower and may be having an opposite effect.
As people start setting aside more money for retirement, it may hamper economic growth by reducing consumption — the opposite of the intention of central bank rate cuts.
The Swedish Riksbank, Sweden’s central bank, recently hinted at the long term damage that negative rates could have on economic behavior,
“If negative nominal interest rates are perceived as a more permanent state, the behavior of agents may change and negative effects may arise.”
What these “negative effects” are was not made explicit, but one obvious danger is the accumulation of risk and leverage as structurally important pension funds no longer provide ballast in financial markets, instead, adding to instability by piling on risk.
And then there are the systemic risks.
Last month, the IMF warned in its annual report on global financial stability that the rush by pension funds into illiquid assets will hamstring “the traditional role they play in stabilizing markets during periods of stress,” as they have less liquid funds to scoop up bargains in times of economic stress.
Pension plans invest in a broad array of asset classes, but with many stock markets at or near record highs, the prospect of gains are diminishing across the board.
Because pension funds have a longer term time horizon, they have typically served as a moderating influence during periods of sharp selldowns, but that role may be hamstrung as pension funds become bogged down in illiquid assets that are difficult both to value and unwind.
Which is why cryptocurrencies made for an interesting proposition for pension funds.
While well beyond the mandate of direct investment from most pension funds, some have gained exposure to cryptocurrencies through their investments in digital asset-themed hedge funds, which although more volatile and unproven, are sometimes more liquid than other alternative asset classes.
Because while real estate and leveraged debt buyouts may be difficult to unwind, cryptocurrencies, volatile as they may be, tend to be more liquid and derivatives, which many crypto-hedge funds trade in, are even more liquid.
Beggars Can’t Be Choosers
To be sure, pension funds are running low on options.
With both stocks and bonds looking expensive, their returns in the future are likely capped off.
For those who are today’s asset owners, the unlikely situation of expensive bonds and stocks is welcome news, but for young people today, or anyone trying to save, invest, or manage well into the future, the return landscape is far more barren.
And young people are starting to figure it out.
Unlike their forebears, for whom the prospect of owning property and watching the value of that property grow, as well as the typical 60 / 40 stocks and bonds portfolio providing for a comfortable retirement, many young people are having doubts about their economic futures.
The rise of the gig economy, where lifelong employment and pensions are remnants from an antiquated era, as well as prolonged asset price appreciation against a backdrop of stagnant wages has caused an entire generation to grow increasingly disillusioned with traditional asset classes.
While tech stocks continue to grow in favor with young people, so have cryptocurrencies, a factor that has weighed in on pension fund allocators.
And with the bulk of pension funds either underfunded or likely to undershoot their liabilities in the long term, the future of pensions in general looks bleak.
To counteract the fading outlook for returns from mainstream bonds and equity markets, many pension plans are ratcheting up their investments in alternative or private assets, including private equity, real estate, venture capital, infrastructure, untraded loans and yes, cryptocurrencies.
Because for long-term investors who can accept the illiquidity in return for the promise of higher returns, this makes absolute sense.
Long-only Bitcoin-based crypto funds have, depending on the time of entry, delivered thousands’ of percent worth of returns for investors.
A housing project or a toll road can produce a “bond-like” steady income stream.
Loaning out cryptocurrencies can provide an 8% coupon rate, compared to a negative-yield bond.
But with almost every institutional investor exploring these new roads for yield, froth has started to build up in private as well as cryptocurrency markets.
Which is why despite China’s ongoing crackdown of cryptocurrency companies, Bitcoin still remains above US$7,000, despite starting the year at about half that amount.
According to Bloomberg, two pension funds of the Fairfax Retirement System recently increased their exposure to the digital asset industry.
Earlier this year, Harvard University’s endowment backed crypto company Blockstack Inc.
And at the start of this year, when Bitcoin was at an all-time low for the year, a Fidelity survey revealed that institutional investment into cryptocurrencies is likely to increase over the next five years.
But institutional involvement in cryptocurrency investment has not come at the pace or magnitude that even the most cautiously optimistic may have hoped for.
Part of the reason for the glacial pace of cryptocurrency investment by institutions is certainly due to regulatory oversight. Rampant scams, uncertainty and volatility of the underlying asset class itself do not help the case for cryptocurrencies either.
Regardless, for some pension funds at least, against a backdrop of negative interest rates and sky high company valuations, cryptocurrencies are perhaps no more “risky” than real estate, venture capital and other more exotic private equity instruments.