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Asians must wake up to the hidden costs of retirement

With rapid aging, countries cannot sustain today's pension systems and must cut a fast-growing bill

Asia should look at the West's pension problems and prepare better for their aging populations.   © LightRocket/Getty Images

It is no secret that global debt levels are rising, and now stand above 300% of overall gross domestic product, to the consternation of at least some investors.

Less well known is the equally disturbing fact that retirement liabilities -- future commitments covering pensions, health and social care costs -- are also rising rapidly and, in some countries, they already dwarf current debt levels.

Today, this is primarily a problem for the developed world, including the U.S., Europe and Japan. But the very rapid aging of Asia's population, means that the region as a whole could face even bigger challenges than the West, where demographic change came much more slowly giving more time to adjust.

Above-average economic growth in Asia gives the region the chance to develop cost-effective and economically sustainable ways of financing the retirements of increasing numbers of people with ever-rising life expectancy. But Asian governments cannot delay in dealing with problems ranging from unacceptable early retirement ages, overgenerous pensions (including in China), a historic dependency on families caring for their elders, and poorly managed public investment funds.

The current global pension deficit is around $70 trillion, compared with global GDP of just over $80 trillion, and is expected to rise to $400 trillion by 2050. A substantial portion of this is in Asia: Japan's pension funding gap is $11 trillion, expected to rise to $26 trillion in 2050; China's funding gap is $11 trillion, expected to rise to $119 trillion in 2050; India's funding gap is $3 trillion expected to rise to $85 trillion in 2050. Aged care and health care costs, such as the proposed "Modicare" initiative in India, are additional and will add significantly to the burden.

The idea of ceasing work after attaining a specified age began in the 19th century under German Chancellor Otto Von Bismarck. It was adopted globally as government policy in the 20th century especially after World War II.

One structure is defined benefit ("DB") schemes where beneficiaries enjoy a fixed entitlement, usually a percentage of final salary, indexed for inflation. Under the alternative -- defined contribution ("DC") schemes -- beneficiaries rely on contributions they make over their working life and returns earned on the funds. Health care benefits may be included.

DB schemes are financed by contributions from the sponsor -- government or employer -- and/or workers. Where fully funded, the funds expected liabilities are covered by the value of invested contributions. Where the investments are insufficient, benefits must be met on a pay-as-you-go basis out of the fund's inflows, sponsor's current income, tax revenues or borrowings. DC schemes are funded by individuals, supplemented by employer or government contributions and supported by tax incentives.

Design flaws mean investments and contributions are unlikely to cover future liabilities. Employers and governments traded overgenerous future benefits, which would not need to be paid for immediately, in return for lower current wages or votes.

Demographic factors pose problems. In OECD countries, the percentage of the population aged 65 or more is approaching 30%, up from 20% in 1975. It will reach over 50% by 2050.

Where schemes are not fully funded, falling workforces and taxpayers as a proportion of population mean that new contributions will fall when payments to beneficiaries are rising. The proportion of income or taxes needed to finance retirement payments will increase.

Medical advances have converted fatal diseases into manageable chronic conditions increasing health care costs. Retirement payments, aged care and medical costs now exceed original actuarial estimates.

Where contributions are invested to meet future liabilities, falling investment returns affect the ability to meet obligations. Lower returns force pension funds to move away from the safety of bonds into riskier assets such as shares, real estate, hedge fund and private equity.

The result is underfunded schemes. If retirement savings prove inadequate, then retirees may need state welfare safety nets. Governments will face additional outflows.

While idiosyncrasies of individual pension systems make comparisons difficult, Asia increasingly faces similar problems to the West as well as additional issues of its own.

First, falling birthrates and increasing life expectancy mean that the population over 65 will increase rapidly, twice as fast as that in the developed world. This increase will be most marked in Japan, China, South Korea, Singapore and Thailand.

Second, pension system coverage is generally low, reflecting substantial rural populations, a large informal economy and lower income levels. Significant parts of the population lack an adequate post-work income. Avoiding old age poverty relies on family networks, which are weakening. Economic activity will slow as consumption and savings fall as resources are diverted to meeting these needs. Even where there is coverage, pension systems may not provide necessary income because withdrawing savings as a lump sum before retirement is common, with the risk that people outlive their resources.

Third, Asian pension schemes are frequently structurally weak. Many are DB arrangements that pay earnings-related pensions. In some countries, such as China, Vietnam, Pakistan and Taiwan, pension levels are high relative to earnings. The problem is magnified by early retirement ages, especially for women. After adjustment for shorter average Asian life expectancy outside of Japan, expected retirement duration in Asia is around two years longer for men and four years longer for women than in developed nations. This may prove financially unsustainable.

Fourth, current investment assets available to finance retirement costs, measured against GDP, are modest compared with developed countries. Pension investment assets in the U.S., U.K., Switzerland, Australia and Canada are above 100% of GDP. Pension investment assets in Japan, China, South Korea, Hong Kong and Malaysia are 63%, 1.5%, 47.4%, 49.1% and 73.4% respectively.

Fifth, Asian pension schemes are generally government-sponsored and publicly managed, exposing them to political pressures. Funds are frequently used as a source of funding for governments and state-owned enterprises, to hold strategic shareholdings or otherwise advance government policy. The returns are, to put it politely, often suboptimal.

Sixth, in addition to the global low return outlook, funds must contend with limited investment choices because of typically small domestic capital markets in Asia, necessitating more foreign investment, with the attendant currency risk. It complicates investment decisions. For example, Singapore's highly regarded GIC and Temasek made poorly timed investments in Western banks in 2007-2008. Return and funding pressures are forcing regional pension funds to increase exposure to high-risk growth sectors, including China and nascent technologies.

In developed economies, the pension underfunding problem will require difficult decisions such as deferring retirement, reducing payments or benefits, increasing contributions or taxes or, in extreme cases, allowing funds to go insolvent. In Asia, similar measures are also needed, as well as steps to increase coverage and alter the structure of pension schemes to ensure their financial security. Given the long time horizons involved, Asia must act soon to avoid repeating the perhaps irretrievable mistakes of developed economies.

Satyajit Das is a former banker. His latest book is "A Banquet of Consequences" (published in North America as The Age of Stagnation). He is also the author of "Extreme Money" and "Traders, Guns & Money."

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