This is the second article in a three-part series.
Part 1: Keynes stole your ship
A core aspect of the logic of folk who support stimulus programs in the name of John Maynard Keynes is that government spending to offset private sector contraction remains a victimless crime. This is completely untrue, and understanding the actual costs of Keynesian machinations by studying real-world examples of dysfunction is important to unravel this pernicious logic.
In the first part of this series, we considered the impact of random intervention in the shipping sector, in particular the role it has played to crush profits and imperil employment in the sector globally.
In the second part of this series, we will look at conditions in the area of retirement planning and returns. The notion of stealthy wealth transfers is part of a longer debate that goes into the core aspects of the financial crisis; to a large extent many of the issues have been raised previously in these pages but perhaps more in passing than as the core focus.
The core function of financial markets is to connect pools of savings with the people who need money for their immediate future. In demographic terms, this can be expressed as markets being the intermediary between older people with savings and young people who need to borrow to set up house, buy cars and other utilitarian requirements.
Construct of pensions – a quick primer
This a quick primer, and not all the nuances are or even can be covered in such a short summary. First let’s quickly recap the theory here, even if parts of it will appear unrealistic to many readers who have been hardened with real-world experiences over the past few years.
The rate of return for these old people is meant to take into account two primary factors: the cost of money and the risks entailed. The cost of money is measured by one of two factors – either as the minimum rate of return on money that keeps its purchasing power constant; or as a cumulative measure of opportunity lost by renting it out without risk.
Typically these two rates are close to the same, or in other words, returns on local government bonds are meant to offset the loss of purchasing power while preserving the principal. Instead of local government bonds, one could consider bank deposits as a suitable alternative.
Real world impact: if you consider the historical depreciation in the value of money – purchasing power – across the Group of Seven nations, and the needs of a comfortable existence in future, then a realistic return rate on pension portfolios would range between 5% and 10%. Remember also that this rate needs to account for capital withdrawal once people actually retire. Once we remove the periods of overly high inflation as well as stagnation or deflation (that would be you, Japan) the base (minimum) rate works out to 6%. This is the realistic minimum rate that needs to be achieved on pension portfolios, but one could also consider it a weighted average of returns before people actually retire.
The second aspect, namely risk, is merely a function of (a) the probability of losing principal and (b) the severity of such losses, should they occur. Consider as an example the difference between investing in the share market and investing in a farm. Investments in share markets typically are more volatile, but because of the investment’s liquidity the severity of losses is relatively small (that is, people can exit pretty quickly or hedge their losses). In the case of farm investments though, the likelihood of losses is small – because crop yields and animal product prices tend to be fairly similar from year to year; but when there is volatility (for example, because of a natural disaster like a tornado or a hurricane) the extent of losses is usually quite severe.
Arguably therefore, the compound term risk as an explanatory variable for the above two investments would be quite similar – for stocks a high probability multiplied by a low severity and for farmland a low probability multiplied by a high severity. We could thus say that the expected return of both these investments would be similar.
(Of course, similar doesn’t mean people will be neutral in choosing between the two investments as heuristics would play an important part; a man who saw his brethren suffer significant losses on a farm would be more partial to stock investing, and vice versa).
This ladder of choices that makes up one’s risk preferences contains one more factor of choice, namely the type of returns. While some investors are perfectly happy churning in and out of stocks, selling a part of their portfolio whenever they need to paint the house of example, others would prefer to secure regular returns – that is, coupon payments from the likes of bonds.
Typically, older people would prefer steady returns as it helps them plan their costs and thus lifestyle, while younger folk could / would withstand greater volatility in their choice of investments as the requirement for immediate income is less (contrast these younger people though with young people – those who don’t have net savings, and who need net borrowings to get along).
Real world impact: To make choices easier for fund managers, various countries around the world have set minimum standards for pension investments in terms of appropriateness, liquidity, maturity or duration matching and so on. Some even prescribe the ideal mix of income generating assets such as bonds and capital growth assets such as stocks.
The most famous example of such regulations is Employee Retirement Income Security Act in the United States; there are a host of similar initiatives in other countries. Whilst some offer broad guidelines, others get rather specific – for example Dutch pensions aren’t allowed direct exposure to physical commodities.
Given the various restrictions on pensions, overall performance in terms of returns has been mediocre to say the least. When you look at 30-year data streams, it is easy to see that mutual funds barely track the performance of broader indices such as the S&P500; this is primarily due to overheads such as management fees and of course, paying for regulatory oversight. For pensions, in addition to the underperformance of mutual funds, one has to add the impact of enforced asset mixes – certain investments in bonds for example as required diversification – and the underperformance becomes even more pronounced.
This is a core point to consider: asset allocation should not be set in stone, but in the case of pensions the flexibility afforded to managers is perilously low. Consider a situation where the economy is at rock bottom – such as now – and then think of what happens if pension funds are required to continually purchase government bonds even at yields below the rate of inflation (negative real yields). The effect is twofold: firstly to lose money hand over fist for their pensioners and secondly that whenever rates rebound higher, the portfolios also nurse massive mark-to-market losses.
Real world impact: As some countries require pension managers to exit loss-making assets past a particular threshold, in effect managers end up both buying and selling financial assets at the worst possible times. It is not that these folk are stupid, but rather that their jobs have fairly ill-considered portfolio conditions in place that engender stupidity. And of course, when that kind of scenario prevails, that is, managers simply do not have the ability to apply their skills, the industry gets dumbed down.
Another factor affecting performance is the construct itself. Underlying assumptions for constructing pension portfolios are driven by actuarial calculations that focus on how long people live and what that means for the mix of income and growth in portfolios.
If a chap had a life expectancy of 70 and retired at the age of 60, the pension portfolio only needs to be sufficient for 10 years of capital withdrawals. No one wants to save too much and leave a large balance in the pension portfolios for heirs to squabble over, particularly not in countries where estates are taxed on death at punitive rates. So the idea is to match the initial size of the pension pot and target returns with the requirements for capital withdrawals or income generation over a fixed timeframe.
Real world impact: Typically, pension portfolios assume life expectancies that are lower than those being observed currently. In many countries, pension plans, particularly those from the private sector, state explicitly that payments will be over a fixed term only with a lump sum amount available on maturity – say on a person’s 85th birthday.
The second real world impact, particularly in European countries and now increasingly in the case of the US, is to shift the burden of pension under-payments (due to poor performance for example) and longevity issues to government budgets.
Indeed, in many countries such as Germany and France, employers pay their pension contributions directly to the government-designated accounts, which then have the responsibility for managing the pension pots. While this spares companies from pension-related risks (remember the famous case of General Motors 10 years ago when the company needed billions of dollars to top up its pensions pot for employees), it also exposes pensioners to worse investment performance as well as residual systemic risk on their sovereign budgets. As a recent real world example, when the Greek government went bust, pensioners in the country suffered the most.
Analyze the vectors
So if one chooses to analyze the vectors, we end up looking at the following: mediocre returns, inappropriate asset mixes and incorrect actuarial assumptions. The shift of risk away from private-sector funding to the public sector entails greater urgency in assessing systemic risk of sovereigns, particularly given the mandated asset mix in investment portfolios.
Real world impact: In the markets, the sum total of all risk calculations is expressed by a single variable, namely price. However, that signal can be easily clouded by government actions. For example, consider what happened when France was downgraded by the rating agencies. Whilst a widening of bond yields against say Germany would have been the correct response, the exact opposite happened because pension plans – thanks to the automatic sell-off requirements that were triggered on French stocks – ended up purchasing more “safe” securities, that is, French government bonds, thereby helping to tighten spreads against better quality sovereigns. Pretty much the same thing happened after the United Kingdom was downgraded a few weeks ago.
In this dangerous territory of invalid price signals clouding the actual calculations of risk entailed in pension portfolios, we also have had to contend with the actions of central banks, particularly over the past 18 months.
Uninterrupted purchases of low-risk assets such as government bonds have been pushed through in the name of quantitative easing, intended as it were for investment funds to flow towards more risky assets and eventually, credit creation that could help to regenerate growth.
But this theory has a fatal flaw that is partly driven by demographics. When a large number of old people expect to receive certain amounts from their pension portfolios, reductions in running yields end up reducing their monthly income. This in turn causes them to cut spending even more as they try to add savings to their overall pot, in effect more than mitigating the positive actions of the central banks.
There is also the effect of systemic risk in that rising sovereign risk is obvious to pensioners; and as they fear â€œhaircutsâ€? on their pension plans in future, the motivation to save becomes larger. This is also true for people close to pension age (say folks in their 50s) and then slowly extends to those in their 40s and so on. That is precisely what happened in Japan from the mid-’90s to 2012 and now threatens to happen across Europe.
There is also a pernicious moral perfidy here: going back to the initial definition of financial markets’ function, it is obvious that the key intention is to shift money from the hands of savers (generally old people) to those of borrowers (generally younger people).
In some countries such as the US and the UK, this debate has been framed around race and even immigration. With demographic narrowing in these countries, new entrants are usually the target market for lending by banks; and such folks tend to be immigrants or members of minority communities that have better demographic profiles than the majority.
Real world impact: It is actually now impossible to construct a pension portfolio with an expected return for 6% whilst meeting investment restrictions set by the authorities. The best that people manage to eke out in general pensions is 2% to 3%; anything higher requires inordinate principal risks. Add in the liability calculation (future payments at the current low discount rates) and effectively every G-7 sovereign is bankrupt many times over when pension deficits are taken into account.
With all the best intentions, the facts are clear on the ground that Keynesian strategies have been counterproductive, especially for retirees. The larger battle for people’s minds though has swung in favor of the Keynesian orthodoxy with the “anything necessary” mantra of European Central Bank president Mario Draghi being taken up with a vengeance by other central bankers from Haruhiko Kuroda in Japan to Ben Bernanke in the US.
By pushing even more quantitative easing down the throats of their economies, these central bankers are doubling down, but at the cost of pensioners’ security in coming decades.
Have you ever imagined standing in the middle of the road and watching helplessly as a 60-tonne truck barrels down at you at 100 kilometers an hour? That feeling is not dissimilar to what the average retiree now faces.
Next: Asset bubbles