With bond yields at extreme lows, stock prices at historic highs and return correlations unstable, pension fund managers are taking ever greater risks. As a result, plan participants are “increasingly being exposed to the threat of losses that cannot be recouped quickly,” concludes Mohamed A. El-Erian, chairman of President Barack Obama's Global Development Council and former chief executive officer and co-chief investment officer of Pacific Investment Management Co. LLC, in a recent commentary.
To ensure the global retirement system stays afloat rather than sinks like the Titanic, Mr. El-Erian recommends three course corrections to policymakers and plan sponsors:
1. Be realistic about investment return prospects “within traditional risk tolerance parameters.”
2. Put in place policies to boost retirement savings, especially for the “most vulnerable” citizens.
3. Offer less risky investment options “with explicitly lower expected returns.”
But I have a different take on the necessary corrections. My analysis recalls Albert Einstein's famous dictum: “Make things as simple as possible, but no simpler.” It struck me that the recommendations failed the Einstein test for at least three reasons:
1. There is no “global retirement system.” The 1994 World Bank study “Averting the Old-Age Crisis” observed that most national retirement income systems have three pillars: a “pay-as-you go” universal pillar, a workplace-based pre-funded pillar (e.g., defined benefit and defined contribution plans), and an individual-based “do-it-yourself” tax-deferred savings pillar. Also, the Melbourne-Mercer Global Pension index has been scoring the effectiveness and efficiency of these three-pillar national retirement income systems since 2008. The range of index scores suggests there is a great deal of variance in the effectiveness and efficiency of these systems.
The implication is that it is not very useful to write about a hypothetical Titanic-like “global retirement system.” Mr. El-Erian needs to be more specific. Which of the three pillars is the Titanic? And which countries does he have in mind?
2: There are good and bad ways to “boost retirement savings.” For example, it is hard to think of a worse policy initiative than to require, or nudge, individuals to save more for their retirement through high-cost pillar 3 channels. Unknowingly, over multidecade accumulation and decumulation periods, these high fees will cost participants half their potential pensions. Further, it tends to be the rich who think it is a good idea for the poor to become even less able to make day-to-day ends meet by contributing to a retirement savings account. Countries with high Melbourne-Mercer Global Pension Index scores look after their poor with means-tested pillar 1 retirement income supplements, not by extracting retirement savings from their meager incomes.
The other thing countries with high MMGPI scores do is to facilitate high levels of participation in pillar 2 pension plans, and to create cost-effective, fiduciary-oriented pillar 2 pension intermediaries. The combination of these two features ensures broad pillar 2 coverage, creates measurable value-for-money for participants, and eliminates the need for high-cost pillar 3 “solutions.”
Far from being Titanics, these cost-effective, fiduciary-oriented pillar 2 pension organizations are a critical ingredient of sustainable 21st-century capitalism.
3: Volatility and risk are not the same thing. Mr. El-Erian makes much of investment managers deciding they have to move out further on the risk scale in order to hit their return targets in the new low-return world. He warns that heightened return volatility will result in exposure to losses “that cannot be recouped quickly.” Here he shows himself captive of the short-termism embedded in traditional portfolio theory and traditional active management.
The lifecycle theory of personal finance makes it clear that this volatility-is-risk assumption is relevant only for the end-of-cycle payment safety phase (i.e., for older workers and retirees). In contrast, for most of an individual's lifecycle, the absence of sustainable long-term return compounding is the dominant risk. The source of this risk is owning cash flows (e.g., dividend payments) that are not sustainable beyond the short-term. Investment organizations that understand they must distinguish between these two different types of risks will split their total asset pool into separate long-term return compounding, and short-term payment-safety subpools.
Mr. El-Erian fails to make this distinction when he recommends that pension organizations “offer less risky investment options with explicitly lower expected returns.” There is no need to do that for asset pools with an explicit long-term return compounding focus. Let me explain by example. From 1871 to 2014, U.S. stocks and Treasury bonds generated annualized real returns of 6.7% and 3%, respectively. However, of that 6.7%, one percentage point a year was due to unanticipated upward price valuation of stock earnings and dividends. So arguably, the average expected risk premium was not 3.7% (i.e., 6.7% minus 3%), but 2.7% a year. How does that compare to a reasonable forward-looking expectation today? The Gordon growth model (return equals income plus capital gain) suggests an annualized real return of 3.6% for stocks and 0.5% for bonds. This implies an expected annualized risk premium today of 3.1%, actually higher than the historical annualized 2.7% expectation. This in turn suggests that stock prices today are not at historic highs as Mr. El-Erian suggests.
A final point: Logic concludes and research confirms that genuine long-term investors have outperformed, and will continue to outperform broad equity indexes over the long term. Further, they have done this, and will continue to do so with less “sustainable return compounding” risk than other investors. Why? Because genuine long-term investors focus on assessing the risk that the cash flows they acquire and own will not be sustainable over the long-term, while other investors mistakenly focus on short-term price volatility-related risks (e.g., actual quarterly earnings announcements vs. guidance).
Keeping things as simple as possible is a good thing. However, oversimplifying is not. The global retirement system is not about to become the Titanic for the simple reason there is no global retirement system. We need to understand retirement income systems at the national level before recommending improvements. Boosting retirement savings without ensuring it is being done in a measurable value-for-money manner will lead to a cure worse than the disease. The same is true for risk-reduction strategies that misspecify the true financial risks people face over the course of their lives.
National retirement income systems and their components are by no means perfect. But to improve them requires we be clear about what should be done, and why, country by country. n
Keith Ambachtsheer is president, KPA Advisory Services Ltd., Toronto, and director emeritus, International Centre for Pension Management, Rotman School of Management, University of Toronto.