“As I took in this powerful portrayal of human failures that sank a ship thought to be be unsinkable, it occurred to me that…..the story could also end up describing the fate of the global retirement system…..”.
Mohamed A. El-ErianBloomberg News, August 12, 2016
In a weekend Bloomberg News article “The Titanic Risks of the Retirement System”, the Chair of President Obama’s Global Development Council (and former PIMCO CEO) told readers that he attended a performance of the musical Titanic in London recently. Mr. El-Erian writes that the story could end up describing “the fate of the global retirement system”. Why? Because with bond yields “at extreme lows”, stock prices (especially of high-quality, dividend-paying corporations) “at historic highs”, and return correlations “unstable”, pension fund managers are “taking ever greater risks”. As a result, individuals are “increasingly being exposed to the threat of losses that cannot be recouped quickly”.
To ensure that the global retirement system doesn’t suffer the fate of the Titanic, Mr. El-Erian suggests three policy course corrections:
- Be realistic about investment return prospects "within traditional risk tolerance parameters”.
- Put in place policies to boost retirement savings, especially for the “most vulnerable” citizens.
- Offer less risky investment options “with explicitly lower expected returns”.
Just as Mr. El-Erian had his Titanic moment as he left the theatre, I had a different one after reading his article. Mine was to recall Albert Einstein’s famous dictum: “Make things as simple as possible….but no simpler”. It struck me that the article failed the Einstein test for at least three reasons.
Reason #1: There Is No “Global Retirement System”
The 1994 World Bank study “Averting the Old-Age Crisis” made the useful point that most national retirement income systems have three pillars: 1. A ‘pay-go’ universal Pillar 1, 2. A workplace-based pre-funded Pillar 2, and 3. An individual/family-based ‘do-it-yourself’ Pillar 3. Using this World Bank model, the Melbourne-Mercer Global Pension Index (MMGPI) has been scoring the effectiveness/efficiency of national retirement income systems since 2008. The range of Index scores suggests there is a great deal of variance in the effectiveness/efficiency of national retirement income systems.
The implication is that it is not very useful to write about a hypothetical “global retirement system”. Mr. El-Erian needs to be more specific. Which of the three Pillars is his Titanic? And which countries does he have in mind?
Reason #2: There are Good and Bad Ways to “Boost Retirement Savings”
On his ‘boosting retirement savings’ recommendation, 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 multi-decade accumulation/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 MMGPI scores look after their poor with means-tested Pillar 1 retirement income supplements, not by extracting retirement savings from their meagre 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.
Reason #3: Volatility and Risk are Not the Same Thing
Mr. El-Erian makes much of investment managers deciding they have to move out 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 powerful life-cycle theory of personal/family 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/family’s financial life-cycle, 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 sub-pools.
Mr. El-Erian fails to make this distinction when he recommends that pension organization “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. Historically U.S. stocks have generated a real return of 6.7%/yr., and Treasury bonds 3.0%/yr. (for the 1871-2014 period). A realized stock/bond risk premium of 3.7%/yr. is implied. However, of that 6.7%/yr, 1.0%/yr. was due to unanticipated upward price valuation of stock earnings and dividends. So arguably, the average expected risk premium was not 3.7%/yr., but 2.7%/yr. How does that compare to a reasonable forward-looking expectation today? The Gordon Model suggests a 3.6%/yr. real return for stocks and 0.5%/yr. for bonds. This implies an expected risk premium today of 3.1%/yr., actually higher than the historical 2.7%/yr. expectation. This in turn suggests that stock prices today are not at the “historic highs” 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 mis-specify 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.
President, KPA Advisory Services Ltd.
Director Emeritus, International Centre for Pension Management
Rotman School of Management, University of Toronto
Keith Ambachtsheer is cited regularly in the world’s leading financial publications, including The New York Times, The Wall Street Journal, The Economist, The Financial Times, and The Globe & Mail. His editorials and articles have been published in the Financial Analysts Journal, the Journal of Portfolio Management, the Rotman International Journal of Pension Management, and other professional journals. His 4th book, The Future of Pension Management, was released by Wiley in March.
He has received many professional awards including, ‘Top 30 Difference-Maker’ from P&I, the ‘Globe’s #1 Knowledge Broker in Institutional Investing’ from aiCIO, ‘Top Pension 40’ from II, the ‘Outstanding Industry Contribution’ Award from IPE, the Lilywhite Award from EBRI, and the ‘Professional Excellence’ and ‘James Vertin’ Awards from the CFA Institute.
On the academic side, aiCIO named Keith one of the globe’s "10 Most Influential Academics in Institutional Investing". He is Adjunct Professor of Finance, Rotman School of Management, University of Toronto, Founding Editor, Rotman International Journal of Pension Management, and Founding Academic Director and Faculty Member, Rotman-ICPM Board Effectiveness Program for Pension and Other Long-Horizon Investment Institutions. He is a member of the Melbourne-Mercer Global Pension Index Advisory Council, the CFA Institute’s Future of Finance Advisory Council, and the Georgetown University Center for Retirement Initiatives Scholars Council.