September 2, 2019

Pension Funding And Investment Policies Under 'Radical Uncertainty': The Cases Of The USA, Netherlands, And Canada

"Solvency is the degree to which current assets of an entity exceed the current liabilities of that entity." 

"Sustainability is the ability of an entity to exist constantly in the 21st Century and beyond."



Pension Management Needs Context

Last month’s Letter set out two possible contexts for pension management. One was the shorter-term ‘small world’ where financial risks are well-defined and follow from known probability distributions. The other was the longer-term world of ‘radical uncertainty’ without known probability distributions. Here risk is best defined as ‘the failure of the projected reference narrative, derived from realistic expectations, to unfold as envisaged’. Click HERE to access the August Letter.

People governing and managing pension arrangements need to be clear which context best fits their situation. Is it the shorter-term ‘small world’ where investment policy can be ‘optimized’ in terms of maximizing the short-term risk/reward preferences of the pension plan’s stakeholders? Or is it the ‘radical uncertainty’ world of realistic longer-term narratives that ultimately either unfold or do not?  

Last month’s Letter showed the ‘which context?’ question matters a great deal in today’s world where a realistic long-term real return expectation on a well-diversified portfolio of equity investments is 4.5%/yr. versus 1%/yr. on a laddered risk-free bond portfolio. One hundred dollars earning 4.5%/yr. over 25yrs. compounds to $301, and over 50yrs. to $903. At 1%/yr. it compounds to $128 and $164 respectively. So certainty over long horizons today likely has a very high opportunity cost in wealth foregone. There is also an important macro-economic message here: long-term retirement savings invested effectively in equity-oriented opportunities today carry far greater potential to be a sustainable wealth-producing catalyst in capitalist societies than buying government bonds.   

There is, however, a caveat. While funds with long investment horizons can realistically expect to generate materially more wealth than funds having to pass regular ‘small world’ solvency tests, they do so in the face of radical uncertainty. Thus fund managers must think through the consequences of their projected reference narrative failing to unfold. How might the narrative fail, and what are the failure implications? Have a look at last month’s Letter which posited three ‘fail’ scenarios, each with its own set of consequences and response implications.  

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