(As an aside, it is worth noting the similarities between the US healthcare system and its pension system. Firms also offered healthcare as a tax-advantaged benefit in lieu of wage increases. Over time, this became our current “managed care” highly financialized system. Like pension funds that are controlled by money managers, our healthcare is managed by highly oligopolized financial firms run by well-compensated executives. Workers have little control over their healthcare or their pensions. They are not “sovereign consumers” because they have neither the knowledge nor the ability to shop around for healthcare or pensions—in both cases, employers negotiate with providers and pass fees along to workers. With others in control, there is little to hold down costs—even as wages were sacrificed on the argument that workers were receiving valuable nonwage compensation. Now both healthcare and pensions are endangered by the same Washington forces promoting even greater financialization. (Go here.)
As time went on and it became apparent that “legacy” firms might not survive for the necessary half century (or more), unions and government felt that a mere promise to pay pensions would not suffice. Either firms would have to kick in a huge amount of cash to fully fund the pensions, or government would have to guarantee the pensions. Corporations did not like the costs attached to full funding. The grand compromise was that firms would increase funding a bit, and government would provide insurance through the PBGC. Funding did increase, although the more frequent and more severe crises in the post 1970 period always wiped out enough assets in each crisis to cause pension funding to dip below prudent levels. Only a financial bubble could get them back to full funding. To make matters worse, firms were allowed to reduce contributions during speculative bubbles (since asset values would be rising)—ensuring that the funds would face a crisis whenever the economy was not bubbling.
Just before the current global crisis hit, pension funding was, on average, doing well—thanks to the speculative bubble as well as to some deregulation that took place at the end of the Clinton administration that allowed pensions to gamble in more exotic instruments, and in riskier markets such as commodities. Previous to 2000, pensions could not buy commodities because these are purely speculative bets. There is no return to holding commodities unless their prices rise—indeed, holding them is costly. However, Goldman Sachs promoted investment in commodities as a hedge, on the basis that commodities prices are uncorrelated with equities. In the aftermath of the dot com collapse, that was appealing. (In truth, when managed money flows into an asset class that had previously been uncorrelated with other assets, that asset will become correlated. Hence, by marketing commodities Wall Street ensured a commodities bubble that would collapse along with everything else.)
You know the rest of that story: pension funds poured into commodities and commodity futures, driving up prices of energy, metals, and food. As energy prices rose, Congress mandated biofuels—which added to pressures on food prices that contributed to starvation around the globe. The bubble popped in what is known as the great Mike Masters inventory liquidation, as pension funds pulled out of commodities on the fear that Congress was coming after them. They didn’t want all the bad publicity that would be caused if workers knew that it was their own pension funds that were driving up gas prices at the pump.
However, pensions have quietly moved back into commodities—and oil prices have doubled. (go here) Indeed, pensions are also looking into placing bets on death through the so-called life settlements market (securitized life insurance policies that pay-off when people die early). (Go here) Ironically, this would be a sort of doubling down on death of retirees—since early death reduces the amount of time that pensions have to be paid, even as it increases pension fund assets. To conclude, pension funds are so large that they will bubble-up any financial market they are allowed to enter—and what goes up must come down.
But that is not what I want to write about here. I always had my suspicions about the strategy followed by pension fund managers, so the conference gave me the opportunity to talk to experts.
Here’s the deal. Each pension fund manager must come from the land of Lake Wobegone, because she/he must beat the average return or get fired. There are two fundamental principles widely believed to operate in financial markets that make such an outcome unlikely: the risk-return relation and the efficient markets hypothesis. Higher risk is rewarded with higher returns, hence, fund managers must take on more risk to get the reward of above-average returns. But since the higher return only rewards higher risk, with efficient markets the average fund manager will only receive the risk-free return. The higher returns of the brighter or luckier managers will be offset by the lower returns of the dumber and luckless money runners.
In other words, if your fund manager does not come from Lake Wobegone, you’d be better off investing in riskless Treasury bonds. Indeed, it is even worse than that because hiring an above average fund manager will require above average compensation—so even those funds with B-rated managers would probably provide lower net returns than Treasuries. To be sure, there is some shuffling of the deck so that one manager with a run of good luck can beat the average for a while, but she will probably fail catastrophically and wipe out several years of winnings in one swoop as some other lucky fool takes her place in the Wall Street lottery. Only the fortunate few can permanently live in Lake Wobegone and thereby beat Treasuries over the long run.
To be clear, these two principles may not be entirely correct—or, there could be other forces at play to allow for a positive return to risk even after subtracting losses. If so, that would go against the conventional wisdom that drives Wall Street. I think it is likely that over long periods of time, markets do tend to push risk-adjusted net returns toward zero so that on average safe Treasuries will beat net returns on risky assets. There is, however, a positive return to taking illiquid positions. And all things equal, it is probable that longer term maturities (long duration) receive a premium. Still, when all is said and done, pension managers that follow similar strategies, including taking positions in traded, liquid assets, will push risk spreads toward to the point that they just compensate for losses due to risk.
Each time there is a financial crisis, the funds tank and managers look for strategies to reduce risk. Enter Wall Street marketeers with an array of instruments to hedge and diversify risks. That was one of the big topics of the conference I attended. There is one sure bet when it comes to gambling: the house always wins. In financial markets, the big boys on Wall Street are the house, and they always win. Even if we leave to the side their ability to dupe and defraud country bumpkin pension fund managers, they charge fees for all the stuff they are selling. This ensures that on average pension funds will net less than a risk-free return. But wherever Wall Street intrudes, sucker bets and fraud exist. So the average return should be way below that of Treasuries, and even the managers from Lake Wobegone will probably net less than the risk-free return.
To recap: pension fund managers take on risk on the assumption that with higher risk comes higher return. Wall Street manufactures risky assets such as securitized subprime mortgages. It then convinces pension funds that they ought to diversify to reduce risk, for example by gambling on commodities. By coincidence, Wall Street just happens to be marketing commodities futures indexes to satisfy the demand it has created. It also provides a wide array of complex hedging strategies to shift risk onto better fools, as well as credit default “insurance” and buy-back assurances in case anything goes wrong. If all of these “risk management” strategies were completely successful, the pension fund would achieve a risk-free portfolio. Of course, it could have achieved this if it had bypassed Wall Street entirely and gone straight to the Treasury. However, Wall Street’s masters of the universe then would have had no market for the junk they were pushing, and pension fund managers would not have received their generous compensation. So workers are left with fees that drain their pension funds, and with massive counter-party risk as the hedges, insurance, and assurance go bad.
As mentioned above, we reward pensions with tax advantages and government guarantees. Before this crisis, private pension fund assets reached about 50% of GDP and state and local government pension fund assets reached almost 25%. That is a huge industry that has created a lot of well-compensated jobs for managers as well as Wall Street snake oil sales staff. The entire industry can be justified only if through skill or luck pension fund management can beat the average risk-free return by enough to pay all of those industry compensations. Yet, the expectation should be that fund managers are significantly less skilled and less “lucky” than, say, Goldman Sachs and J.P. Morgan banksters. Hence, workers would be far better off if their employers were required to fully fund pensions with investments restricted to Treasury debt. At most, each pension plan would require one lowly paid employee who would log-in to www.treasurydirect.gov to transfer funds out of the firm’s bank deposit and into Treasuries, in an amount determined by actuarial tables plus nominal benefits promised. Goodbye fund managers and Wall Street sales staff.
Indeed, this raises the question: should the federal government promote and protect pensions at all? Surely individuals should be free to place savings with fund managers of their choice, and each saver can try to find that manager from Lake Wobegone. But it makes no sense to promote a scheme that cannot succeed at the aggregate level—the average fund manager cannot beat the average, and on average there is no reason to believe that managed funds will provide a net return that is above the return on Treasuries. It would be far better to remove the tax advantages and government guarantees provided to pension plans, and instead allow individuals to put their savings directly into US Treasuries that are automatically government-backed and provide a risk-free return.
The US retirement system is supposed to rest on a three-legged stool: pensions, individual savings, and Social Security. Pensions are mostly employer-related and are chronically and seriously underfunded. There are also huge and growing administrative problems posed by the transformation of the US workplace—with the typical worker switching jobs many times over the course of her career, and with the lifespan of the typical firm measured in years rather than decades. And, finally, as discussed here the most plausible long-term return on managed money would be somewhat below the risk-free return on Treasuries.
The problem with private savings is that Americans do not save enough for their retirement. They never have. And even if they tried to do so, they would be duped out of their savings by Wall Street.
Thus, the best solution would be to eliminate government support for pension plans and instead to boost Social Security to ensure that anyone who works long enough to qualify will receive a comfortable retirement. They can supplement this with private savings, according to ability and desires.
I ran these arguments by several of the pension experts at the conference. All of them agreed that this would be the best public policy. But they pleaded with me to keep it a secret because such a change would be devastating for fund managers and Wall Street. Can you keep a secret?
Fantastic article Randy!!!!! Only two things I'd like to see added to this. Empirically show investing in treasuries is better than mutual funds over the long run."To be clear, these two (Risk-return relation and EMH] principles may not be entirely correct—or, there could be other forces at play to allow for a positive return to risk even after subtracting losses. "More on this would be interesting. There are a couple ideas floating in my head- less of what the economy does is due to markets, but actually capital allocators (some guys behind a desk), choosing where to allocate capital. Allocators have tremendous power in the economy. They might use it to inflate a housing bubble (thank you rating agencies and MBS), or they may use it to finance a woman in nigeria who wants to open an ice cream factory (thank you kiva). Since the so much of the direction of the economy is in the hands of the capital allocators, there should probably be some system of making sure that the allocator's goals are the same as society's. I think that is the future of economics. Democratically defined goals, and letting market players figure out the optimum way to achieve them. The other thing I am interested in is to see how the "dumber" players influence the market. Do they cause problems like a 9 year old flying your airplane would?
The Efficient Markets Hypothesis does not imply that investors in the aggregate can only earn the risk-free rate of return. EMH argues that the price of assets accurately incorporates all necessary information pertaining to their valuation. Since an individual investor cannot have more or better knowledge than the market, the only way he can earn a higher return than the market is by luck.You argue that if a risky asset produced a higher return, all fund managers would flock to that asset, pushing its return down until it is equal to the risk free rate. But an EMH proponent would use your same logic to argue for the opposite effect. If two assets, one more risky and one less risky, had the same rate of return, managers would flock to the less risky asset, pushing its return down until both assets had the same risk-adjusted return.In fact, your argument is a common critique of EMH advanced by researchers in the field of Behavioural Finance and Economics.There is another concept called the Risk-Neutral Measure which assumes that investors are risk-neutral and thus all assets earn the risk-free rate of return. However, this is just a probability measure used in the theoretical development of derivatives pricing models. It is not assumed to be true in the real world.I do agree with your main point though. Pensions suffer from managers who are overpaid and trade too much. They are often duped by overpriced investment vehicles sold by investment banks, and they fall prey to "hot-trends" investment ideas such as investing in commodities as an inflation hedge. All of this does not necessarily mean that there is no room for equity and corporate debt in pension portfolios, but pension managers need to recognize that they cannot beat the market, and instead stick to low cost investments in index-based instruments.
The pricing of assets should be just sufficient to cover the risk; on average there is no better return to taking risk. That is what I was trying to say, and DS seems to agree. Anything above that is due to luck. So you must get that manager from Lake Wobegone. I did say that it is possible other factors come into play, such as liquidity. I do believe there is an extra return to taking illiquid positions. Finally, of course, insider info and fraud are important but do not show up in mainstream theory and at least by regulation, pension mngrs are not allowed to use inside info or fraud. No doubt they do, and that is probably far more important than luck in explaining returns that beat treasuries. LRWray
I just saw this in the Wally, it looks like Volker was looking for some insider views as well, here is an excerpt: A few years ago I happened to be at a conference of business people, not financial people, and I was making a presentation. The conference was being addressed by a very vigorous young investment banker from London who was explaining to all these older executives how their companies would be dust if they did not realize the joys of financial innovation and financial engineering, and that they had better get with it.I was listening to this, and I found myself sitting next to one of the inventors of financial engineering. I didn't know him, but I knew who he was and that he had won a Nobel Prize, and I nudged him and asked what all the financial engineering does for the economy and what it does for productivity.Much to my surprise, he leaned over and whispered in my ear that it does nothing—and this was from a leader in the world of financial engineering. I asked him what it did do, and he said that it moves around the rents in the financial system—and besides, it's a lot of intellectual fun. Article
Of the articles I've seen here so far, this is the one I would most like to reprint (noncommercially, in the hoped-for resurrection of San Diego's 'Street Light') because it comes closest to what nonacademic people who are still employed should find of practical interest (so long as the system remains able to fo on employing them!)In one of your old levy.org pieces you were talking about Hyman Minsky's thoughts on how investment markets tend to evolve into a "Ponzi" phase, in which professional investors need to choose increasingly risky investments just to satisfy their clients' and employers' escalating demands for high returns… I think something about that would fit here.
Randy, I think you're making the wrong argument. .The point is not to correct the current illogical, unfair and risky pension system, but rather that Social Security benefits are far too low. They should be the same for every person (not dependent on salary) and increased fivefold, perhaps more..Why not? And while we're at it, eliminate FICA. Again, why not? The federal government can "afford" to support our senior citizens, and we are nowhere near inflation (which easily is controllable, anyway)..In my ideal world, there would be no federally regulated, private pension plans. People would save or not save, as they choose, using their salaries and other income. And everyone would receive the same Social Security (and Medicare) benefits sufficient alone to maintain a middle-class life style..For better than a middle-class life style, use your savings to add to your spending ability..Why get into extended and fruitless arguments about how to fix private pension plans, when no private pension system will work. Better to fix Social Security by increasing benefits and eliminating FICA. Simple, straightforward, fair, safe and economically stimulative..Rodger Malcolm Mitchell
This is amazing like the previous one..Thank you for this article..