Allison's ode to the second moment


Hello,

Welcome to the 25th issue of Allison’s Ode to the Second Moment, a newsletter that tells you everything you need to know about risk, whether you plan to tackle financial markets or invade a foreign power.

Risk and Warfare

I recently had a long chat with H. R. McMaster, the new National Security Advisor. It happened a month ago, before he was considered for the job. We spoke about how the military manages risk and uncertainty. He is a very impressive thinker.

Many people would find it surprising how much military generals and finance professors have in common. There are many similarities. Both solve constrained stochastic optimization problems. The stakes are just much higher in warfare.

It also surprised me how many people in financial markets and the Pentagon are prone to the same risk-related mistakes. In the 1990s, both became confident that risk modeling and technology could engineer the risk out of markets and warfare. But no model can predict everything that might happen, or sometimes we use the right model the wrong way. A few good outcomes, such as the first Iraq war and a mild 2001 recession, can convince us we’ve eliminated risk or that our models work in all seasons.

McMaster explained to me how that blind confidence introduces new vulnerabilities, as we saw in the second Iraq war and the financial crisis.

Here is one part of my conversation with him; there will be more later.

Pension Geeks Rejoice!

Secretary of the Treasury Steven Mnuchin is studying the possibility of issuing 100-year bonds! Just think of the duration you can add to your portfolio (goodness knows the military pension fund could use some duration)……and the years of predictable income flows we could engineer.

It sounds like the motivation behind the 100-year bond is to take advantage of low interest rates. I fully support extending the maturity of government debt.

But an even better reason is the future of retirement. If people start caring about income, they’ll look to annuities or LDI strategies to hedge interest rate risk. Financial markets will be hungry for more duration (and yield). Right now, low yields on long term debt makes the security of regular income very expensive (looking at you, British Gilts).

A new market for long-duration bonds could mean cheaper, safer income.

The Fiduciary Standard Everyone, but Anthony Scaramucci and Me, Seems to Love

The Department of Labor has requested that the implementation of the fiduciary rule (the rule whereby financial advisors must be fiduciaries) be delayed for 60 days. The fate of the rule is now even more uncertain, which is causing stress in the financial industry.

It is not clear what’s worse, a poorly conceived/implemented regulation or regulatory uncertainty.

But on a more positive note, the goal of the rule, steering more investors into low-fee funds, appears to be happening. Bloomberg reports the pressure is on at large asset managers to provide more funds with lower fees. It seems like, “How much is this costing me?” is now one of the first questions people ask.

Entitlements

I know, I know entitlement cuts are not even under consideration. But is it really wise to increase entitlements? There is a new proposal to change the price index used to adjust government benefits to CPI-E because it more accurately tracks how elderly people spend money, mainly on health care. This index grows faster than the other CPIs we use.

This all sounds nice, but it will make entitlements even more expensive. To a large extent, health-care inflation is already covered by Medicare. CPI-E also has other limitations. This is a worthwhile discussion, but with a Republican Congress, I can’t imagine it will go anywhere.

Meanwhile, Canada is planning on increasing the generosity of its pension.

Entitlements are a funny thing. They are easy to give out, but nearly impossible to take away. Reform generally means giving more of something, rather than cutting anything.

I reckon why that’s why health-care reform is more complicated than people realized. An efficient health-care system isn’t really that complicated. What’s complicated is figuring out a way to give people more of something without asking anyone to give up anything.

As If We Need Another Reminder Why That Is A Problem

Things are not going well in Puerto Rico. In any financial crisis, there are three stakeholders: bond holders, pensioners, and residents who need services. Generally, the residents get the lowest priority (pensioners usually get the highest). But the Puerto Rican Governor is pushing back on some of the Control Board’s austerity measures. He, like most politicians, also has wildly optimistic revenue projections.

And speaking of debt crises, things aren’t going so well in Greece either. At least some are hopeful Brazil’s proposed pension cuts will pass and help Brazil avoid a debt crisis of its own. We’ll see how that goes down after Carnival. After all, if there is one thing that unites everyone, it is that no one tolerates entitlement cuts.

How did we get here? I suppose we keep promising more (even if we can’t take it back) because we are short-sighted, assume the future is more certain that it is, or under-estimate risk's costs. In that case, maybe the border adjustment tax won’t work as intended; exchange rates can be unpredictable.

Or maybe special ops and drones aren’t furthering our interests and minimizing warfare risk after all.

Until next time, Pension Geeks.

Allison