Allison's ode to the second moment


Welcome to the fifteenth issue of Allison’s Ode to the Second Moment, a newsletter that aims to resolve the greatest rivalries of our time--unless it involves actuaries.

The best things in life aren’t free (at least if you want them guaranteed)

Like it or not, we live in a defined contribution world. Defined benefit plans are not coming back; individuals are responsible for funding a large share of their retirement spending and must bear the risks associated with it. As you know, I think that’s a major issue and we need more creative solutions and discussion about risk sharing. Thus, I welcome new proposals that start the conversation—even if the proposals have some serious flaws. The new, hot idea is to guarantee savers’ investment returns.

At first glance, it sounds like a fine idea. Investment returns are a big source of risk and risky assets normally have higher returns than bonds---so let’s just encourage risky investment (more money for everyone) and put a floor on returns (no risk). Boom! We get rid of the big risk and it won’t cost much, because odds are stocks will out-perform bonds over the long term. But us pension geeks see some problems with that argument. First of all, the guarantee is not free—or even cheap. Insurance companies charged A LOT (hundreds of basis points) for modest guarantees and still lost money. Even guaranteeing that your principle keeps up with inflation is expensive; conservative estimates say it costs 5 to 6% of contributions.

And guaranteeing returns still doesn’t eliminate the biggest risk in the room. Remember, in theory, defined contribution plans are supposed to replace traditional pensions. That means they need to provide predictable income in retirement. Even if you guarantee everyone $1 million when they retire, people still face risk because they need to invest that money and know how much to spend each month before they die.

One way to deal with that risk is to buy a life annuity. But annuity prices vary with interest rates. The higher rates are, the more income you get for a given premium. Depending on interest rates when you retire, you might feast on bologna (buy an annuity today) or fillet (bought an annuity in 1992).

We can get rid of this risk by guaranteeing the annuity rate too. OK, but now all these guarantees are getting super expensive. For example, did you know the state of Nebraska offers a 7.75%(!!!!!!) interest rate for the annuities in its Cash Balance plan? Where do I sign up? It just shows how easy it is to underestimate the costs of what we promise future generations.

You might be thinking that I am not a fan of guaranteed returns. Well, yes. But I am excited we are at least having a conversation about defined contribution risk and how to manage it. It’s a big step in the right direction.

The long-awaited revenge of British manufacturing

I studied lots of economic history as an undergraduate. Back then, I read a series of documents, from the end of the 19th century, that argued the UK economy doomed itself to decline because Brits were “abandoning” manufacturers of the North for the burgeoning financial sector in the City of London.

Some things never change. There’s been a series of odd arguments that the pound’s recent depreciation isn’t so terrible because it will harm the financial sector (evil) and subsidize exports and that will benefit the manufacturing industry (good).

In some ways that makes sense. After all, a cheap currency helped grow manufacturing in China (though it also had cheap labor) and Germany (though they had a fixed exchange rate and unfettered market access with the rest of the EU). Not only does the UK have more expensive labor and uncertain access to the EU market, it also has a floating currency. Many of these arguments seem to assume the UK has a fixed exchange rate now. Did I miss a major post-Brexit economic policy?

Cheaper sterling may indeed prove beneficial for the British economy. But probably not if it represents increased uncertainty about the UK’s economic prospects.

Besides it’s generally not advisable to build an industrial policy (bring back manufacturing!) around a volatile market price. It may feel satisfying to think Brexit will finally resolve the centuries old finance vs. manufacturing rivalry, and anoint manufacturing the winner. But it would probably be more productive to accept it’s not a zero-sum game and wake up to the fact you have a floating exchange rate.

Can you have a run on equity? And other existential questions

The SEC is worried about runs on mutual funds. Last week it released rules that would require funds hold a certain amount of money in liquid assets. Liquid means the assets can be sold within three days. To no surprise, asset managers are pushing back.

It all seems strange to me. I sort of get the concern; but I don’t get the defining liquid as sellable in three days thing. Does that mean sellable in this market? Or does it mean liquid in the extreme market conditions we imagine provoked the run?

Maybe we should just educate investors that equity investment is inherently risky and there’s something called a liquidity premium.

Another referendum to look forward to

Scotland is threatening another referendum on seceding from the UK. Several months ago I explained why seceding is a terrible idea. Scots can’t afford to be independent—qualifying for EU membership would require a level austerity that makes Greek spending cuts look extravagant. Who wants to be a small, poor country in the EU? One Scot I know said it best, “Brexit is terrible for us, but independence would be a disaster.”

Watch this space

The city of Hartford’s bonds were downgraded to junk, and the mayor called it a “sober assessment.” Bless him.

Until next time, Pension Geeks!