Allison's Ode to the Second Moment


Welcome to the 56th issue of Allison’s Ode the Second Moment, a newsletter that wants everyone to take more risk—as long as it is diversified and then hedged or insured.

Generation risk-averse

The 10th anniversary of the financial crisis was a time for reflection on what has changed and what has not. Most of the conversations centered around the financial health of banks, regulation, and household finances. But I think something way more profound has changed.

The Great Depression made a generation more risk averse. Children of the Depression remained wary of the stock market their entire lives. Luckily for them, risk aversion worked out. Their prime working years featured large, unionized companies that offered job security and generous benefits. If they showed up and did what they were told, the economy thrived and they were rewarded.

Today, young Millennials and Gen Z appear to be more risk averse than previous generations. They own less stock, are less likely to be self-employed, and make risk-averse human capital investments by studying sensible things in college like actuarial science.

I worry their risk fear may leave more lasting scars on the economy than anything in Dodd-Frank. A more global, tech-driven economy does not favor the timid. A less entrepreneurial economy is also less dynamic and innovative. And owning less stock means less wealth accumulation.

It is not clear you can change your risk preferences after they are formed. But who knows? Perhaps the same technology that demands more risk-taking will also offer new ways to hedge and insure risk and that will embolden even risk-averse people to go for more.

Story about public pensions and infrastructure

Josh Rauh has a great paper out on public pension funds and infrastructure investments. It seems everyone agrees we need to do something about “crumbling” infrastructure and are looking to the federal government. But most infrastructure spending occurs at the state and local levels.

Many states and municipalities don’t have the money. They are reluctant to raise taxes and they are already stretched to the limit financing all of their pension obligations. It always seems to come down to pensions, right?

It is tempting to find a solution there, too. Pension funds have lots of money, so why not use it to finance infrastructure? It seems so obvious even New York Mayor DeBlasio thinks it is a great idea.

But Josh Rauh and his coauthors have found public pension funds aren’t so great at picking infrastructure projects that pay off. Funds of infrastructure projects typically offer a similar return as private equity, but not pension fund investors. Their internal rate for return on infrastructure funds is about 1.3 percentage points lower than what other institutional investors earn.

These are funds made up of different projects. They are not even subject to political capture. So investing directly in local projects is not expected to do much better and is a bad risk strategy. The projects may generate less revenue when the tax base is struggling.

Sometimes there is a free lunch for investing in infrastructure, but not for public pension funds. We still need to make hard choices.

Low rates aren’t a free lunch either

When I studied monetary policy in graduate school, I was told all policy choices pose costs and benefits and create winners and losers. This was not a controversial argument back then, but now it is.

It is popular to argue that everything about low interest rates is wonderful. They raise employment (they can even fix structural unemployment!), wages, keep the yield curve steep, and will never, ever cause inflation—for the rest of civilization.

Even if all of this is true, there is one big cost to low interest rates: It makes risk hedging a lot more expensive. The price of safety is higher, and the risk-free interest rate is the foundation of any risk strategy.

So not surprisingly, universal life insurance premiums have become very expensive. This is not just about rich people or Chinese sovereign wealth; it is hitting retirees struggling to get by. When they bought the policies 20 or 30 years ago, such low rates for so long was unthinkable. Now the burden is borne by policyholders.

Now low rates, especially on the long end of the curve, are not all the result of monetary policy. But this low-rate religion and, worse, the belief that rates will stay low forever so we needn't to worry about debt should concern us. The life insurance example shows how unpredictable rates are; it is a risky bet when you have a long term obligation to finance.

Because anything can happen

Who knows, maybe rates will go up and insurance premiums will go down. Relationships and correlations change. All this uncertainty is one reason why financing retirement is so hard.

I am not sure why the 4% rule caught on. This is the idea you spend 4% of your asset balance at or during retirement. Well, no I do. It is simple and easy, and we all want a simple solution we can put on a notecard to solve complex risk problems. But the 4% rule means retirement income varies with markets. This is a terrible idea. Imagine your income depending on the stock market and bearing all that uncertainty in your most vulnerable years.

The Wall Street Journal says the 4% rule should just be the foundation of a retirement plan. I think the opposite. The foundation of a spending plan needs to be predictable income. Then you can add on a 4%-income-varying-type plan on top of that foundation.

Oh, and for goodness sake, a cash buffer does not hedge rate and market risks in retirement. What about inflation? Never mind the duration mismatch. “Retirement experts” really need to do better.

Some other interesting things

Until next time, Pension Geeks!