Welcome to the seventh edition of Allison’s Ode to the Second Moment, a newsletter that dares to acknowledge that we may not know the future---but we can guess it will fall within a range of possible outcomes.
There are only two things for certain in a post-Brexit world
We’ll have to listen to friends and acquaintances share their non-legal interpretations of Article 50
The world is a riskier place.
Because we really don’t know what this will mean. Some are certain there will be a smooth transition to a thriving Britain free from the tyranny of inept Brussels bureaucrats. Others are convinced Britain (or possibly just England and Wales) will retreat into near autarky and the British economy will collapse.
I’d guess these are both tail events. The actual outcome will lie somewhere in-between, creating confusion and uncertainty in the mean time. We can count on more volatility, which makes investing harder and the price of safety more dear. That’s terrible news for retiring baby boomers. Unless you are that rare, clever person who can beat the market, more risk makes you worse off.
Speaking of investing in volatile markets
Now no one loves index funds more than I do. I used to work at DFA for goodness sake. I participated in jamborees celebrating the virtues of passive investing. But I think some are overselling the benefits of index funds. Last week satirist John Oliver repeated the new conventional wisdom: investing for retirement isn’t that “complicated.” Just invest in a portfolio of index funds that gradually moves from equities to bonds as you approach retirement. That is great advice if you never retire and spend your money.
For most people, saving for retirement requires solving the classic financial problem of turning a stream of income today into a stream of income in the future. Even a basic understanding of finance tells you a target date index fund isn’t sufficient to achieve that goal. It can build wealth, but it is lousy at turning wealth into income income when you need to spend. And that is the whole point. To any one who thinks it is so easy I ask you, why did so many defined benefit plans fail at it?
Now I received a lot of hate email for taking this view. I worry about how unprepared people are for retirement, mentally and financially. We’ve hard-wired most people to think about wealth and therefore leave them hanging when they retire and must solve the hardest part of the problem.
Incidentally, the last time I got so much hate mail was when I wrote about the fallacy of time diversification. It makes me wonder if the retail finance industry is pushing ideas (now widely accepted) that lack an intellectual foundation.
Pension Geeks, we’ve got a lot more work to do.
More interesting news from the UK
It was overshadowed by Brexit last week, but there’s been an interesting discussion in the UK on the British Steel pension plan. Tata UK Steel has a defined benefit plan short £700 million. The Indian conglomerate that owns UK Steel hopes to sell it (though all bets are off with Brexit). The sale may be necessary to save the company and 11,500 jobs. No one will buy it if they must absorb the underfunded pension.
There is a radical proposal discussed here by the Department of Work and Pensions (note to casual Pension Geeks: please bear with me as I get a little technical—I promise this is important). It involves cutting benefits by changing the inflation measure used to make cost-of-living adjustments from the RPI index to CPI. CPI normally grows slower because it doesn’t include housing costs (which seniors consume) and it assumes people alter their consumption when prices increase. The plan is sold as the least bad alternative. Or it's better than the benefit cuts if the pension were taken over by the Pension Protection Fund (the British equivalent of the PBGC). Yet, some are opposed because it sets a precedent where you can cut benefits promised to pensioners. But this may be a sad reality if the money is just not there.
This is important because it is just the start. The world is full of underfunded pensions and everyone is looking for a way to cut benefits. Changing how benefits increase with inflation is the most likely target because inflation has been low for a long time and the reductions occur far into the future. We already see the idea catching on.
Many Dutch pensions base cost-of-living increases on asset performance
so does the state of Wisconsin (they can even claw back old COLAs!!)
It offers a legal loophole to cut benefits in state and local plans in the United States
President Obama, at one point, supported a lower indexation rate to cut Social Security
I see the temptation. Inflation has been low for so long, people will barely notice the benefit cut. They would freak out if you cut benefits 5%, an inflation index cut isn’t so obvious. But still, I’d take a flat haircut. If inflation does pick up one day, retirees are exposed to more risk. People pay to avoid risk, isn’t a flat haircut a better choice?
Like most economists I idealize the most efficient outcome, not what’s politically possible….
And speaking of what’s possible, but never happens
The new Social Security Trustees report just came out. Not much new. 2034 is still the year full benefits can’t be paid from pay-roll tax revenues and the trust fund runs out. People can claim this isn’t big deal and we can wait until 2034 before taking action. It is true things might work out. There’s a chance the 2020s will bring unprecedented, high productivity growth or people may die earlier than we expect. But those are tail cases. Waiting probably means larger benefit cuts and tax increases than if we fix the problem now. We say that every year and no one listens.
Until next time, Pension Geeks!