I have been arguing for well over a decade that pension funds should be focussing their investment efforts on long term bonds issued by local authorities, government and related organisations who use the capital entrusted to them to invest in long term infrastructure such as housing, transport, hospitals, schools and so on.
My logic has been twofold. The first is that there is a real, but unwritten, inter-generational contract regarding pensions as a result of which one generation agrees to leave enough real capital for use by the next generation in exchange for that next generation giving up part of its income to maintain those in retirement. Capital in this sense is real, tangible stuff that the next generation can use that means they can afford to give up current income to maintain the elderly - because that is exactly what we ask them to do via the pensions system.
We've forgotten this and so instead invest pension funds in what are largely intangible assets. Intangible assets are, as it says on the tin, by definition not real. That's because they represent the current value of the excess price that can be charged to future consumers as a result of the legally enforced premium that can be charged to them for the value of current inventions. In other words, intangible assets only have value because they represent the exploitation of future consumers.
The trouble is, those future consumers are the very people who those about to retire want to forego income to keep them in old age. So investing in intangible rather than tangible assets represents a double whammy on the young who need to support the next generation: we do not leave them the real capital they need if they are to forego income to keep us in old age and we also seek to reduce their future income by charging excess prices for the benefit of past economic activity, all at the same time. That's a recipe for pension disaster.
But there's a second reason why this is also guaranteed to fail. As the FT noted yesterday, stock markets are dire at picking out which investments to pick. Just over 10% of all active stock market managers beat the market in 2014 in the USA. Randomly you would expect half to do so. That has not happened since 2009. And that's before paying for the costs of these managers who get their judgement on which intangible assets to invest in (because that's what most company shares represent) so spectacularly wrong.
What is more, of the best 25% of fund managers in 2010 almost none remained in the top 25% in 2014. So getting this selection right once is no guarantee at all of doing it again.
In that case investing in intangible assets makes no sense at all for pension purposes.
But requiring pension funds to invest 25% of all their contributions in infrastructure that creates new jobs in exchange for the tax relief they get would not just be good for the economy - which would be beyond dispute as it would give a £20 billion boost each year - but would also be fantastic for the stability of pension fund returns whilst seriously cutting the costs of pension fund management. And it would also respect that fundamental pension contract between generations.
But the City will fight it tooth and nail. Which is why, no doubt, such a radical, and essential, pension reform is not on the political agenda right now. Feeding the myth of the City is more important, of course.
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I’d describe that last as feeding the maw of the City myself!
“stock markets are dire at picking out which investments to pick. Just over 10% of all active stock market managers beat the market in 2014 in the USA”
This makes no sense. It is exactly like saying “football matches are no guide to which team is best. Pundits didn’t predict Chelsea would be top of the league…”
Stock markets can and do identify winners. They are the league table. Fund managers are less good at doing so: they are the pundits. However, and this is interesting, the more “efficient” the market, the worse fund managers do. Hence it is not difficult to find an emerging markets manager who beats the index, is fairly easy to find a UK or global one that does (Woodford, Barnett, Train and Smith spring to mind), but in the US, nobody beats a tracker.
It had to happen: the efficient market hypothesis rears its ugly head
You’re totally ignoring his point Richard. If a market *is* good at picking winners, then a lower proportion of active managers will outperform the index.
A market where a significant number of active managers beat the benchmark is, by definition, one which has inefficiency which better-informed managers are taking advantage of.
As to your suggestion that 25% of pension fund AUM should be in infrastructure, that would simply serve to impoverish future generations of pensioners. It would, certainly be ‘fantastic for the stability of pension fund returns’ – they’d be stable, and low. I’m not quite sure why you think such a strategy would reduce pension fund costs? Infrastructure strategies are pretty expensive to run, when compared with core Bond / Equity products.
There is no proof stock markets can fund pensions
Tax relief does at present
Infrastructure would give good returns and almost no trading cost
And the rest is in the links
They are efficient in the sense that they are subject to a vast amount of research, and so as a result it is widely accepted that outperforming the US market is almost impossible to do, as the share prices represent the consensus of a large number of people who have researched the companies concerned. There will be thousands of people who do nothing other than pore over the accounts of Apple, Microsoft etc to see what can be gleaned about the future, and as a result, the chances of either company surprising significantly in the future is reduced. Whereas in the UK there are FTSE 100 companies that have only 2 or 3 analysts covering them in detail, and so the chances of them surprising the market consensus is much higher.
That is simply a statement of fact. I don’t disagree with your basic proposition that most fund managers underperform the market by an amount that is (roughly, over the long term) equivalent to their charges. I was merely explaining why this is particularly the case in the US and less so in other markets.
The fund managers do the research
No one else does
And they under perform
Shoots your hypothesis, doesn’t it?
‘Stock Markets identify winners’ – they are a league table that’s right, but they don’t predict winners just tabulate them – so the idea that the market is efficient or ‘wins’ in any way is a false implication. I’m not an expert – am I close?
Very close
I find it hard to believe that people so unquestionably talk of the so called ‘wisdom of markets'(efficient markets hypothesis). I mean come on people – that model is well and truly broken now!!
Have some of these people never heard of ‘bubbles’ – a phenomenon which sees assets rise above their true value and then contract rapidly? OK, there have not been many of them but no-one can argue that they have not caused significant harm in the global economy when they have occurred. Can we remember the South Sea bubble? The Tulip bubble? The recent internet bubble? The even more recent CDO/sub-prime bubble (toxic/sub-prime loans)?
Historically some of this is created by the irrational (er…greedy) behaviour of investors – not wisdom – or, they are created by powerful individuals or companies – perhaps some sort of perverted wisdom/rationality is going on here. It seems all too often that the latter leads the former!
OK, some market apologists will say that the contraction in bubbles itself is wisdom making its presence felt – but at what cost? How many people have to have their lives destroyed before wisdom gains ground? Before the market corrects itself (if markets are wise, why do they need to ‘correct’ at all)?
In the case of the CDO’s I understand that the issue was not any prevailing wisdom that halted things but the fact that too many people (who should never have had mortgages) could not afford their home loans and simply walked away from their mortgage debt in which they had no stake when they ran into trouble. If no-one is going to pay off the debt, then to the person who buys the debt, the CDO can no longer be an investment can it, because no money is coming in? This left holders of the CDOs (made up of mortgages – sub-prime mixed in with viable lending) exposed and then panic set in the system and we know what happened next. Note that I said ‘panic’ – not wisdom.
So this was ‘wisdom’ at work was it? This was ‘efficiency’? All these bubbles did was to transfer millions into the financial sector. It didn’t make any new money; it just moved it around to people who already had more than enough.
Again I ask, where was the wisdom? Not in the researchers of ratings agencies; not in the regulators; not in the risk managers (some of whom were told to shut up) of companies trading CDO’s because they were so keen on making money they had no wisdom to ask for more information – to look in the tranches of CDO’s in detail and see how many of them were well below investment grade investments. Or to look at what is now defined as predatory lending that that the FBI had been investigating before 9/11. This is because rather than wisdom, there was the ‘herding mentality’ (think sheep) rather than any ‘wisdom’. So rather than a bull or bear market, what we had was a sheep market. Did you hear that: a sheep market.
The only wisdom I saw was a twisted version where apparently a well known ‘investement bank’ sold CDOs and at the same time insured them if they did not pay out and earnt millions from the failure of these investments in the process. Clever if you are a greedy neo-lib; ethically and morally without redemption if you are a normal person.
And then market proponents turn up on this blog about pension investment extolling the virtues of markets!!! I ask you – what planet are some of you on? Make the most of it whilst you can.
Everyday more and more people are working out that ‘markets’ – left to their own devices – do not work for them. And that ‘markets’ are a source of their problems – not the answer.
The captialism I aspire to is one that ‘creates the most social utility
for the greatest amount of people’. The version of captialism we have now creates the most social utility for the few, thus sowing the seeds of its destruction. Think about it.
The issue of the intergenerational contract is critical. It is not all about generating income to pay pensions. For that pension capital might be best off invested overseas, but that leaves the next domestic generation in danger of being under capitalised. These are the pensioners children and grand children, the ones who are also there to look out for their elderly relatives. If they are struggling in their lives with low paid work, poor housing and a lack of opportunities, how can they be expected to share their limited income with an elder generation? Maybe one day we will live in a world governed by equitable global institutions, but until then, pension investments need to remain local and long term.
Agreed
Richard
I get your point about this but please be so kind as to accept a caveat ot two about pension fund investment which I have raised before on your excellent blog.
There is evidence to suggest that pension funds that have invested in tangible things (manufacture of goods & services) are themselves some of the biggest drivers of lower wages and poor conditions for employees. This may be a by-product of the legal requirement placed on pension fund managers to keep the pension fund viable – by searching for the highest return possible to maintain the value of the pension (money devalues over time apparently). I think that the phenomenon was known as ‘shareholdere value’ – and look online to see what it made Jack Welch of GEC do.
So, if we say that pension funds did fund some of the projects above – what would be the wages of the employees, their contracts or conditions? How much would the companies doing the work manage to get out of say using green energy or materials because it eats into the bottom line? What would the health and safety record be of such companies carrying out these investment projects? I’d have to be assured that wages and conditions would be reasonable and fair, as these factors are usually ripe for cost cutting measures to ensure an expected rate of return. This leads to the perversity of retired people effectively supressing the wages of working people in order to maintain the value of their pensions.
Some of this is not really related to the pensions funds themselves but of course is related to how the markets ‘work’ (I use that term lightly). Shareholding is now fast and furious with the expectation of higher returns over shorter stock holding periods. Those stock brokers who got out of stocks and into bond markets are even now trying to turn bonds into shares!! The culture of short-termism is entrenched in the financial sector and the need for the brokers to get a cut of the cut so to speak.
Anyhow, the point is that I feel that there should be a root and branch review of how the stock market works before we attempt to direct pensions into the projects you suggest. I think that I recall economists like Steve Keen suggesting longer lock-in periods for shareholders as a means to bring more stability into the stock holding process for example. No doubt if the City is involved, there will be fat charges up front too for arranging such investment.
The lack of city regulation continues to worry me. Funnelling that money through the City of London is almost like watching a herd of prime wilde beast crossing a crocodile infested river. If there was some way for the pension funds to connect with areas of investment without going through the City, then that would be better IMHO.
The current architecture for financial investment needs to be recast. Quite a bit.
In the post crash documentary The Flaw, there is an excellent dissection of the efficient markets hypothesis that should be made into a public information film. Worth watching.
I’m knocking off for Christmas now, but I’d like to thank you for your work and most of all the energy and passion you bring to these issues which gives me and many others hope for a better world.
Mark
Mark
I agree other reforms are needed
I think they are capable of being pursued independently and not sequentially
Have a good Christmas
Richard
Richard. You couldn’t be more wrong. Lots of people do research who aren’t ‘the fund managers’ – e.g. the huge universe of sell-side equity analysts. It really might be worth spending a little more time educating yourself as to how investment managers / equity markets actually function (I have a briefing paper we have our new hires read, which I’d be happy to send to you).
Oh come on: please get real
These sell side analysts only exist to target fund managers
And candidly sell side is hard to call research
“Shareholding is now fast and furious with the expectation of higher returns over shorter stock holding periods.”
This is disingenuous. The truth is more complex. It is true that there are a relatively small number of funds that trade in unbelievable volumes over tiny timescales. It is also true that, despite the best efforts of the fund management industry to conceal this, it is increasingly accepted that the best returns come not from trading but from buying and holding. I don’t want to sound like an advert for Nick Train and Terry Smith, but their funds demonstrate that buying the right companies at the start, holding and minimising the costs of trading is the way to make long term gains.
Terry Smith is a great source of quotes by the way: he once said he would only buy a company if it was straightforward enough to be run by an idiot, because sooner or later, they all are.
We are in a period of depressed returns – most investors, and I speak to lots of them – are targeting returns of 6-8% pa. There are a few get rich quick merchants but they never do get rich and they soon end up leaving the market. I do not know anyone who expects high returns over a short period. Those people were around during the dotcom boom and the boom in junior oilers, but not any more.
Disingenuous?
I can assure you that I am being sincere and I am not pretending to know less, and neither are economists who advocate longer stockholding periods either. They and I are looking at the tangible negative outcomes of ‘shareholder value’ – something that even Jack Welch suggests has come to an end. We might have – but we and the communities we live in are still living with the consequences.
If the best returns are given by hanging on to stock longer and the finance industry is good at hiding this fact, then why accuse me of being disingenuous when the ‘d’ word obviously should be directed at the ‘industry’ you seem to be defending.
It might be that some of these investment fund managers are very good – fair enough – they actually turn up from time to time to soberly explain where things went wrong but come on Roger……………..how many bad apples have there been in finance since the BCCI crisis? Barings? What about day trading on internet stocks – more chaos? Are you going to tell me it did not happen? And what happened in the USA with the Savings and Loan industry after Reagan started to deregulate even earlier.
So for every good apple, there seems to be too many bad ones in finance who think they know what they are doing and want to get on the band wagon.
As for the poor rates the people you know are getting now, have you or they ever thought that its because they and their kind stripped out so much value from people who actually make things or deliver services that – as Jack Welch has said – there is just no more to strip out? I think so.
So now, there will be sector rotation and my guess is that bonds (even Government ones) will be vulnerable to some very dodgy practices by the financial sector and I believe some pundits have been asking questions about the rates rises on these for example ealier this year suggesting that they were being manipulated in a way not seen before. I mean look at the facts Roger: the same sector rotation happened with stock traders moving into the long-term mortgage industry and look what they did to that with CDOs (see my contribution above).
‘A few get rich quick merchants’ you say? The finance sector is full of ’em Roger and you know it. They are an ever-present problem and to pretend otherwise as you do is not just disingenuous but also plain wrong.
Going-Going: “The Bond Bubble’s Risk Hits an Unbelievable $555 TRILLION in Size”
http://www.zerohedge.com/news/2014-12-22/bond-bubbles-risk-hits-unbelievable-555-trillion-size
Trying to stop the dam breaking by allowing more water in the reservoir: what could go wrong?
Derivatives are not bonds
Government bonds and corporate bonds are not the same
The risk is mispricing is rates rise
Is that priced in? I do not know for sure?
Is there risk? Sure as heck
But I think that note overstates it
But let’s not be under any illusion about the risk rising rates create – it is enormous
“Reading all of this is no doubt concerning. However, the situation becomes much worse when you consider that over 81% of ALL derivatives trades are based on interest rates (BONDS)”
Then you have to consider that the UK, via the City, is over-represented in derivatives. Derivatives also comprise bonds via the associated credit default swaps, collateralised debt obligations etc…
Of course, none of it will matter when the financial equivalent of musical chairs stops, and everyone realises that there are no chairs anymore.
All dressed-up, nowhere to go, nothing to pay with and nothing to buy.
I think I grasp all that
But it’s rate rises will trigger it
New jobs for whom if there is EU free movement of labour and Mode 4 provision in all the EU’s trade agreements (workers brought in from outside of the EU as part of ‘trade’)?
This needs facing up to if ‘jobs’ are going to be invoked.
A big infrastructure project that was supposed to be about ‘jobs’ was the Olympics – but while the price trebled, very few UK workers could get onto the site, and in fact were systematically excluded.
That’s why we need an adult conversation on this aspect if the ‘jobs’ rationale is going to be used.
I have tried it Linda
Wow, the back lash is harsh
http://www.dailymail.co.uk/news/article-2885843/Paramedics-recruited-Poland-Ambulance-bosses-forced-look-abroad-amid-nationwide-shortage-3-000-staff.html
Nationwide management incompetence. Lack of interest in funding the training. Another sad tale of all-too-familiar inability of management to run a business.
Well someone has to have the guts to do it.