Martin Wolf had an article in the FT, published yesterday that began by saying:
He then lamented three things.
The first is that we have too many pension funds.
The second was that these are run with a view to minimal risk by insurance companies and fund managers influenced by them.
So, thirdly, he lamented the fact that UK pension funds hold many more bonds than do those of most countries. He blamed this on regulation.
Based on these arguments (which I think I correctly summarise) he suggested that Jeremy Hunt's plan to ask pension funds to diversify by investing five per cent of their money in the notoriously unreliable venture capital sector was misguided and much more fundamental reform, including the massive consolidation of funds into a few large entities was the answer, before saying:
In essence, it looks as though Martin Wolf and I agree with each other, but we do not.
I have long argued that there is a fundamental pension contract:
This is that one generation, the older one, will through its own efforts create capital assets and infrastructure in both the state and private sectors which the following younger generation can use in the course of their work. In exchange for their subsequent use of these assets for their own benefit that succeeding younger generation will, in effect, meet the income needs of the older generation when they are in retirement. Unless this fundamental compact that underpins all pensions is honoured any pension system will fail.
As I have then argued of private pensions:
This compact is ignored in the existing pension system that does not even recognise that it exists. Our state subsidised saving for pensions makes no link between that activity and the necessary investment in new capital goods, infrastructure, job creation and skills that we need as a country. As a result state subsidy is being given with no return to the state appearing to arise as a consequence, precisely because this is a subsidy for saving which does not generate any new wealth. This is the fundamental economic problem and malaise in our current pension arrangement.
I would argue that pay-as-you-go pensions also fail this test, but at least they recognise one side of the equation correctly, whilst the private pension system fails to do so altogether. Public sector pay-as-you-go pensions recognise that we divert the income of those currently in work through the pension system to the old. By expressing the cost of pensions as an expense of those in work it gets half the equation right. What it does not do is recognise the capital value of the assets those in old age created whilst they were in work. That's what it gets wrong.
What we need to do to get the rest of the pension equation right is to recognise that current pension contributions must be used to create capital value within society to meet the needs of future generations — at the same time as the needs of current pensioners are met from the depletion of the capital stock they left to those currently in work.
This is really not a difficult issue to comprehend: it's a simple investment cycle. And yet we have got this fundamental wrong and for one very simple reason. We confuse saving with investment.
Saving is putting money in the bank.
Or it's buying and speculating in second had shares issued by companies many years ago and now quoted on a stock exchange.
Alternatively, it is dealing in land and second-hand building.
It can also be the financing of speculation which simply seeks a financial return.
All those things are savings activities. That's fine, but for one thing: none of them earn a real economic return. They do not directly, and many of them cannot indirectly, add value to society by creating gainful employment. As such they do not add to the sum of human capital or income. They merely reallocate that income and capital that already exists. And that's not the same thing at all.
So the last thing we need is more saving for pensions. That's a complete mistake. Savings for pensions takes money out of the productive economy and deflates that economy as a consequence. Saving diverts resources from productive activity. It inflates the return to unproductive activity within the financial services sector. It reduces well-being. And saving can, by misallocating resources, reduce income and so reduce our capacity to pay pensions. Those are all things we'd best avoid.
What we want is investment in pensions. Investment is very different from saving. Investment creates new assets, tangible or intangible. We can see, touch, and use some tangible assets in the long term. They include private sector assets such as plant and machinery, offices and IT, transport and agricultural equipment, power plants and recycling equipment. Intangibles can include inventions, copyrights and music. They also include education, training, and social infrastructure. This is spending money for a purpose, to achieve a goal, to increase income and to increase well-being and the support structures in society.
It is an unfortunate fact that the terms investment and savings are terms often used interchangeably. That's wrong. Investment does not need saving to happen, it just needs cash. It's indifferent as to where that cash comes from: it can be from savings and it can be from borrowing or it can be from tax. There is no tie between investment and saving: it's just one can be used for the other, but need not be.
We can afford pensions for the old in this country, now and in the future. But we can't if we save for them without creating a specific link between those savings and new investments. Simply saving removes our chance of meeting the needs of the old.
In that case Martin Wolf is wrong when he demands reforms intended to increase savings without in any way suggesting how these will result in increased real investment in the economy.
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This all reminds me of the Greenspan explanation ..
https://www.youtube.com/watch?v=DNCZHAQnfGU
The following article reveals the failure of the Tory government in that like Japan Britain experienced the worst export record over the last decade in the G7:-
https://www.theguardian.com/business/2023/jul/24/british-manufacturers-share-of-eu-business-falls-despite-global-trade-boom
A consequence of this is the falling value of the pound. Things no doubt will start to look up when the UK is at the same relative level of development as the Chinese at the start of the 1980’s!
I wish to approach this from a slightly different, historical direction. Wolf’s starting point disguises a strange outcome; because the pension industry was largely composed of mutual funds until around 2000. The mutual funds were generally run exclusively for the long term by actuaries who were not paid large bonuses for taking a short-term market view of investment. The transformation made private pensions a mere profit opportunity for the corporate financial sector; driven by short-termism.
Spool forward to the present consequences of this short-termist approach,
Sarah Breedon, Executive Director for Financial Stability Strategy and Risk and a member of the Financial Policy Committee (FPC – macroprudential authority) gave a speech titled ‘Risks from leverage: how did a small corner of the pensions industry threaten financial stability?’ (November, 2022 BoE website). The Liability Driven Investment (LDI) crisis, that threatened to destabilise the gilt market, Breedon argues was caused originally by the fact that many pension funds are running deficits (assets insufficient to cover all future liabilities; a timing, issue but with potentially adverse consequences). Pension funds hedge in long term bonds, but at the same time “they invest in ‘growth assets’, such as equities, to get extra return to grow the value of their assets … …. using leveraged gilt funds to allow schemes both to maintain material hedges and to invest in growth assets. Of course that leverage needs to be well managed.” The last sentence is crucial.
I will not rehearse the crisis (a rise of 130 basis points in 30 year nominal yields in September, 2022). £200Bn of pooled LDI pension funds “threatened the £1.4Trn gilt market”. It led to the underlying, implicit risks exposed by leverage (the clue is in the name – LDI) accelerating to the point the in-built buffers were quickly overwhelmed and crisis ensues. This pattern has a long history in the financial sector. “Management is crucial”, and it was wanting.
In Breedon’s words “what happened to LDI funds is just the latest example of poorly managed non-bank leverage throwing a large rock into the pool of financial stability. From Long Term Capital Management in 1998; to the 2007 run on the repo market; to hedge fund behaviour in the 2020 dash for cash; and the failure of Archegos in 2021.
These episodes highlight the need to take into account the potential amplifying effect of poorly managed leverage, and to pay attention to non-banks’ behaviours which, particularly when aggregated, could lead to the emergence of systemic risk.”
Breedon describes the solution to the crisis poivided by the BoE and subsequently, and points to the need for better management: “The onus for building resilience in the non-bank system sits first and foremost with the firms themselves.
If firms use leverage, they must be able to manage the liquidity consequences of their risk exposures. As part of this, they need to learn from the decades of experience that show how leverage and liquidity risk creates rollover risks; volatility; operational challenges in accessing liquidity; and exposures to amplification mechanisms from the wider system.”
Breedon observes that in responding to the crisis Regulators worked with LDI funds and BoE to ensure a more robust system to withstand stress. suggesting LDI funds raised over £40 billion in funds and made over £30 billion of gilt sales in order to lower leverage. The question arises, why did it require a crisis to raise the £40Bn. Returning to my opening I wonder whether a mutual fund system, run by actuaries, and without any short-termism would have hazarded higher leverage investment without more funds, and better stress management. The milited liability philosphy carries a fundamentally different attitude to risk management , and attracts a different kind of (less risk adverse individual). This in the end is not about the mathematics, it is about people and risk.
Short-term profit and long term investment are not natural bedfellows.
Your conclusion is correct
Thanks
Richard,
I have previously mentioned the idea of a National Earnings Related pension scheme.
But the one thing we don’t seem to talk about is the interests of the pensioners.
Does the current system meet their needs?
I suggest not, look at how much is taken out in Commissions, management Charges – the latter are much higher than in a lot of Europe, and, of course in the last few months many people due to retire have seen the value of their ‘Safety First’ bind funds decimated by interest rate rises.
So some sort of ‘National Pension Fund’ either investing in the UK or an unfunded scheme lomks very attractive for all but the richest and of course the fund managers
I suseoct the fund managers would stiull fund ways to win.
John,
I think NEST pensions have an approach to investing in renewable infrastructure and have clear information on fees. It was set-up by the government and is a public corporation accountable to parliament. This is an approach that has been successful in places such as Norway. btw I have no connection to it.
https://www.nestpensions.org.uk/schemeweb/nest/investing-your-pension/how-nest-invests/investment-approach-benefits.html
https://www.nestpensions.org.uk/schemeweb/nest/nestcorporation/how-nest-is-run.html
Great points, Richard.
It makes me think of fiduciary duty of pension funds. Is it to fill the pockets of pensioners by speculating on the market or is that duty deeper? Like that when I retire there will be a retire-able world to retire into? Like the money will go invested into that retire-able world?
Most economists I have met, including those in investment, have a hard time envisioning an investment in a retire-able, sustainable world that also gives a massive return.
Let’s say there is a town separated by a river. A pension fund builds the bridge. The bridge brings prosperity to the area, better communication, jobs, etc. And that means the value of the property either side of the bridge goes up.
However, barring putting up toll booths on the bridge, there is no way for the fund to monetise not only the crossing, but the added value to society it has brought all stakeholders.
We need to envisage a green new pension infrastructure deal, where investment (that lasts more than a generation) in e.g, infrastructure, energy, productive agriculture (orchards, nut trees lining every road) will find a way to be monetarised with a fair bit going to pension funds.
Some heavy lifting thinking-wise is needed
Agreed
Richard, how, in practice, can pension funds invest in infrastructure? Where would the payback come from?
Rents
Shared invetsment returns
Govermment making a payment akin to bond interest
Thanks.