Monday, February 22, 2016

A Conversation on Pensions and Inequality

A couple of weeks ago I had a conversation with Gordon T. Long of the Financial Repression Authority on how financialization is causing inequality and limiting aggregate demand growth:
In this 45 minute video interview Leo Kolivakis discusses the importance of a good pension system with strong governance being critical in insuring the average persons retirement security. Pension liabilities are going up while bond yields are going lower which is going to create a huge amount of stress on pensions!

Contributory Pensions and 401Ks have proven to be a failure compared to Defined Benefits programs. History will eventually show that the transition from Defined Benefits to Contributory Benefits was in fact is detrimental to the global economy.

Structural Issues

Leo Kolivakis believes we have entered a period of long deflation due to six major structural issues:
  • The global jobs crisis
  • Aging demographics
  • The global pension crisis
  • Rising inequality
  • Technological Advances
  • High and unsustainable debt all over the world
Each of these structural factors is significantly contributing to global deflation. Together they are a domino effect, exacerbating deflationary headwinds in the world. They are causing rates to remain ultra low and will continue to for years to come.
I embedded our conversation below and thank Gordon Long for giving me another opportunity to discuss pensions, rising inequality and how it's impacting aggregate demand.

Let me give you a little background on all this. For years, I've been arguing to prepare for global deflation. I still see a deflation tsunami coming our way but there is a huge battle going on as central banks desperately try to fight it off.

Right now, central banks are the only game in town and this is why we're seeing negative interest rate policies springing up all over the world, all part of the new negative normal. Again, central banks are desperately trying to stoke inflation expectations to thwart deflation because once it becomes entrenched, it will be here for a very long period.

Negative bond yields and ultra low bond yields for years present serious challenges to individuals trying to retire on a fixed income and pensions trying to make their actuarial target rate of return. In effect, people will need to work longer to be able to retire and pensions will need to take increasingly more risk in private markets and hedge funds to make their bogey.

For individuals, I expect to see a rise in pension poverty. The brutal truth on defined-contribution plans is they're simply not working and the inexorable global shift to DC plans will condemn millions to pension poverty, placing huge pressure on governments as social welfare costs soar.

In fact, this is already happening. New research from the Brooking's Institute's Barry Bosworth, Gary Burtless, and Kan Zhang finds evidence that some of Social Security’s progressivity is being offset due to a growing gap in life expectancy between the rich and the poor. Rising inequality among retired Americans is already impacting the United States of pension poverty where most Americans have little to no retirement savings and the great 401(k) experiment has failed them miserably.

In response, some private equity titans have peddled a solution to America's retirement crisis which will effectively allow them to garner more assets so they can continue making off like bandits on fees. This is all part of America's pension justice.

For its part, Congress is enabling the quiet screwing of America which is why we're now seeing thousands of active and retired union workers at the Central States Pension Fund at risk of losing half their pension benefits.

Meanwhile, many state pensions are also at risk. Moody’s released some interesting data last month regarding the adjusted net pension liabilities of U.S. states. Bloomberg then spun that data into the chart below (click on image; h/t Pension 360):

Worse still, far too many states are delusional and still holding on to their pension rate-of return fantasy. I fear the worst for state pensions as global deflation sets in, decimating them and forcing them to come to grips with the fact that 8% will turn out to be more like 0% or lower in coming decade(s).

In her latest comment attacking CalPERS, Yves Smith of the naked capitalism blog notes:
This is just scary.

As those of you who follow the CalPERS soap opera may recall, California Governor Jerry Brown pushed for the giant pension fund CalPERS to lower its assumed investment return from 7.5% to 6.5%. Given that the world is headed towards deflation and that CalPERS earned only 2.4% for the fiscal year ended June 30, 2015, Brown’s request seemed entirely reasonable. Instead, the board approved a staff proposal to move to the 6.5% target over 10 years.

One of the things that is perverse about pension accounting is that the convention is that the liabilities, that is, what the pension fund expects to pay out over time, are discounted at the same rate as the assumed returns. However, for a government pension plan, where taxpayers are on the hook for any shortfalls, the risk of CalPERS beneficiaries getting their money is not the risk measured in terms of what CalPERS projects in terms of future employee contributions, expected returns, and expected payouts; it’s ultimately California state risk, which means the liabilities should be discounted at California’s long term borrowing rate. With California rated S&P AA3, Moody’s Aa-, and 20 year AA muni yields 2.75% and A at 3%, no matter how you look at it, the discount rate on the liability side is indefensibly high.

This matters on the estimation of liabilities because the lower the discount rate, the larger the amount (in current terms) that has to be paid out. Remember, this is the mirror image of “inflation can help bail out underwater borrowers” scenario. High discount rates erode the value of future commitments; low ones increase them. This is why we have been warning that ZIP and QE, which explicitly sets out to lower long-term interest rates, is a death sentence to long-term investors like life insurers and pension funds. And investors like CalPERS are trying to finesse that problem by continuing to pretend that they can earn a higher rate of return than is attainable without taking batshit crazy risks.

But even worse is the incomprehension about what is going on, as reflected in a statement by the president of CalPERS’ board, Robert Feckner. From the CalPERS website, State of the System 2016: Our Progress Toward a Sustainable Pension Fund:
The fact that our members are living longer is a sobering reminder that we have a growing obligation to provide for their pensions. Just a decade ago the ratio of active workers to retirees was over 2 to 1. That ratio is now 1.3 workers to every retiree, and we pay out more in benefits than we receive in contributions.

In response, our Board approved a policy designed to reduce the discount rate, our 7.5 percent assumed rate of return on investments, over time. The result will help pay down the pension fund’s unfunded liability and reduce risk and volatility in the fund.
Huh? This is utterly backwards. What will reduce CalPERS’ unfunded liability is higher contributions or higher earnings. A lower discount rate, while a reflection of current reality, exposes that it will be harder, not easier, to meet this objective.

The worst is that given the level of finance acumen I’ve seen after watching hours of Investment Committee hearings is that the odds are high that this is not an obfuscation misfire but evidence of an utter lack of understanding of finance basics. And worse is that CalPERS staff, which had to have reviewed this text, didn’t see fit to correct this glaring error. Do they also not get it or did they assume that beneficiaries were too clueless to catch it?
At the local and municipal level, the problems are even worse. The Financial Times just published an article on Philadelphia’s $5.7 billion ‘quiet crisis’ and these problems are going on all over U.S. where city, local and municipal pensions have been mismanaged for decades.

The central problem at U.S. public pensions remains governance, or more precisely, lack of proper governance. I wrote a comment for the New York Times back in 2013 discussing the need for independent, qualified investment boards that operate at arms-length from the government.

Instead, you have way too much political interference, and a bunch of underpaid public pension fund managers that are outsourcing investments to external asset managers, including hedge funds getting crushed and private equity funds that are way past their golden age.

[Interestingly, Bloomberg reports that two years after buying it, Carlyle Group LP will shut down its hedge fund-of-funds manager, Diversified Global Asset Management or DGAM of Toronto.]

And even though there are efforts to reduce fees of hedge funds and private equity funds, the sad truth is that quantitative easing, ultra low rates, negative rates and more volatility in public markets will force public pensions to increase their allocations to these alternative investment funds that have become nothing more than glorified asset gathers.

This is all part of the financialization of our economies. In my discussion with Gordon below, I recommend a book I'm currently reading by FT columnist and British economist John Kay, Other People's Money. You can read the introduction here.

The two other books I just ordered on financialization of the economy are Michael Hudson's, Killing the Host: How Financial Parasites and Debt Bondage Destroy the Global Economy (all of Michael's books are must reads) and Gretta Krippner's Capitalizing on Crisis: The Political Origins of the Rise of Finance.

But there is something else out there that a lot of authors examining inequality are not particularly aware of. Public pensions taking increasing risks in alternative asset classes are enriching a new class of hedge fund and private equity billionaires which then use their extraordinary wealth to fund Super PACs against progressive candidates like Bernie Sanders (Bernie should rework Bill Clinton's old campaign slogan and turn it into "It's about inequality, stupid").  

Rising and perverse inequality is a huge problem and it's deflationary. In his recent TED talk, Capitalism Will Eat Democracy, Greece's now defunct former Minister of Finance Yanis Varoufakis talks about the twin peaks: the global glut of savings from billionaires and corporations hoarding cash and the debt crises that many nations face. 

In effect, he's right, this mismatch is one reason why the structural unemployment rate of many developed nations remains stubbornly high. This is part of the global jobs crisis and pension crisis which is related to rising inequality. Of course, Varoufakis and Tsipras lacked the courage to implement real and much needed reforms in Greece which is why that country remains a basket case (after Brexit, Grexit will resurface this summer or later this year).

So what are the solutions to this? I talk about some solutions with Gordon, including bolstering well-governed defined-benefit plans, enhancing Social Security and modelling after the Canada Pension Plan Investment Board, introducing risk sharing in state plans, amalgamating local and municipal plans at the state level. I forgot to mention that we basically need to go Dutch on pensions all around the world.

I continue to defend well-governed defined-benefit plans and believe they are part of the solution to addressing rising inequality which threatens aggregate demand. The benefits of DB plans are greatly under-appreciated by everyone, including policymakers who lack a comprehensive vision of what the real problems are and how we can address them.

I also discussed the need to spend on infrastructure and how pensions which need yield can help cash strapped governments on revitalizing Canada's and America's crumbling infrastructure.

Below, take the time to listen to my conversation. As you can tell, I'm not really a "Skyper" and make a few mistakes here and there but the main message is there and I thank Gordon Long for giving me an opportunity to speak with him on these important issues which politicians tend to ignore.

I also embedded another recent interview I liked from the Financial Repression Authority, featuring another Greek, John Charalambakis, the Managing Director of Black Summit Financial Group, discussing risk mitigation and capital preservation. I don't agree with everything he says but he's extremely intelligent and this is a great interview.

Listen to us Greeks, we know a thing or two about where the world is headed. In all seriousness, I thank Gordon for this opportunity to speak on these issues and hope we can continue the conversation in the future. I'd also like to see other experts debate pension policies on his show in the future and forwarded him a list of people to talk with on this important and often ignored topic.

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