If you own stocks without a hedge, it’s not rational… it’s like owning a house without insurance.
— Nassim Taleb
The late actuary Jeremy Gold. Mayhaps you have heard of him but… in all likelihood you have not unless you read pension news on a regular basis.
He is the mathematician who discovered there was a problem in both public and private pension systems. Pensions are nothing more than organized retirement plans managed by professional money managers. They are usually (but not always) defined benefit plans, meaning they promise a specific payout at retirement.
The parallels between a pension and, say, a 401(k) are obvious to some folks. The differences are mainly that a 401(k) ends up being managed by the investor drawing the income whereas pensions have actuaries figuring out how money should be allocated in the investment account and how much money needs to go into it to make it work.
Anywho, Gold figured out the nation’s pensions were very underfunded… 25 years ago. Most pension plans refused to listen to him because it meant increasing contributions to retirement plans and no one wanted to do that.
Today?
They have no choice. Literally, no choice left. Even if they increased contributions, it won’t help some of these pension plans. They’re bust. Pensioners won’t get their promised payouts and they (probably) won’t hear about it until the check doesn’t arrive in the mail.
This is, by the way, what happened to a local electricians union in upstate New York, and the only (THE ONLY) reason I heard about it was because I was dating someone at the time who worked in the administrative office when they stopped cutting checks to retired electricians. No one knew what hit them until it hit them.
Poof! No more money. Bye bye retirement.
Jeremy Gold is a fascinating guy.
He’s the first one in the pension and retirement industry to openly state the obvious: that $1 million in stocks is the same as $1 million in bonds. The difference is the risk you take in stocks is more than the risk you take in bonds. Always has been. Always will be. This is why stocks have a higher *expected* return than bonds. But… as Gold pointed out, it’s an expected return.
The mistake pensions made was… they looked at the equities market and thought “we could make 7.75% returns on our pension funds”. Of course, the rate of return you earn on your investments determines how much you have to save. If you expect to earn a high rate of return, then you can afford to lower your contributions to a retirement plan.
But… this creates an interesting sort of problem. When you invest in low risk assets, like fixed income securities or (gasp!) life insurance, you have to save more money. You have to save more money because the rate of return is lower. But… this also means you end up with higher contributions and a larger “cushion” in principal payments to your savings plan.
Let’s say you have to contribute $500 per month to a whole life insurance policy earning 4% annually to meet your financial goals. Maybe a stock investment only requires you to save $300 per month to meet the same goal. On the surface of it, the stock investment looks like a better deal because “it’s cheaper”. You don’t have to save as much to hit your goal. But… that cheapness is an illusion. We can show this by looking at it from a different perspective.
Just for a moment, let’s eliminate all interest on both accounts.
This removes all risk and return from the equation and focuses purely on the savings you’re accumulating.
The difference in this scenario comes down to $500 vs $300. Be honest. Would you trade $500 for $300?
Hopefully not.
Now… would you trade $300 for $500?
If you have any functioning brain cells, you absolutely would.
This is the problem pensions had and still have.
They effectively took $500 of guaranteed money and traded traded it for $300 of non-guaranteed money. The rate of return represents the money paid for risk. In the guaranteed side, 4% interest is considered “riskless” because the investments are guaranteed. On the stocks side, not only do pensions have less money shoved into the plan, they are taking enormous risk hoping to achieve 7.75% returns — 3.75% over the riskless rate. The farther you get away from a guaranteed return, the more risk you take.
Pensions (and, this also applies to most individual investors saving for retirement) are hoping the stock market will bail them out of a low savings rate.
That’s a risky proposition. The stock market exists to create liquidity, not to hand-deliver investment returns at the snap of a finger. What you buy, when you buy stocks, is an opportunity to share in the risk (loss) of the company in exchange for potential profits. Now… there’s nothing wrong with that. But.. .if you’re going to take risk, you need to be able to afford said risk and… the pensions cannot afford it and neither can most individual investors.
This doesn’t stop them from taking those risks, of course. People buy things they can’t afford all the time. Doesn’t mean it’s a good idea.
Solution?
Act as if.
Act as if you are only going to earn a guaranteed rate. Then, save money based on that guaranteed rate. Take risks that you can afford to take. Don’t risk money you can’t afford to lose.
I know. I know. Seems like common sense… but, it is (sadly) not common practice.