Pensions
Interesting article by Philip Coggan in the FT on pensions and equities (sadly you have to pay to read it online).He notes that a common view is that equities are no more risky than bonds over a 20yr time horizon, thus equity prices should be a lot higher (as in they are currently too low, and so offer too high an expected return because investors think they need to be compensated for higher risk). This was (one of) the arguments behind the now legendary "Dow 36,000" book.
It's also the view that has informed much discussion about the benefits of 'defined-contribution' pensions. The argument here was the switch from 'defined-benefit' to 'defined-contribution' may seem to transfer risk from the corporate sector to the individual (Dsquared once had lots of interesting things to say about this), but as long as individuals invested them in equities there would hardly be any risk, and much return (ignore some of the obvious contradictions in this about risk and return -- most pension sellers do).
However one obvious caveat was that most of the analysis was done in the US where equities have always delivered a positive return over 20 year periods since 1900. But since 1900 the US has become the world's dominant political, military and economic power. Clearly investing in it's corporate sector would have been sensible. In Japan there was a period of 50 years without a positive return, France and Italy 70 years. No investor can wait this long.
Furthermore if holding equities over a longer time period was less risky, then the cost of 'insurance', i.e. a put option (the right but not the obligation to sell equities at a given price), would fall the longer for which it was available. This is not the case (of course this might mean put options are mispriced, but the implications of this for financial academics is probably too horrible to contemplate).
Indeed one reason why equities might not outperform now is that they have outperformed in the past. Prices are now much higher than their historical levels for precisely that reason. Expected returns (everywhere except the investment industry) have thus fallen.
Thus back to pensions, equities are clearly an important component of any investment strategy, but are probably too risky given most people tend to want to avoid destitution first and foremost, and enjoy luxury as a secondary consideration.
Coggan argues therefore that what is needed is a portfolio of index-linked bonds that will guarantee a minimum level of funding in retirement. The figures of course make depressing reading -- curently they return 2%, so you need £100,000 of them to get £2,000 a year. An annuity obviously offers more but index-linked ones offer a much lower initial income, which makes them unattractive to most pensioners, at least to begin with. And when you are a pension the 'to begin with' is rather important, particularly if you are actuarially challenged.
Thus Coggan argues, what we need is a low-return but safe investment product which creates 'the essence of final salary pensions without the form'. This sounds to me suspiciously like the State Earnings Related Pension scheme, or at least a better variant.
Indeed given Coggan's argument the state pension must clearly be a contender for returning to centre state as the core of pensioners' income. As we have argued many times on this site, there is no demographic problem that is made worse by having a state pension and indeed in many ways state pension provision is much cheaper efficient and effective. If you haven't already read these two excellent papers (in pdf form), the first (and easier and shorter) by John Eatwell and the second by Nicholas Barr (search google for [pensions barr IMF]; it's the first choice).
posted by Matthew @ 6/13/2004 08:35:00 AM
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