Tapping Into The Untapped Potential Of Pensions As Financiers

A proper pension – in popular parlance, a Defined Benefit, or DB, retirement plan; not a Defined Contribution, of DC plan, which is really just a specialized form of limited access, often government subsidized, savings plan – is an actuarial risk pool that uses the science of statistics, the mathematics of probabilities and the Laws of Large Numbers to programmatically provide income security in retirement to a statistically significant population of statistically similar current and future retirees, from the time they retire to their end of life, often with survivor benefits for a spouse.

These risk pools can be imagined as working on a faucets and drains metaphor. Two faucets constantly add new money to the pool, while two drains constantly take money out. In a properly designed and managed pension, the inflows from the “faucets” offset the outflows through the “drains” to keep the level of the pool constant. The pool grows, i.e. the level rises, only if the total population of plan participants increases. Otherwise, it just keeps going.

The two “faucets” are current contributions on behalf of future retirees and cash flows generated through investment of the money in the pool by the plan fiduciaries.

The two “drains” include the actually incurred costs of staffing the plan and the benefits actually paid out to current retirees.

The primary design requirement for any pension plan is that it reliably deliver scheduled pension benefits to current retirees, indefinitely.

It is critical to the integrity of pension design that the cash flows generated by investment always be sufficient, when added to the current contributions being made by or on behalf of future retirees, to offset outflows to operating costs and benefit payouts to current retirees.

There are three ways in which this balance can be disturbed:

actual benefit payouts can exceed the statistically calculated payout rate (because the actuaries did not calculate life expectancies accurately);
plan sponsors don’t make required contributions on behalf of future retirees; or
investments do not generate sufficient cash flows.

There are two reasons why cash flows from investment may not be sufficient. One is that the actual investments are not delivering at the assumed rate, simply because the investments are not performing as expected. Or, shortfall in contributions are keeping the pool levels too low, so that there is not enough money in the pool to generate sufficient cash flow, even if the investments that do get made do deliver as expected.

You can see how problems compound when a pension plan gets out of balance between its faucets and its drains. Less coming in than is going out means the overall level of funds in the pool drops, which means there is less money for investment, which means there is less cash flow being generated through investment, which means there is even less coming in, without an offsetting reduction in what is going out, which means the levels drop again, causing the cash flows from investment to drop again, in a cascading spiral of collapse.

Endowments are not technically actuarial risk pools, but they operate on a similar dynamic, and face the same problem of generating sufficient

Which brings us to the defining question of fiduciary duty for the superfiduciary stewards of society’s superfunds:

“How can I generate sufficient superfund cash flows, forever?”

So, how are our superfunds investing in pursuit of sufficient superfund cash flows?

We think a recent book co-authored by Stephen Davis, Jon Lukomnik and David Pitt-Watson, entitled, What The Do With Your Money might help us properly appreciate the answer to that question.

If we are to set our Pensions & Endowments free from speculation, to function as they are created by design to function, that is as financiers in their own right:

aggregating surpluses saved by individuals to programmatically provide certainty against certain of life’s uncertainties; and
deploying those aggregations as investment in enterprise to generate cash flows sufficient to keep their actuarial risk pools (or equivalent) correctly full and prosperously flowing, always and forever;

we have to confront the technical question, How?

How are Pensions & Endowments going to invest in order to prudently pursue and successfully realize their superfiduciary purpose, to generate sufficient cash flows, forever? What is the mechanism for making investments? What are the visions they should be valuing in enterprise, and what are the patterns, pattern languages, places and professionals they need to value those visions correctly?

The clue to this answer is in the powers we invest in them in order to pursue the purposes we design them to pursue. These are the powers of size, of purpose, and of time.

Pensions & Endowments have to be large in order to be effective. So, we allow and require them to aggregate large sums of Other People’s Money, and to hold those sums in trust for the purpose they are chartered to pursue.

That purpose, as we have seen, includes putting the vast amounts of Other People’s Money that we entrust to their good judgement to work, making more money, constantly and regeneratively, forever, sufficient to keep their core pool correctly full and prosperously flowing benefits across the generations. Their duties are intergenerational. They cannot invest just for today, without worrying about tomorrow. Neither can they invest only for tomorrow, without providing sufficiently for today.

Time is a purpose and also a power for Pensions & Endowments. They do not exist only for a time. They continue to exist across time, ongoing, open-ended and self-regenerating. Evergreen.

The powers of Size, Purpose and Time that we invest in the fiduciary stewards of our Pensions & Endowments give them the power to negotiate. They do not have to speculate.

This is not true for us, as individuals. As individuals, very few of us have savings that are considered large by the standards of any put the smallest of enterprises. Our purpose when investing in enterprise is opportunistic: we purpose to make as much as we can; the more the better. The only minimum is, we do not want to lose our savings. There is no maximum. Our timing as investors is idiosyncratic. We invest whenever we have accumulated savings that we do not need to keep on hand right now. We redeem our investment whenever we do find that we need that money back, to spend on something else. Sometimes we have targets to our saving programs, such as when we are saving for a major purchase, or for a particular life event. Always our saving and investing is subject to the vagaries of life. Things happen, and sometimes we have to spend our savings in ways we did not plan.

This makes it extremely difficult for us, as individuals, to invest directly, through negotiated agreement with the leaders of the enterprise we are investing in. Large enterprises with substantial capital requirements would have to negotiate with many many different investors, each with their own idiosyncratic needs and wants, but all wanting to never get a lesser deal than anybody else. There is no standard against which to measure what we should earn as consideration for our investment: we want as much as we can get. And we need liquidity, where the enterprise needs to keep our money invested for extended periods of time.

It is actually better for us, as individuals to speculate.

The Wall Street system of corporate finance through speculation on future growth in share prices derived from growth in future expectations for future growth in the NPV (net present value) of expected future cash flows, is a practically perfect mechanism for investing by us, as individuals, when we are investing opportunistically and idiosyncratically to put our money to work making more money for as long as we can leave that money working for us, and we do not need to spend it. We can buy in small increments, sized to our available savings. We can buy whenever we can, and sell whenever we need to. Every share is a commodity, exactly equal to every other share of the same class of stock issued by the same corporation. We can make whatever profit we can, based on the luck of our draw, that is the growth in market clearing price for the shares that we do buy, and hold, which experience has proven can sometimes grow very large, very rapidly.

The only downside is, we can also lose some or all of what we invested, if we buy a stock in a corporation that does not grow, or even fails, and enters bankruptcy. That is why Wall Street is not really perfect. It does not provide protection against losing money. In fact, the risk of loss is essential to the way the market works to provide liquidity: you can always find a buyer; but you cannot always get your price.

There is, however, a proven effective way to minimize the downside loss. This is through portfolio diversification: buy a portfolio of stocks in companies that are diversified across different industries. Done properly, in a correctly functioning market, diversification will realize gains to offset losses, so that the portfolio delivers, overall, what is called a market rate of return, that is, an average return that approximates the average return being realized in the market, overall.

Of course, diversification only protects against the vagaries of individual share price movements within a correctly functioning market. If the market overall goes into dysfunction, as happens when the market booms before going bust, as happened in The Gilded Age and The Roaring Twenties, and is happening again today. When the market crashes catastrophically, diversification will not protect portfolios against losses.

The argument is always made that over time, the markets will recover, but what if you don’t have the time?

Pensions & Endowments do not have the time. They exist is a perpetual present. Any time they are losing money on their investments, they are failing their fiduciary purpose to constantly generate sufficient cash flows, forever. This is true even if they are able at some later point in time to make up the losses. Their purpose is to be constant. Booming and busting and recovering and booming and busting again is not constant. It is not their purpose.

Also there is this. Participation in the Wall Street trading markets by Pensions & Endowments alters the market demographics, which alters the market dynamics.

A market dominated by individuals buying and selling opportunistically and idiosyncratically moves to the rhythms of cash flows flowing back and forth between the commercial and the capital markets. That keeps a check on the exuberance of the market clearing mechanism, because buyers buying with their own savings, for their own account, who do not have to buy, need a reason to believe its time to buy. Yes. There will be moments of trend-based buying frenzy, but those moment will be just that. Moments. Limited in time and to scale, usually constrained to a single stock issue, or industry sector. Rarely does it distort the entire market, mostly because individuals, as buyers, just don’t control enough savings to buy the entire market on an irrational feeding frenzy.

The biggest problem for a market dominated by individuals buying and selling with their own savings, for their own account, in pursuit of their own opportunistic and idiosyncratic investment goals, is a lack of liquidity: moments in time, usually limited to specific issues, when there are more would-be sellers than wannabe buyers (or, conversely, there are more sellers than buyers, which is less of a problem, but still a problem). The US exchanges solve for that problem by using market makers. These are market professionals who stand ready to act as buyers, or sellers, of last resort, always willing to buy, or sell, if the market does not provide a buyer or a seller.

When these markets “crash” it is because there are too many sellers at any price, and no buyers, except the market makers, who are overwhelmed by the demand, and can no longer support the stock (or other issue), at any price.

This does not actually ever happen in a market dominated by individuals. It only happens when the markets come to be dominated by paid professional speculators speculating with Other People’s Money, for a fee.

Professional speculators look a lot like market makers, but with these two important differences. First, market makers are not actually speculating on price movements. They are performing a service to the market, buying and selling when there is a hopefully temporary shortage of buyers or sellers. It can be a very lucrative business, because very often they buy shares at what turn out to be steeply discounted prices, and are able to resell those shares, often in only a short period of time, at a substantial profit (conversely, they can “sell short” at premium prices and cover their positions at “normal” prices, often substantially less than their selling price, also often within a short period of time).

Professional speculators mimic market makers, but without the commitment to stabilize the markets, and guarantee liquidity. Instead, they buy on what they perceive to be temporary dips in trading prices, or to get in early on what they see as a run up in prices, or sell in advance of what they expect will be a falling price.

Second, while some speculators trade with their own money – the so-called “day traders” – most speculate with Other People’s Money, as fund managers. Today, many of those funds are pension funds, or endowment funds, that is, society’s superfunds. Speculators speculating for their own account don’t have to be speculating. If they don’t see what they perceive to be a temporary pricing dislocation, they just don’t make a trade. Instead, the “sit in cash”. Or put their money to work in other, less speculative endeavors, or speculating in other markets. Professional speculators are paid to trade. They can “sit in cash” for awhile, but only for a short while, and with not too much of the total cash that has been contracted to them for “management”, i.e. speculating with.

As professional speculators speculating with Other People’s Money for a fee come to dominate the markets, in terms of both the volume of money being traded and also, perhaps more importantly, the volume of trades being made, they drive the markets into hyperdrive: buy and hold becomes buy low to sell high become buy high to sell higher. The markets boom, for a time. Then, they go bust.

This is not what the markets are created by design to do. It does not contribute to a prosperity of peace. It does not fit the fiduciary purposes of society’s superfunds, to reliably provide sufficient cash flows, across the generations, indefinitely.

It is not good for Pensions & Endowments, or for peace and prosperity. It also is not necessary.

Pensions & Endowments are not small; they are not opportunistic; and they are not idiosyncratic. They do not have to buy in small shares in an investment contract with an enterprise negotiated by others, that is securitized for trading as a commodity. They can negotiate their own investment contracts with enterprise, directly.

Since they can, they should.

It will be better for them. It will be better for individuals trading in the markets. It will be a better path to peace and prosperity for all.

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