Debunking the Financial Economic Theory for pension.

Debunking the Financial Economic Theory for pension.

I’ve been reading for the past few days in length the Financial Economic Theory in Pension Plan. Basically they are saying that with title like “The case against Stock in Public Pension Funds” that equity should not go into Pension Funds. Their basic idea is investing in Equity does not reflect Risk Premium and obviously Investor/tax Payer will alter their asset allocation due to Pension Fund allocation.

Honestly, I’ve never heard of an individual really adjusting their Asset Allocation given they invest in S&P500 or the Russel 3000. Such individual must be very determine to look at these multiples companies and adjust their Asset Allocation based on the company Pension Fund allocation. In the end, the question remains that even if ABC Pension Plan is fully in Bonds, and I own ABC, I’m not suddenly feeling like owning more bonds due to my ABC ownership. In the end, if ABC fails, I do not hold those bonds. I’m not the primary holder on them. I hold nothing. I agree that there’s a tax advantage of owning bonds through ABC, but in the end owning bonds through ABC is not the same guarantee than owning myself the bonds.

According to Financial Economics, a company that wants to offer 1000$ of pension in 30 years has multiple ways to pay for it. The value of such pension is say 25,000$ 30 years from now.

Method	Money	Bonds only	60%/40%	Equity
Rate/Factor	0%/1	4%/3.2434	6.4%/6.4306	8%/10.0627
Current Cost	25,000$	7,708$	3,888$	2,484$

Financial Economics says that the company should be indifferent in paying 2,484$, 3,888$, 7,708$ or 25,000$ since it can raises debt to pay for their employees’ pension. I’ve got a hard time believing this. The fact is that for a DB plan, the company is on the hook to provide the 1,000$. 1,000$ of pension from ABC should be equal value which have say bonds only portfolio than XYZ who go for a 60%/40%. Any difference (3,820$) is the risk premium that XYZ is paying. From Financial Economics, any investor should be indifferent and must be inform (through financial statement) that the cost of both ABC and XYZ 1,000$ pension is 7,708$. That is true, since accounting use the interest of Bonds of equivalent terms to value any cash flow.

Personally, (preference driven) I would like to pay 2,484$ now and get 1,000$ in 30 years. Even if I get the same 1,000$ in 30 years, I do not understand why I should pay an extra 1,400$ to get the same pension. Let alone pay 5,000$ more or out of my mind 23,000$ more .I guess I don’t feel the extra risk premium I’m not paying. If I did pay it, nobody claimed it from me. Financial Economics says that my future self will pay for it. However, volatility on a 30 years term equity portfolio is very similar to a bonds portfolio for 30 years term. From the past, I see that my future self will have the same 1,000$ pension. I’m never going to pay for that 23,000$ extra risk premium. If the value of it is lower and I have to pay extra, the same can be said for bonds or 60/40%. If the fund have the same volatility, it’s no mystery. The fund has equal chance to go up or down than his counterpart. The name of the rose do not matter.

One of my issue with Financial Economics is that bonds are not risk free. Even treasury bonds where government can always raise tax, print new bonds or print money to pay back for it is not risk free. If it print money, it create inflation. This in turn hurt the real returns of the bonds. If it prints new bonds, they may be at a higher interest rate, this reduce the current value of my bonds. In fact even treasury bonds are volatile. Year to year volatility is 4.4%. Somehow, 4.4% for bonds is risk free. If it raise tax, well then, I’m happy. My bonds are paid. If Economy decline as Keynesian theory says, then relative value vs equity increase.

What is the risk of Equity? Most recognize volatility of value as the main risk. On a year to year basis, S&P500 fluctuates by about 18% volatility (standard deviation) Does it fluctuates depending on its terms? Equity have only one term. Until sold, ABC repurchase them or ABC goes bankrupt. If I own S&P500 or Russel 2000, all of them need to purchase my share or all of them need to go bankrupt at the same time in order to terminate. Else, I need to sell my share to end the term of the share. If I wait say 10 years, volatility of S&P500 reduces to 5%. Over 30 years, it’s about 1.6%. Is it ever risk free? Definitely not by itself. Year by year the volatility stay the same. However, after 10 years, the volatility aka risk is about the same than year to year bonds. I would argue that a ten years equity (where you sell the thing after 10 years is the same as owning a bonds over one year).

Fixed payment are great. This is what provides bonds. If I need to have fixed payment, bonds are great. However, say that you had to pay 1,000$ and had say 100,000$ and it fluctuates a lot (equity). Even if it goes to 50,000$ next year, you still can pay 1,000$. In fact the Safe Withdrawal rate says that in the past, you could have only 25,000$ in a 60/40% portfolio and been able to withstand 30 years of withdrawal without any ruin and even increase the 1,000$ by an average of 3% inflation. In other term, it was risk free. Then again, if you had gone and have 25,000$ in bonds of 4% and still be ok… except you don’t get the 3% inflation and don’t pass go. Using greater equity ratio, you need more funds, but can enjoy a greater than inflation increase. In the end bonds are not the only way to provide fixed payment. A bunch load of cash or equity can provide the same service.