Long-term investing has never been more important. With the decline of traditional defined benefit or final salary pension plans, which offered employees a guaranteed pension, it is individuals, more than ever before, who are now being held responsible for holding long-term assets.
They have gained this responsibility just as the US and Europe embark on new attempts to resolve the age-old old dilemma of how to ensure that their populations have saved enough for retirement.
Research by Pioneer Investments identifies three broad “macro-themes”, all of which may be drawing to a close. First, household wealth represents an increasing share of the economy. This trend has been in place since 1975, and its implications are made all the more significant by the fact that households are being asked to complement public pensions with their own money.
A second trend is the inexorable growth of securitisation. Whereas in the past, a family saved through bank deposits and their defined-benefits pension plan, now they have much more direct exposure to moves in the markets – through money market funds, mutual funds, and increasingly through exchange-traded funds. Not only are they being given greater responsibility, but they are also being asked to deal with a securitised world where their paper wealth can swiftly fluctuate in value.
Third, the demographics of the developed world have helped to engineer a boom in long-term saving. The “baby boom” generation, born in the decade after the second world war, is nearing retirement. The boomers are investing heavily at present. Across these markets, life assurance, pensions and other long-term assets are increasing as a proportion of households’ assets.
This is probably not sustainable. Once the boomers retire, they will start selling their long-term investments. Meanwhile, the generations that follow them are smaller in numbers. So, total flows into long-term investment plans could reduce, or even turn into net outflows.
That creates a problem for the economy, as there will be fewer people in work attempting to fund more people in retirement. Increased longevity, not normally regarded as a problem, could exacerbate the phenomenon.
Traditional “pay-as-you-go” government pension schemes, where pensions are paid out of contributions from people currently in the workforce, also look increasingly unviable. Instead, the onus will fall on to the individual.
But that creates its own problems. First, it exposes individuals much more directly to the vagaries of the markets. The bear market following the technology bubble of 2000 revealed that even defined-benefit pension plans had not adequately matched the assets in their funds to their liabilities – the cash that they would soon have to pay to pensioners.
That led to the growth of what is now known as “liability-driven investing”. This is the innovative practice of treating future liabilities as the key benchmark for pension funds, and attempting to hedge out risks of changes to inflation and interest rates.
The turmoil that erupted in the credit markets earlier this summer also raised critical questions. The crisis has revolved around securitisation – the practice of taking loans and repackaging them so that they can be traded on the market. Structured credit products, most notoriously those backed by US subprime mortgages, offered fund managers (or individuals) the opportunity to improve on the returns they could get from government bonds, with apparently little increase in risk. But it now turns out that the risks were much greater than many buyers had understood.
It is still not clear how the credit crisis will play out – that discussion is only starting. But the episode has already cast grave doubts on the wisdom of leaving individual non-professional investors to decide on long-term investments.
The growing field of behavioural finance, which applies the techniques of psychology to economics, gives more reasons to worry about allowing people freedom of choice. It suggests that long-term saving is a particularly difficult decision: people do not have the opportunity to learn from experience. As Joseph Stiglitz, winner of the 2001 Nobel Prize for Economics, puts it, you cannot decide at the end of this life that you need to save more in the next one. (See page 14.)
Several ghastly messes show that it can be unwise to leave too much to individual discretion. Following the collapse of Enron in 2001, it became apparent that many employees had invested more than half their pension plans in the company’s stock. The collapse had cost them not only their salary, but also most of their pension.
In the UK, the ambitious introduction of personal pensions in 1988, combined with generous incentives to opt out of existing defined benefits pensions schemes, became a fiasco because of the antics of sales representatives. The press was soon full of sad cases of people who had been persuaded to leave generous final-salary schemes only a few years before retirement in favour of inferior defined contribution plans. By the time the dust had settled, the episode had cost the British investment and life assurance industry about £13.5bn in compensation and administrative costs and had inflicted uncertainty on thousands of retirees.
Episodes such as this prompted governments in the developing world to adopt extreme paternalistic approaches when establishing pension programs. For example, when Mexico unveiled a new pensions infrastructure after the country’s 1994-95 devaluation crisis, contributions were compulsory for all those in private employment, and all portfolios had to be restricted to bonds. Extra choices have only been added slowly.
That approach has worked well in a developing country, where people tended to distrust the financial services industry. But it involves too much of a limitation on individual choice to be politically saleable in the US or Europe. What, therefore, should governments or investment firms do to influence those individuals’ decisions?
Within the past few weeks, regulators in the US and in Europe have rolled out new attempts to deal with this dilemma. In the US, the Department of Labor published the final detailed regulations under last year’s Pension Protection Act.
Meanwhile in the European Union, Mifid (the Markets in Financial Instruments Directive) came into force and, among many other things, implemented new rules that will affect the advice that financial services companies give to potential savers.
These plans take differing approaches. The avowed aim of the Pension Protection Act is to increase drastically the proportion of employees saving through 401(k) corporate pension plans from 50 per cent to closer to 80 per cent.
The key provision makes it easier for companies to enroll employees who have expressed no preference into a “default” option. Previously, this had presented legal difficulties, as employers could be sued if such options lost money. Most employers responded either by making money market funds the default option or, by having no default option at all – so that those employees who took no action would go without making pension contributions saving.
Now, they can offer a wider range of default options without falling foul of litigation. This is appealing
because individuals will still have a choice. If they want to put it all into China, or keep it all in cash, such options will be open to them. But if they do nothing and choose to tick no boxes, a choice will be made for them and that choice will be designed specifically for their needs.
An example of this philosophy is already widely on offer in the US. “Lifecycle funds”, also known as “target-date funds”, are designed for people who are retiring on a particular date. For instance, Fidelity Investments’ 2020 fund has a heavy weighting in equities – 69 per cent. But, with retirement 12 years away, it also has 17.4 per cent in bonds. Its 2015 fund, with retirement only seven years away, is noticeably more conservative, with 31 per cent in bonds, although it still has 56 per cent in stock.
All the saver needs to do is pick the fund for the year when they plan to retire and their asset allocation will be changed steadily as they grow older. The largest US mutual fund companies now offer funds along these lines, and they are often presented as major options in 401(k) plans. Index providers now offer indices for target-date funds to make it easier to compare their performance against a benchmark.
The Department of Labor has named lifecycle funds an appropriate default option, so the industry is already prepared for this change.
However, Prof Stiglitz suggests that “default” plans could still become much more sophisticated. At the moment, they rely on one factor: age. In time, he is aiming to find ways to incorporate other factors into defaults. Someone’s marital status, or the amount of wealth they have tied up in real estate, for example, could be important factors that would change the appropriate default option.
Such factors underpin the ideas behind Mifid, which takes a different approach to investor protection, putting the onus on advisers – traditionally a weak link in European financial services – to understand their clients. In turn, the directive will put much more of an onus on investment firms to understand and know their clients and to design savings products which are appropriate for different distribution channels. It does not preclude default options as a way to deal with the dilemma, but it arguably does not go as far as US regulators to make defaults easier to implement.
On both sides of the Atlantic, the reforms could have far-reaching consequences. But Vernon Smith, who won the 2002 Nobel Prize, cautions that increased use of default options, with investors not checking how the companies in their portfolios are performing, might mean that there are fewer effective checks on how companies are run. Thus, it could also make the process of capital allocation less efficient.
Prof Smith also argues that once more people have saved heavily, they may draw on their pool of capital earlier than policymakers intend. “All I’m arguing is we just don’t know,” he says.
Unfortunately, we only will know, as with most everything else to do with long-term investing, in the long term.
