So here we are in the 21st century of 'Pension cuts'. How could this happen and can we do something about it?
No flood of words in this blog, more staccato text and illustrations.
Let the images do their work......
instead of endless calculation and deliberation.
- Most Pension agreements started in the fifties and sixties of the 20th century
- Employees were promised a nominal pension (plain coffee, so to speak)
- Any additional returns meant indexation (steamed-milk in your coffee)
- Fabulous returns in the seventies and eighties made (full) indexation possible
- The idea of 'free indexation' caught fire
- Cappuccino = Coffee + steamed-milk = Nom. Pension + Indexation, was born
- Common opinion, Science up front, started to redefine our pension concept...
- Credo: 'Pension is only pension if it's "Real Pension" (indexed)
- The 21th century's first decade returns made it clear: no room for Indexation!
- Things (returns!) got worse; Stock markets underperformed, Low Bond rates
- Nominal Pension under pressure: Pension cuts seem inevitable
Key question: How to cut pension rights?
Table 1
In addition, due to implementing Market Value Principles in the nineties and later, Bonds have become more risky on the balance sheet.
To paint the dilemma of pension funds even more,
- actual artificial low interest rates (how long?)
- extremely overvalued stock market (Total Market Cap/GDP=95%)
- increasing covariance of asset classes in times of crisis
- systemic risks everywhere
- worldwide unsure economic outlook
- unregulated and non transparent hedge and debt markets
- unidentified risk in derivatives; central clearing on its way
- upcoming unsure supervisory legislation (e.g. Solvency)
make it very hard , if not impossible, to take sustainable underpinned decisions.
To illustrate the investment part of this dilemma, take a look at the next chart:
As a consequence of the above development (and longevity effects) our pensions got screwed up.
In short the next chart illustrates what happened to the (1 year) confidence level of our pensions on basis of the historical returns and risks as defined in
Table 1 on basis of a 'Return Portfolio' approach:
The above chart clearly shows that our initial cautious (Nominal+ Pension) approach in the sixties, was replaced by an (retrospective) much too optimistic (Real Pension) belief in the eighties and nineties.
A real pension objective puts the nominal pension at risk
Even more important is to realize that - as the approach 2000-2011 shows - it's only (questionable) possible to achieve a kind of Real Pension (with a corresponding substantial (needed) return of 5% or more) by putting the Nominal Pension (extra) at risk!!!!
More in detail:
Therefore, the challenging question that still remains, is:
Outlook
Mean Variance analysis in historical perspective, gives food for thought....
The 2012-2020 outlook seems tricky and is not directly showing a 'shiny future'...
Investment Management: What a fool believes
As risk or investment manager these are challenging times. Perhaps the only truth in investment land is: What a fool believes
But what a fool believes ... he sees
No wise man has the power to reason away
What seems ... to be
Is always better than nothing
And nothing at all keeps sending him
Related Links:
- Gold-plated pensions lose shine (2012)
- Where Are We with Market Valuations? (2012)
- Value-at-Risk: An Overview of Analytical VaR (JPM)
- Solvency II nightmare still looms but worst-case scenario averted
Spreadsheets (Raw, download):
- Real ambition
- Risk Return
No flood of words in this blog, more staccato text and illustrations.
Let the images do their work......
Risk Management
is all about
is all about
'getting the picture'
instead of endless calculation and deliberation.
Cappuccino
Let's start with comparing your pension with a cup of coffee......- Most Pension agreements started in the fifties and sixties of the 20th century
- Employees were promised a nominal pension (plain coffee, so to speak)
- Any additional returns meant indexation (steamed-milk in your coffee)
- Fabulous returns in the seventies and eighties made (full) indexation possible
- The idea of 'free indexation' caught fire
- Cappuccino = Coffee + steamed-milk = Nom. Pension + Indexation, was born
- Common opinion, Science up front, started to redefine our pension concept...
- Credo: 'Pension is only pension if it's "Real Pension" (indexed)
- The 21th century's first decade returns made it clear: no room for Indexation!
- Things (returns!) got worse; Stock markets underperformed, Low Bond rates
- Nominal Pension under pressure: Pension cuts seem inevitable
Key question: How to cut pension rights?
- Cut Nominal Pension and keep room for Indexation?
- Cut on Indexation as much as possible, before cutting Nominal Pension?
Return wrap up
Looking backwards at 10Y T. Bonds and Stocks (S&P 500) as an example, this is - in short - our 'back-up' challenge for the future :Table 1
| Period | Average Arith. Returns | Risk (Standard Deviation) | ||
|---|---|---|---|---|
| Bonds | Stocks | Bonds | Stocks | |
| 1960-1980 | 4.04% | 8.06% | 5.39% | 15.95% |
| 1980-2000 | 10.21% | 18.38% | 11.14% | 12.51% |
| 2000-2011 | 7.56% | 2.37% | 8.39% | 18.45% |
| Period | Average Compound Returns | |||
| Bonds | Stocks | |||
| 1960-1980 | 3.91% | 6.82% | ||
| 1980-2000 | 9.64% | 17.69% | ||
| 2000-2011 | 7.22% | 0.53% | ||
In addition, due to implementing Market Value Principles in the nineties and later, Bonds have become more risky on the balance sheet.
To paint the dilemma of pension funds even more,
- actual artificial low interest rates (how long?)
- extremely overvalued stock market (Total Market Cap/GDP=95%)
- increasing covariance of asset classes in times of crisis
- systemic risks everywhere
- worldwide unsure economic outlook
- unregulated and non transparent hedge and debt markets
- unidentified risk in derivatives; central clearing on its way
- upcoming unsure supervisory legislation (e.g. Solvency)
make it very hard , if not impossible, to take sustainable underpinned decisions.
To illustrate the investment part of this dilemma, take a look at the next chart:
Confidence Level
In short the next chart illustrates what happened to the (1 year) confidence level of our pensions on basis of the historical returns and risks as defined in
Table 1 on basis of a 'Return Portfolio' approach:
The above chart clearly shows that our initial cautious (Nominal+ Pension) approach in the sixties, was replaced by an (retrospective) much too optimistic (Real Pension) belief in the eighties and nineties.
A real pension objective puts the nominal pension at risk
Even more important is to realize that - as the approach 2000-2011 shows - it's only (questionable) possible to achieve a kind of Real Pension (with a corresponding substantial (needed) return of 5% or more) by putting the Nominal Pension (extra) at risk!!!!
More in detail:
Long term view
Looking not just at '1 year return risks', but also at 3 and 10 year return risks, we may conclude the risk of underperformance is still substantial.Therefore, the challenging question that still remains, is:
Is it wise to put our 'nominal pension' at substantial risk to achieve a highly unsure real pension?
Outlook
Mean Variance analysis in historical perspective, gives food for thought....
The 2012-2020 outlook seems tricky and is not directly showing a 'shiny future'...
Some remarks...
- Last decade+ (2000-2011) with higher Bond than stock returns (see Table 1), shows a major optimizing problem
- Future approach (2012-2020) is based on the current low 10Y Bond rate of about 2% (SD=8%), which will keep low as a result of the FED's low rate strategy, and low expected stock returns of about 4% (SD=16%).
- Even if the outlook returns would be slightly higher, this wouldn't change the picture.....
As risk or investment manager these are challenging times. Perhaps the only truth in investment land is: What a fool believes
But what a fool believes ... he sees
No wise man has the power to reason away
What seems ... to be
Is always better than nothing
And nothing at all keeps sending him
NB All (above) calculations, tables and charts are indicative and strongly simplified to make it possible to 'get the picture' and 'get feeling for the direction', in order to support complex decision making without straying too far from reality.....
Related Links:
- Gold-plated pensions lose shine (2012)
- Where Are We with Market Valuations? (2012)
- Value-at-Risk: An Overview of Analytical VaR (JPM)
- Solvency II nightmare still looms but worst-case scenario averted
Spreadsheets (Raw, download):
- Real ambition
- Risk Return
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