Tuesday, May 16, 2006

My insecurities about the social security debate

About disseminating our knowledge 

It really is not possible for the value of investment funds to grow, forever, at a higher rate than the underlying economy, unless they are just inflating it with air, or unless they are taking a chunk of the growth from someone else. Therefore when we observe how many Social Security System Reforms are based on the underlying assumption that they will be growing 5 to 7 percent, in real terms, for ever. I wonder when we are going to use our knowledge, and inform the world that this is just plain crazy. 

When we speak of expected returns, let say a real 3%, this is just an average of a distribution curve where there are a lot of winners, with higher returns, and a lot of losers, taken to the cleaners. Knowing this, how come we allow the debate on Social Security reforms to use the averages? In systems where you are supposing to pay someone to manage the funds, you should expect the managers to produce different results. Yes of course the returns could be average, but for that you just buy a stock index, and pay no fees. 

A question 

Are there any real differences between a pay-as-you-go, governmentally backed pension system, and a pension fund that invests completely in government paper? 

About the timing and the losers 

Any individual Social Security accumulation system that has the luck to start when the markets are close to rock bottom will always perform better than those systems that start when the markets are at the top. This has been the real beginner luck of the Chilean system and future generations of Chilean accumulators might not be as happy with the results as the pioneers were. 

When we now read how investment funds publicly state that they do not wish to receive more funds since they do not know where to invest them and we also observe how many private pension schemes in the United States are running for public cover, we need perhaps to ask ourselves whether the timing for those Social Security reforms that might be en route is really that good. 

Those who beat the market average will always love to be on their own, and therefore the problem does always reside with the losers. The difficult question is whether in an individual security accumulation system all of the future losers have truly surrendered their expectations of receiving official assistance and, even if they have, proudly preferring to starve than to ask for help, whether the governments could really get away from their social responsibilities by answering the losers with a “Hard luck, pal, you had a private plan.” 

And so, at the end of the day, to me it seems that you might just be substituting a pay-as-they-fall for a mean-based pay-as-you-go system. So, when we add it all up, it all boils down to the same—except of course for the fees. 

On Social Security in Real Terms 

In order for your savings and social security investments to be worth something when you need them, the real economy must be in a reasonable condition at the time of your selling your investments. When I hear the many discussions about the financial preparation needed to accommodate for the upcoming demographic changes, I find it truly amazing how little is being said about the economy in real terms. 

Considering that there will be many fewer young ones to drive people around and shovel snow, much of today’s beautiful real estate might drop in value when the elderly start selling their houses to live close to a metro, hospital, and more reasonable weather conditions. So, before putting the money away in a private accumulation trust I think we need to rethink the whole retirement strategy. 

Jim, my editor: “The Philadelphia suburbs have many Metro stations where it is safe to wait, many outstanding hospitals, and fairly good weather. Philadelphia proper has stations where it is not safe to be, hospitals overcrowded with uninsured indigent patients who are certainly not going to get the cutting-edge high-tech expensive care available in the suburbs, and somewhat worse weather (hotter in summer, less effective snow and ice removal in winter). Any sensible elder would move to the suburbs. Doing the opposite is like swimming towards a sinking ship.” 

I: “That’s OK Jim. I did not mean that my real-terms projections are necessarily correct, but, now that I have you thinking of the future in real terms may I also suggest looking into beautiful Isla de Margarita off the coast of South America?” 

Now back to my voice (and noise) 

Also we should never forget that historically, through all economic cycles, there is nothing so valuable in terms of personal social security as having many well-educated loving children to take care of you, and that you can’t, in real terms, beat that with any social security reform.

Two current updates on the social-security issue 

Sir, Delphi’s (a company that supplies General Motors) problems do indeed pose a threat to public-pension institutions, but it also evidences the structural weakness of the alternative of accumulations in private-investment accounts. The fact is that when the old retire and might need to sell their stocks, the young might not be willing to buy them. 

Sir, With respect to GM’s pension woes, you claim that the company recorded a return of 5 per cent in the first half of the year, putting it on track for its assumed annual return of 9% but also that if GM’s pension funds produced the same poor returns as the equity and bond markets, this would of course have a dramatic negative impact. What is thereby implied makes a case for developing a formula that calculates how much arrogance it must take to promise to pay 9% on funds over a life span, and/or to beat the markets continuously. 

About the SEC, the human factor, and laughing 

A couple of days ago, our SEC reported that their pension fund had also been the victim of a fraudulent stock-managing firm, and that they had lost a lot of money. 

I also read recently about the Mars Climate Orbiter spaceship that, after having required an investment of 125 million dollars, had to be declared as a total loss due to a technical confusion derived from simultaneously applying metric and English measures. 

If what happened to NASA or what happened to our SEC is of any mutual comfort to them, I don’t care, but what I do hope is that they have learned a bit more about humility. 

I bring this opinion to the table since I recently heard that our SEC was now establishing higher capital requirements for stockbroker firms, arguing that “. . . the weak have to merge to remain. We have to get rid of the rotten apples so that we can renew the trust in the system.” As I read it, it establishes a very dangerous relationship between weak and rotten. In fact, the financially weakest stockbroker in the system could be providing the most honest services while the big ones, just because of their size, can also bring down the whole world. It has always surprised me how the financial regulatory authorities, while preaching the value of diversification, act in favor of concentration. 

The SEC should not substitute the need for capital in place of the need for ethics, nor should it allow that fraudulent behavior hides amid the anonymity of huge firms. In this respect, let us not forget that the risk of social sanctions should be one of the most fundamental tools in controlling financial activities. 

If there is a relation between weakness and a rotten apple, it could really be in the SEC itself, since, though they frequently complain about the lack of resources, that doesn’t stop them from transmitting institutional messages about how well they are fulfilling their responsibilities. Perhaps the best thing that the SEC could do is to stop all their actions that are creating a false sense of security in the investor, acknowledging the absence of any supervisory capacity, and instead stamp each share prospectus with a big “BUYERS BEWARE.” 

We read an article in Newsweek (“Giving Big Blue a Shiner, November 1999), about the surprising 20% drop in value that IBM shares had suffered in just one day. It also states that this drop was not in any way the result of any especially surprising event. The purported lesson of the article was “To teach not to take too seriously the investigative capacity of Wall Street and to remember to laugh next time you hear that the stock-market is a rational place where the big investors know what they are doing.” I would also like to suggest remembering to laugh next time a regulator presumptuously assures you he is doing his job. 

Extract from Economía Hoy, Caracas, November 16, 1999

All this extracted from my Voice and Noise 2006

And more from 1997 "Pension funds - not yet"