October 2022 Investment Memo

On Risk Tolerance, Liability Matching, Retirement, and Leverage

Just Add Leverage

I am a huge fan of economist Allison Schrager’s substack and podcast. Last week, she wrote about the pension crisis happening in the United Kingdom.

Pension Geeks have their moment

Have you ever heard of liability-driven investment? Pensions use this to match and immunize liabilities. Essentially, you buy bonds with the same duration as your future pension liability. Easy, right?

Except, there is one huge problem for prospective liability-matchers: There is a dearth of long-duration bonds in the market.

And unfortunately, you need to buy A LOT of bonds to match long-term pension liabilities. So pension investment committees have been confronting three major issues:

1. There is a shortage of long-duration debt.

2. Bonds offer historically low-interest rates (especially pre-2022).

3. Inflation is outpacing bond interest rates.

So, what did pension consultants recommend?

Leverage! Of course! Why not?

Consider this scenario. Imagine you are on the board of a pension investment committee, and you are listening to the same pitch our clients hear in steakhouses around the country from annuity salesmen:

You can have more return with less risk.

You look around at your colleagues, titans of industry and government, and everyone nods affirmatively. “This sounds great, right? What could go wrong?”

Here’s from the blog:

The same thing that goes wrong anytime anyone tells you they can get you low-risk and high returns: There was a tail risk lurking. Pension funds were only prepared to post collateral if rates went up 100 basis points, but then rates went up 400 basis points in less than a year. Because, yeah—that’s what rates do when people get freaked out. Unfortunately, the whole world has memory-holed its US bond market data from the years preceding 1995. So, the pensions lost their hedge, the underlying bonds were sold, and the Bank of England had to step in [emphasis added].

There is nothing wrong with liability matching, per se. It is by far the best option for pensions to consider. Yet, retirees are fundamentally different. Barring an unexpected inheritance, neither the government nor your former employer will inject more cash into your retirement when funding is lacking. Neither will the Bank of England nor the Federal Reserve provide quantitative easing for your personal liquidity concerns.

Additionally, most individuals can’t save 30-40 years of retirement cash flow. Rather, most retirees save 20-25x expected cash flow needs above and beyond social security and pensions.

Of course, that creates two problems:

• Longevity Risk: A longer-than-expected retirement may be underfunded.

• Inflation Risk: Your purchasing power will get eaten up over the years without some sort of growth element.

So what’s the answer?

Well, stocks, of course.

Stocks, or owning the world's great companies, offer us both inflation protection and growth. At worst, leaning further into stocks than retirement convention dictates better protects against longevity risk than a bond-heavy portfolio. At best, it can shift a retiree from ‘enough’ or even ‘just enough’ to ‘more than enough.’ The latter then compounds into further blessings of more spending, giving, compounding, or legacy.

Instead of matching liabilities with fixed income to immunize risk, we coach our clients on taking on risk, if that is indeed what we call volatility, for better retirement outcomes.

Here’s the gist: Equities are the only QE, monetary stimulus, or economic package our clients can truly count on.

Stocks for the long run, indeed.

Photo by Jamie Street on Unsplash

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