Dominic Hobson reviews Global Pension Crisis: Unfunded Liabilities and How We Can Fill the Gap

Rich Marin's new book is reviewed by Dominic Hobson.

Rich Marin,  Global Pension Crisis: Unfunded Liabilities and How We Can Fill the Gap, John Wiley & Sons 2013 

Rich Marin is an optimist puzzled to find himself writing so pessimistically about the future of retirement provision. The thought-experiment with which he begins and ends this book - pondering the likely positions of different social archetypes in the year 2050 – is a neat way to bring the macro-economics of demography, savings and income down to the level of the individual, but it would be hard to describe the outlook it embodies as optimistic. Indeed, Marin reckons the “game over” scenario put forward by Larry Kotlikoff, in which the obligations of the Federal government devour the entire earnings of the entire working population of the United States, could occur within 30 years. In his Europe of 2050, the European Union has collapsed – because no German pensioner wanted his lifestyle curtailed to bail out his opposite numbers in Greece, Italy, Portugal and Spain - and debt default is the norm, inheritance tax averages 90 per cent, and the few energetic members of the population left alive are emigrating to Brazil (which by 2050 is home to 40 of the top 100 billionaires) and even Africa. The future of Europe, concludes Marin, is simply to become a “servile service economy” or “playground” to rich investors that require an historical setting for their fun and games.

Many have written lately about the clash of generations as well as civilizations, but the dystopia Marin conjures up for 2050 would not look out of place in a text about an environmental or nuclear catastrophe. By then, he reckons, both stock and houses prices will be at the tail-end of a prolonged secular decline, which will have put paid to the combination that made Baby Boomers such as himself feel so rich: leverage re-paid by rising asset prices. “This is about food and shelter,” he writes. “This is about saving our elderly. This is about everyone’s right to a healthy life within the best scientific means available. And mostly, this is about the economic order we leave not for our grandchildren, but our very children … We all recognize that we are an interconnected world and there simply is no way for any of us to build our walls high enough to ignore this global problem … How insulated can you be when your state services are being provided by policemen and fire-fighters who can no longer rely on pensions sponsored by bankrupt state and municipal governments?  … The housing crisis that you have successfully avoided by living in a good neighbourhood and paying off your mortgage will not leave you unscathed. You can’t build your walls high enough.”

As Marin points out, one reason nobody can insulate themselves from the consequences of under-provision is that the pension problem is not spread evenly across the countries of the world. The period of life after retirement ranges from 22 years in France (where workers often spend more time retired than they spent at work) to minus 16 in South Africa (where most people die before reaching retirement age).  “Countries with the lowest funding levels look to have the highest retirement burden,” he writes. “This is not a good thing.” Even in countries with long traditions of saving for retirement, such as the United Kingdom and the United States, Marin reckons pension funds have been so under-funded for so long that they have taken outrageous risks in an effort to bridge the gap. On his calculations, the United States – where Larry Kotlikoff has put the NPV of the total fiscal shortfall at $222 trillion – has the smallest retirement savings shortfall as a percentage of the national income. But it is still 50 per cent of what it needs to be. It is 300 per cent and more in France, Germany and Japan. Europe certainly looks in deep trouble for, as Marin points out, there is something exquisitely stupid about a way of life that combines youth unemployment rates of 22 per cent (the United Kingdom) to 48 per cent (Spain) with ageing populations that like to spend at least 20 years in retirement.  

Yet a close reading of the book proves that Marin is a lot more optimistic than his gloomy analysis suggests. At bottom, he believes the funding shortfall (“to get more retirement income you need better investment results”) and the accompanying demographic time-bomb are eminently soluble (“going forward, there will need to be a much better correlation between longevity and retirement age”). To prove it, he performs a simple but illuminating discounted cash flow calculation. He puts the total savings of the world, as captured by private wealth managers, mutual funds, pension funds, insurance companies and sovereign wealth funds, at $132 trillion. After stripping out assets not aimed directly at retirement, that sum falls to $50.4 trillion. Next, he assumes that the 26 per cent of the population of the world that is retired will eat an average of 60 per cent of global GDP for the 37 years down to 2050. Discounting that back at 5 per cent a year, Marin arrives at a current global retirement funding need of $149.3 trillion. Less $50.4 trillion, the global retirement savings shortfall is a cool $98 trillion. That is a large number, but for a man who believes only gravity can rival compounding as a force for changing reality – in the opening chapter readers are reminded that a penny doubled for just 30 days is worth $5.37 million – it is also an attainable one. 

The question is how. On that score, Marin is nothing if not realistic. He is clear that, to generate a sum as large as $98 trillion, there are no short-cuts. “Unless you are prepared to literally break the social contract made perhaps as long ago as 40 years, and renege on pension promises, the only way to solve the problem is through some form of increased contribution and/or better management of the assets,” he declares.  He is not against people paying more. Indeed, he praises post-Allende Chile for having the courage to tackle the results of previously profligate regimes by selling State assets and making savings mandatory. (Oddly, he does not mention Australia, where retirement saving, like voting, is also mandatory.)  But his obvious preference, based on his confidence that investment returns are far more important than contributions at every stage except immediately prior to retirement, is to improve asset management.  Yet even here, his sense of reality does not abandon him. A theme of the book is that “constrained” investors such as mutual funds and ERISA funds can never measure up to the scale of the $98 trillion challenge. He also worries that pension funds have already taken excessive risks in an effort to bridge the funding gap. He is distinctly cool about strategies which aim to capitalise on the premium inherent to illiquid assets such as real estate, private equity and gate-able hedge funds of the kind that pole-axed American university endowment funds in 2008. “Risk profiles have increased as pension under-funding has increased, as did allocations to extremely speculative and illiquid securities” he writes. As a result, warns Marin, “now pension plans are faced with under-funded liabilities, significant volatility and generally considerably greater illiquidity.”

Those caveats aside, his belief in the power of compound interest (“How your money is invested is far more important than the amount you save”) and technical innovation is written on almost every page. He regrets the degradation of swaps into yet another means of adding leverage, but retains his enthusiasm for their ability to parse risk. At Bankers Trust in the early 1980s, Marin was not just present at the creation of the swaps markets, but was the first to recognize and exploit the fact that swaps are no more than long-dated, contractual futures and options. Hence swaps also became “derivatives,” albeit of the OTC variety. (He will be enjoying the sight of history reversing itself via the newly created “futurized swap.”) Likewise, despite his own misgivings about the science of investment management (“Good enough for a Nobel Prize, but unfortunately not good enough for the reality of markets over time”), his respect for the people (Harry Markowitz, Bill Sharpe, Fisher Black and Myron Scholes) and the techniques (Efficient Frontier, Capital Asset Pricing Model) that fuelled the quantitative investment management has survived implosions in 2007-09 that others blame directly upon them.  Marin states confidently that a professional fund manager will out-perform the proverbial dart-thrower or troop of monkeys by 3 per cent per annum, and ends by urging his readers to “get professional money management at a reasonable price and let them at it over the long term.” Much of his argument ultimately hinges on whether he is right about that, not least because a growing majority of retirement savers are now reliant on defined contribution pension schemes whose ultimate value depends on investment performance. Marin himself reckons 85-99 per cent of the sum available for retirement from a defined contribution plan depends on investment returns alone. 

To drive returns up to the necessary level, Marin puts forward a number of ideas. One he likes a lot is synthetic mutual fund notes. “Invented by my most creative Wall Street friend, Peter Freund,” Marin believes these can take advantage of what “may well be the greatest and most persistent arbitrage in the history of mankind.” The arbitrage opportunity exists because actively managed equity mutual funds are popular (Americans alone own $4.4 trillion of them) but inefficient (management, execution, and buying, selling and switching costs eat 1.5-2 per cent a year) and so profitable to mutual fund managers (operating margins are 30-40 per cent) that they can sell a mutual fund business for 3-4 per cent of assets under management.  Synthetic mutual fund notes, by contrast, can mimic any mutual fund investment strategy and deliver higher returns by eliminating the frictional costs of orthodox mutual funds. Marin thinks pension funds, and especially the defined contribution plans heavily invested in mutual funds already, can benefit from the higher returns of synthetic mutual fund notes as both a counter-party to the swaps that issuers of notes execute to hedge their risks and by investing directly in them. Marin says that back-testing to 1983 indicates that such notes would have delivered 6 per cent per annum compound for 30 years.

A second enthusiasm is hedge funds. Marin was among the first to notice the institutional potential of hedge funds in the early 1990s, and his enthusiasm for their ability to generate alpha is demonstrably undimmed. He notes, somewhat mischievously, that even Warren Buffett made his first fortune in the 1950s by short-selling rather than buying-and-holding.  For Marin, hedge funds are “as or more adept at using derivatives than anyone” and “the best able to deliver asymmetrical risk configurations labelled as absolute return strategies” and “generally better at delivering uncorrelated risk” than long-only managers. He dismisses the criticism of Simon Lack that managers eat returns in high fees as a matter of intelligent discernment (“differentiate between managers delivering true alpha and those collecting high fees and under-performing”). As to the fear that the weight of institutional money will chase alpha out of the hedge fund industry, Marin argues that will not happen because hedge fund managers eat their own cooking (“managers self-police this issue pretty well given that their own money is likely to be diluted”). In fact, he thinks institutional pressure for a more resilient operational infrastructure, plus the sheer weight of regulation, will have a much larger negative impact on the hedge fund industry than the wall of institutional money that is now falling on to it. He reckons a “much more controlled, regulated, transparent and generally buttoned-up approach to what had grown up as a cottage industry” is already forcing managers to “fundamentally change their way of doing business” and making the business “less profitable and, in some instances, less attractive to managers … It is certainly fair to say that some of these institutional elements are cramping managers’ style and cutting in on returns for both managers and investors.” 

Given those misgivings, what makes Rich Marin think hedge funds can help to plug that $98 trillion gap? One way he identifies is by improving their share of securities lending revenues, and sharing the higher returns that accrue with the institutional investors that are the principal source of those securities in the first place. This makes sense. Securities are borrowed by hedge funds to fulfil short sales. Short-selling is one of the principal drivers of hedge fund alpha. Lending hedge funds securities to cover short sales accounts for a substantial proportion of the profitability of both indexed investing and custody banking. Custodians, in return for a share of the revenues, lend securities on behalf of their end-investor clients to the prime brokerage arms of the investment banks which on-lend them to hedge funds. This is why Marin makes the counter-intuitive point that “the biggest clients of the major custodian banks are not the pension funds but the prime brokers.”  In effect, custodian and investment banks have profited massively from lending securities that belong to pension funds. On grounds that its revenues are reliable, Marin reckons securities lending might account for half the value of investment banks. He notes that, 383 Madison apart, the only piece of Bear Stearns J.P. Morgan really paid for in March 2008 was its prime brokerage franchise, whose profits depended almost entirely on securities lending and financing. The pension funds, meanwhile, enjoy what Marin calls “a small amount of incremental revenue” while taking “most of the risk.” He estimates that asset owners collect an average of 23 per cent of the revenue from securities lending, while the intermediaries devour the other 77 per cent. 

Unusually, in a world in which additional return is tightly correlated with increased risk, a more favourable split of securities lending revenues between investors and intermediaries could be achieved while actually reducing the level of risk. Marin is hard on the abuses that characterised securities lending in the pre-crisis marketplace. He lambasts custodians for their role in lending their clients’ securities on terms that were blatantly in their favour, even describing the boom-time practice of shovelling general collateral into the investment banks to maximise returns on cash collateral reinvestment as a “truly fraudulent activity because it benefits the custodian while hurting the beneficial owner.” As bad, in his view, was the exploitation of the ignorance of end-investors by investment banks, which used the cash generated by on-lending the securities to third parties – re-hypothecation, as the technical term has it – to fund their own business. This practice led to losses by end-investors when Lehman Brothers and MF Global collapsed. But, as Marin points out, it is what tends to happen when under-funded, return-hungry investors enter “the deep end of the pool.” A story he tells against himself, of winning a $1 billion indexed mandate for Bankers Trust at a price of zero basis points, says it all about how the character of the market at the height of the boom: Bankers Trust did not need a fee because they knew they would make a fortune lending the stocks in the portfolio.

In other hands, stories of that kind might easily furnish the opportunity to moralise. Because Marin is more interested in problem-solving than sermonising, he gives himself a different sort of opportunity: to agree that market practices and solutions are less than ideal, but look to modify rather than replace them. The chapter on Liability Driven Investing (LDI), for example, portrays LDI as a necessary evil at best. Marin understands that LDI is a godsend for investment consultants (since plan sponsors have to consult them repeatedly to fine-tune the portfolio of assets held against pension liabilities) and a golden opportunity for investment banks (to sell pension plans interest rate swaps to fix the rates they pay or collect). He regrets the fact that LDI is behind the current institutional preference for fixed income and pension risk transfers. But he nevertheless concludes that LDI is “the best single tool for pension fund management readily available for managers today.” This is because he can also see LDI as a positive force, in terms of the encouragement it gives to funds to shift their equity portfolios into a mix of indexed and high alpha asset classes (such as hedge funds and private equity). That, thinks Marin, is a prudent way to combine predictability with enough risk to make a difference to the returns.  

Likewise, his discussion of the merits of freezing a pension plan (a term which covers closing it to new entrants as well as halting or attenuating benefit accruals), terminating it or transferring the risk to an insurance company is dispassionate to the point of unenthusiastic. Each option is nevertheless included as a potential part of the solution to the under-funding crisis.  Even his palpable dislikes exhibit a similar willingness to grasp the counter-arguments. Marin is scathing about accounting rules such as FAS 158, for example. He reckons that, by forcing plan sponsors to include funding shortfalls on the balance sheet, FAS 158 encourages the freezing of pension benefits in Defined Benefit plans and the shift to Defined Contribution alternatives, incentivises full funding risk transfers via buy-outs boost, and boosts the spread of liability-driven investing (LDI). Yet he accepts that all such measures are explicable: they offer plan sponsors a reduction in volatility, in terms of the impact on the company financials. But that understanding does not stop him arguing that reducing volatility is the wrong priority, and that pension funds should be focusing on the maximisation of returns. 

Where Marin is unequivocally impolite is in addressing misguided regulation. He describes ERISA as “the most arcane and devious tool of corporate torture ever invented … It would make Torquemada blush.” Marin blames ERISA for discouraging plan sponsors from maintaining defined benefit pension schemes by increasing their costs and decreasing their returns through over-tight regulation of what they can invest in. That has, he thinks, constrained the investment options of pension funds, emphasised relative rather than absolute performance, encouraged excessive specialization in money management (notably the concomitant search for alpha through hedge funds and beta through indexed funds) and inadvertently promoted the over-selling of OTC derivatives. He is equally unimpressed by regulatory pressure (such as the US Pension Protection Act of 2006 and the UK equivalent, which set up the Pension Protection Fund) to force ailing companies with under-funded pension plans to top up them up, even specifying the (currently near-zero) discount rates which determine the size of the shortfall, and actually penalising under-funded schemes. This prevents them, says Marin, from finding their own solutions to their difficulties through merger, a benefits freeze, termination or the transfer of the liability to a third party. Indeed, he likens forcing increases in contributions on to ailing plans to “imposing a heavy tax burden on a dying man specifically because his death worries you that he will leave obligations that cannot otherwise be met. It might be fair to say that this sort of taxation might very well create a self-fulfilling prophecy.” Nor is Marin convinced that investment consultants help pension fund managers when they publish alarmist surveys and studies that attempt to measure the scale of under-funding. 

Such gloomy prognostications offend his sense of the possibilities. For Rich Marin is one of those people - rare, even in America - who cannot fail to make their readers, any less than their interlocutors, feel anything is possible. He describes himself at the outset as “more than anything, a storyteller” (he is a lover of movies, and HBO has filmed one of his stories) and he certainly uses his ring-side seat at many of the most exciting developments of the 25 year boom in investment banking to enliven the text with personal anecdotes, including more than one story he tells against himself. His reassertion of his own optimism in the final paragraphs (“I am an optimist at heart”) is the least necessary passage in a book whose pages reverberate with authorial enthusiasm for what comes next. Unlike most men of his age and experience, Marin has even retained his confidence that the next generation can learn the lessons of his own. “Yes, we have a temporal problem, and it is big problem,” he concludes. “But the problem does indeed go away and the future beyond that does, indeed, look bright, given the lessons we can reasonably expect our younger generations to have acquired.” This is allied to a strong distaste for the theft-from-the-future of his own generation, which imparts a distinctly Austrian flavour to the work.  “As a member of the Baby Boomer generation, I can say with great personal conviction that we are far too gratification-focused for our own good,” he writes. “We are only now waking up to the realities that our over-extended lifestyles, financial miscalculations and `live-in-the-moment’ ways are now due and payable ... We created a generation that was driven by instant gratification and entitlement that was prepared to borrow from the future to finance its lifestyle today, thereby creating the very dangerous `privilege gap’ that will set generation against generation as we all seek to enjoy the lifestyle we all thought we were due.” 

This is why in the end the economics of the book are also Austrian rather than Keynesian-cum-Friedmanite. At bottom, Rich Marin believes that growth will solve the problem of retirement provision, and that growth come from the wise investment of real savings rather than borrowed money. He believes that living standards rise when people put something aside, and use it productively. Like the best of the Austrians, he believes that takes time above all else. Marin played a small part in the creation of the Chilean pension fund market in the mid-1980s, when he led the Bankers Trust bid to swap its non-performing sovereign debt for equity ownership of local pension fund and insurance companies, and it is in the pages examining what Chilean savers have achieved over the last quarter century that his vision of the importance as well as future of savings-funded retirement achieves its clearest expression. “Capital generally hates being committed long term, but the best place to find such patient capital is in the long term savings pools which tend to be retirement pools,” he writes. “Institutionalized retirement savings simply perform better (as we have discussed, by 2-10 per cent, which is an enormous edge over the long horizon of retirement planning) and thus the discipline of mandatory retirement savings organized into pension funds may well be the most important element in creating a sustainable and prosperous economy. And please remember (for the libertarians in the audience) that mandatory retirement savings is the best means of avoiding the ultimate fiscal deadweight of nationally supported retirement, especially in an ageing population.”