Paper Promises: Linear Desires In a Changing World

So many people want the world to go like this.

Yet the world actually goes a little bit more like this.

The financial industry earns a huge amount of money promising the former experience to the public and whilst I understand people’s desire for things to be predictable and to feel like things are under control, it can lead to missing out on investment returns and paying a high price for some degree of certainty, or perhaps just a perception of predictability.

In the realm of pensions this has lead to the wide use of products that I feel are either now not really working for the public, or has led to large scale promises that will be extremely challenging, perhaps even impossible to deliver.

Annuities

An annuity is a product where you hand over your capital to an insurance company and in return they provide a stable income for the remainder of your life, no matter how long you live.

It is basically insurance against living for a very long time and not having enough capital to support yourself, as you receive the benefit of the capital from people who have these contracts but don’t live as long. So what happens is that some people who purchase an annuity receive very poor value and some receive excellent value, dependent upon how long you live.

What it provides is the piece of mind that you will receive a consistent income.

However my concern is that you pay a very high price, especially at the present time.

The manipulation of interest rates and the introduction of QE have caused government bond yields to go to historical lows and this has basically ruined the attractiveness of an annuity.

At annuity rates of 5% for example, you need to live for 20 years just to get your capital back! That is a very risky gamble on how long you will live. Annuities will seem more sensible when government bond yields rise and annuity rates are at 10% for example, but even then consideration needs to be given to the return available directly from government bonds (and other investments) without giving up your capital.

Public and Private Defined Benefit Pensions and State Pensions

Giving into people’s desire for certainty only creates additional problems if our experience of defined benefit schemes and state pensions is anything to go by.

Attempting to apply precision to the future and promising a linear world has created a sorry mess in the realm of defined benefit schemes and state pensions.

As a country, we are going to have a very difficult time trying to either honor the contractual promises that have been made, or explaining to people they can’t actually get what has been promised.

Basically the capital isn’t there to back up these promises.

The realm of pensions has basically become a giant legalised Ponzi scheme, where the money that people pay in now is paid out to existing retirees.

With respect to the state pension, in absence of the legal compulsion to contribute, the system would collapse.

A system that only works through force is hardly a good system. Please don’t rely on it to support you in older age. I feel you’ll be disappointed, especially if you’re under say age 40.

As we have created the perception that the money is there, simply by providing a piece of paper saying that someone is entitled to it, everyone who now expects these payments will feel aggrieved if it is taken away, even just by a small amount (and perhaps quite rightly).

Yet how exactly can these promises be honoured without taking money away from somebody else?

The money simply isn’t there.

It turns out that taking away an empty cookie jar is actually extremely difficult to execute, especially when we’ve told people for years that it’s full of cookies.

Think about recent teacher and firemen pension strikes and the difficulty of trying to water down on promises that we have made.

This is from just small reductions in their pension promises.

(As an aside, this reaction to loss is partly why inflationary policy is so desirable for people in the business of making grand promises they cannot keep, such as governments).

Charlie Munger discusses this behavioural bias in his 1995 Harvard speech.

So by creating a linear perception in people’s minds through paper promises, we have created a scenario where any attempts to take away part of something that isn’t actually even there will create huge anger amongst the public who are expecting such payments.

Yet how exactly will these promises be paid for without taking away from one group to give to another? And how can we milk a younger generation that largely hasn’t even been working?

It would have been better if everyone were consistently honest from the outset.