In his presentation to the Chartered Institute of Securities and Investment conference on Risk and Uncertainty, Jon Exley made the case, eloquently and at length, for using bonds to match pension liabilities. This argument is rooted in the “Law of One Price” and that is a key ingredient in modern finance theory. It is, of course firmly based in ‘Model Land’ to borrow from Erica Thomson who also spoke on the day.
Reality is a very different world to ‘Model Land’, as can be seen when examining the cost of capital to the private sector and the returns earned on that capital. This is shown for the US in Figure 1. The US is chosen to show these rather than some other country’s figures as the US has the largest and most sophisticated financial markets and can be expected to satisfy most closely the conditions for the “Law of One Price” to hold.
Figure 1: US Cost of capital and returns to capital in the US, 2009 – 2022
As The Economist noted in 2013:
“When things are in equilibrium, the return on capital (the profits of businesses) should equal the cost of capital (their borrowing costs).”
Equilibrium is the condition in which the “Law of One Price” is expected to apply. The Economist further noted that:
“If the return on capital is higher than the cost, there will be great demand for credit and an economic boom will ensue. If the return on capital is lower than the cost, there will be a slump as companies go out of business.”
This has clearly been borne out by subsequent developments, most notably in the case of the ‘surprising’ growth and resilience of the US economy under monetary tightening.
For a pension fund investor, the lesson is clear: equity offers superior returns in all but the most unusual of circumstances, which in this illustration was in 2009, and there was rather a lot going on in that year to make it unusual.
Matching pension fund cash flows with bonds i.e. dedication is quite simply a very expensive and far from optimal way in which to deliver the returns needed for our pensioners to have a dignified retirement in the real world.