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
Source: LSEG Datastream, Credit Capital Advisory
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.
Sadly my building society wasn’t impressed with my suggestion of trebling my mortgage, investing 2/3rds in equities, assuming an extra equity return of 3-4% pa and halving the monthly repayment over a shorter repayment period.
I am not surprised – that is not their purpose.
You put up 14 years of data with only the first showing a shortfall to suggest this implies that in all but the most unusual of circumstances equities do better. That’s an absudly small set of data points to make such a wild and inaccurate suggestion. Fortunately I recognised strong recognition at that conference that bonds do match the liabilities.
The theme of the conference could be paraphrased as “Junk the models and look at the data”. To falsify a hypothesis or model, such as the ‘Law of Price’, just one instance is sufficient; there are 14 in the figure illustrating the blog. I could challenge you to show me a single instance where the cost of capital has equalled the return on capital. To show another instance in the US where the cost of capital exceeded the returns on capital, I would have had to show data going back to the early 1980s when Volker raised federal funds to 20% and prime rate reached 21.5%. Scarcely normal times as Continental Illinois would testify to. Then of course, this would be open to the criticism that this situation prevailed in the UK in the 1991/92 period – though that was also another highly unusual if nationally dominated period – in the UK, the negative equity crisis, exchange rate mechanism turmoil and Maastricht all come to mind.
I am not saying that pensions liabilities cannot be matched with bonds as, clearly, they can. I am saying that this is a far more expensive method of defeasing liabilities than using equities (in a diversified portfolio) and of course, this higher cost to their corporate sponsors has been a significant contributor to the decline of corporate investment. The extent of this bond fetish has been sufficiently large that over the two decades of its application, it has served a material role in both the relative depression of UK stock market returns and capitalisation and the inflation of gilt prices and suppression of their yields, until late 2021. These are among the concerns motivating the Mansion House agreement.
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