Posted by on May 13, 2015

(I have to issue a geek alert at the beginning of this post. Many of the topics discussed below – pension accounting, Chinese demographics and UK electoral mathematics – have, shall we say, limited general appeal.  If you are squeamish about geekiness, I suggest you avert your eyes now.)

One of the advantages of living abroad is that you see how other societies have approached common problems.  You realise that things you take for granted need not be the way they are.  The pension system in the US is an excellent example.

The first thing to observe about pensions in the US is the insane way that the accountants treat them.  One of the first lessons you learn when studying finance is something called the “separation theorem”, which holds that a company’s investment decisions are separate from its financing decisions.  In other words, if a company borrows low-risk and low-cost money to make an investment, that doesn’t mean that the company should be satisfied with a similarly low return on the projects it undertakes with the money.  Nor does it mean that the expected return on that investment is relevant for determining the cost of the debt that has been undertaken to make it.  The financing decision and the investment decision are “separate” and each should be considered on its own merits.

For the most part, accountants adhere to this principle.  But pension accounting is a notable exception.   The pension promises that a company or government makes to its employees, to secure their current labour in return for a promise to pay them something in the future, are no different from a promise to pay any other debt.  Even the most benighted accountant would never think of using the expected return on an investment to determine the cost of the debt undertaken to make that investment; the debt has its own risk and cost and that is the appropriate rate to use when determining its value.  Yet, amazingly, that is precisely what generally accepted accounting principles (GAAP) prescribe when it comes to determining pension liabilities.  Instead of discounting promises to pay pensions at an appropriately low rate, the accountants accept that they are discounted at the expected return on the pension investments the company or government sets aside to fund them.  But let’s be crystal clear: although the pension assets are the first port of call for making these payments, if they prove inadequate, then the company or government has an unconditional obligation to make the payments.   This obligation is no different from any other debt, as the recent bankruptcy of the Detroit, largely brought down by its pension liabilities, has just proven.

Now, why bring up this relatively arcane matter?  And why now?  Because this violation of sound theory is responsible for some of the dumbest stuff out there, all of which is part of the general tendency to kick our financial problems down the road.  Let’s look at a few of them.

The first is the problem of pension underfunding, especially in the public sector.  Everyone knows about this problem, but it is probably less known that pension accounting means that it is grossly understated.  A typical discount rate for pension liabilities is in the 7-8% range, when in fact they should be evaluated at a much lower rate, something on the order of 2-3%.   Which means that the liabilities are understated by at least 50%.  For example, the State of Illinois, already a basket case with a pension that is underfunded by 60%, is actually in much worse shape than this.

It is also clear that, in addition to understating the financial difficulties of the public and private sector, this misguided accounting encourages it.  If governments and companies were required to recognize the true cost of these future promises to pay, is there any doubt they would be less generous in granting them?   Likewise, would we have the pension system that we have without the accounting – and tax, since we can never have anything this irrational without a major push from the tax code – impetus that this treatment provides?

Americans probably don’t realize it, but our pension system is the exception, rather than the rule, in a world context.   The system of individual employer (company or governmental) pension plans is totally anomalous and deeply dysfunctional.  In most countries, pensions are provided by a collective entity (public or private), which does nothing else but provide this service.  Pensions are funded by a combination of employer and employee contributions, but they are owned by the employee and are totally independent of his employment; they are, to use the jargon, “portable”.   Which means that workers are free to choose the most beneficial and productive employment without overly worrying about losing pension benefits from a change.  Which means that we don’t have the bizarre situation of a company like General Motors, where the servicing of its legacy pension and medical benefits dwarf its current industrial activities.  And which means that pension funds stay fully funded, since no independent entity would allow a company or an individual to accumulate pension rights “on credit.”

The absolute absurdity of this situation is crystalized in something called a “Pension Obligation Bond.”  This is a tax-exempt bond issued by a government entity where the proceeds are dedicated to pension investments.  In other words, this is retirement investing on margin, a policy that is considered grossly imprudent when employed by individuals but which is positively encouraged by the bizarre accounting applicable to pension funds.  Although usually the preserve of Democrat-controlled and fiscally irresponsible states such as California and Illinois, a large issuance of these bonds is currently being considered by Republican Governor Sam Brownback of Kansas  in order to dress up his pension numbers.  This goes to prove that, despite their strong market share, Democrats do not have a monopoly on economic stupidity.

And, of course, we mustn’t forget the role that the Federal Reserve plays in all of this.  In many respects, the crisis in the pension sector and the increasingly otherworldly accounting treatment of these liabilities is another manifestation of the retirement time bomb that the Fed’s policies of “financial repression” and zero interest rates (ZIRP) are helping to create.  In my last blog, I commented on the havoc that these policies are wreaking with the retirement planning of individuals.  The institutional sector is feeling the same pain.

Disturbing Demographics

There have recently been some interesting articles about Chinese demographic trends.  The first was published by the Economist and is entitled “Bare branches, redundant males.”  This article chronicles how the Chinese one-child-per-couple policy (the “OCPCP”), enforced since 1980, has, when combined with a cultural preference for boys and sex-selective abortions, completely distorted the marriage market.

Babies are naturally born in the ratio of about 105 boys for each 100 girls.  In China, with sex-selective abortions, this ratio has recently been in the range of 116 to 100.  This translates into 66 million “missing” girls, or roughly 10% of the female population.  Through a series of other demographic factors – including falling fertility rates, the tendency of men to marry younger women, a “queuing effect” (resulting from the fact that men have a longer shelf-life in the marriage market than women), and the tendency of women to stay single as they become wealthier – this disparity is expected to be amplified.   A projection from a French population think tank indicates that, at its worst in the years 2050 through 2054, there could be 186 single men for each 100 single women looking to marry.  This “marriage squeeze” will also not be proportionately spread across the population: since women tend to “marry up” from a socioeconomic perspective, and men tend to “marry down,” this means that men at the bottom of the ladder and women at the top will find very slim pickings indeed.

All of this matters, among other reasons, because a lot of unattached males, particularly from the lower socioeconomic strata, does not exactly promote a healthy society.  A Columbia University study, for example, found that a 1% rise in the Chinese sex ratio was associated with a 6-7% increase in violent crimes and theft.   Belatedly, the Chinese government – those hyper-intelligent Mandarins in whom investors place so much faith – has recognized this problem.  They have loosened some of the restrictions in the OCPCP.  They are also doing helpful things like publishing articles in state-run newspapers promoting marriage to foreigners.  One of their fatuous suggestions: Ukraine is apparently a very promising source of mail-order brides, which goes to prove that Chinese political leaders have obviously never read A Short History of Tractors in Ukrainian.

Other interesting demographic dynamics are the coming end of rural migration to the cities and China’s rapidly aging population, both as highlighted in a recent article in the Financial Times.  When a country is developing, its economy receives a huge boost from shifting labour from low-productivity rural activities (such as farming) to higher productivity jobs in the cities.   Since Deng Xiaoping launched his reforms in 1978, 278 million Chinese workers have moved from villages to the cities, greatly accelerating China’s growth.  This migration is coming to an end, in an event known to demographic’s geeks as the “Lewis Turning Point”. In addition to this, China has a rapidly aging population, the result of falling fertility and the OCPCP, which means that the working age share of the Chinese population will peak this year at 72%.   From this point, the fall in the Chinese working population will be even sharper than is being experienced by Japan, where adult diapers now routinely outsell baby ones.  Put the Lewis Turning Point and a greying population together, and the potential growth of the Chinese economy is due for a sharp decline.

And there is another factor.  When it comes to development, the easy part is at the beginning, particularly for top-down economies and cultures.  The path of development has been well trodden by previous societies.  A country like China can advance very quickly simply by employing the strategies and technologies pioneered elsewhere – there is a huge amount of “second mover” advantage in economic development.  However, the ability to advance by copying others decreases over time and eventually developing countries have to start working at the innovation coal face, like their more advanced brethren.  One of the reasons Japan has struggled is that it never successfully made this transition from “input-based growth” (throwing more human and capital resources at doing the same things) to “innovation-based growth” (using the same inputs, but doing things smarter).  For years, Japan’s failure to successfully navigate this change was masked by a huge economic bubble.  With China, it may be a case of déjà vu all over again.

British Elections

I think that everyone has heard more than enough about the results of the English elections by now – if not, here is a very good summary of the numbers.  In a surprising result, the Conservatives have come out with a thin majority in Parliament, replacing the coalition government that they previously headed.  Other major results were the evisceration of the Liberal Democratic Party (the junior member of the previous coalition, which saw its representation in Parliament plummet from 57 to 8) and the rise of the Scottish National Party (“SNP”) (which captured 56 of the 59 seats north of the border).

I would just like to make three points about these results.  The first is that, in my humble opinion, the major factor behind the Conservative victory is that voters, when faced with the alternative of a Labour/SNP coalition, quite wisely decided not to jump off that particular cliff.  The SNP, in addition to its advocacy of an independent Scotland, is also very left wing; it would have dragged a coalition government into the looney fringes (with Ed Miliband, the putative Labour Prime Minister, probably offering French levels of résistance).  This is the reason for the enormous sigh of relief in the financial markets when the Conservatives came out on top.

But the combined ascendency of the Conservatives and the SNP means that the battle lines over Scottish independence are now more sharply drawn than ever.  One of the strongest arguments used by the SNP has always been that a left-leaning Scotland should not be under the adult supervision of a right-leaning England.  This election makes the split very stark and another referendum on Scottish independence is certainly in the offing.  The Conservatives may try to head this off by devolving further authority to the Scottish Parliament, including greater taxing and spending powers.  A recent Economist editorial argues that this could be wise politics in more ways than one: stating that Scotland’s “rent-seeking (ie., parasitical) political culture will end only when the Scottish government has power over finances.”

The last point is that the English electoral system will come into further question.  The English have a system of electoral districts (called “seats”) and a “first past the post”, winner-take-all voting system.  As with the Electoral College in the US, these two factors can produce election results which differ from the popular vote.  For years, the dominance of the Conservatives and Labour kept the differences reasonable, but with the recent emergence of small parties – notably the SNP and the United Kingdom Independence Party (“UKIP”) – the disparity has grown.  So, the Conservatives’ majority in the House of Commons was earned with only 36.9% of the popular vote, whereas each SNP voter has roughly twice the representation in Parliament as the average (8.6% of the Parliamentary seats resulting from only 4.7% of the popular vote).  At the opposite end of the spectrum, UKIP – the party that wants to take the UK out of the EU – garnered 12.6% of the popular vote, up a whopping 9.5% from the last elections, but had but one MP to show for it.    As the same Economist editorial puts it: “With the relationship between votes and MPS in the Commons now almost random, the first-past-the-post method of allocating seats has clearly failed.”

But for the moment, we denizens of the UK are quite happy to have it.

Daydreaming

The results of the 2014 National Assessment of Education Progress, the so-called “nation’s report card” for 8th grade students, have recently been published.  I can’t find any references for this, but apparently some of the results are hilarious.  Like, for example, roughly one quarter of American students think that Canada is a dictatorship.  I guess they got this from watching South Park: The Movie.

This has got me indulging in one of my favourite daydreams: requiring people to pass a rudimentary test of civics, economics, world and current affairs before they are allowed to vote.  I would love to try to get an amendment to the Constitution passed imposing this requirement, if only for the amusement of watching who would line up on each side of the question and the arguments they would use.   Sadly, it’s not obvious that this would break along party lines, although I think that most Republicans would side with me.

Until the glorious day arrives when this amendment is passed, and I am sure that it is just a matter of time, I will remain resolutely opposed to any efforts to make voting easier.  If people can’t be bothered to work a bit to vote, then the chance that they represent informed consent approaches zero.

Roger Barris, London

 

I Wish That I Had Said That (Although Decidedly Not This Time)…

“We decide on something, leave it lying around and wait and see what happens.  If no one kicks up a fuss, because most people don’t understand what has been decided, we continue step by step until there is no turning back.”

“When it becomes serious, you have to lie”

“If the donkey were a cat it could climb a tree.  But it is not a cat.  Nevertheless, this is a question that worries many people.  My answer to it is almost a little theological: I do not believe that this question will ever be asked,” Jean-Claude Juncker, the President of the European Commission, in response to various questions about the workings of the EU and the Greek crisis

 

 

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Comments

  1. Dave Anderson
    May 13, 2015

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    Re pensions, I agree with you, what simple counter-example would you use to deal with the simple perception that, if I owe a $107 pension payment in one year, and can plausibly assume that the $100 in my pension plan will earn 7% this year, my current net obligation is $0?
    Re China’s male surplus, shouldn’t we worry that the natural result is to have a war using all these excess males as cannon fodder? Note that in Rwanda, the intensity of the genocide in each district correlated well to the degree of overpopulation in that district.
    Re election systems, note that U.S. system produces the result that 75% of U.S. Senators are elected by 25% of the US population. Hence things like ethanol subsidies.

    • Roger
      May 14, 2015

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      Thanks for your comments, Dave. If there was anyone out there who would not be deterred by my alert, it was definitely you.

      To respond to your first comment: The key is your phrase “plausibly assume.” As you know, in accounting, there is a general presumption that we do not net assets and liabilities, but rather show the gross numbers on both sides of the balance sheet. One exception to this rule is the “defeasance” of a liability. In this case, the accountants allow such netting because a liability is exactly matched by payoff from a riskless asset, such as United States Treasury Bonds. The accountants allow this because there is no risk — baring a default on the Treasuries — that the asset will not produce sufficient money to pay off the liability and the cash receipts are exactly timed to the cash outflows, both of which are fixed. This strikes me as a logical accounting treatment but it is far, far from the situation with pension assets and liabilities, where both the assets and the liabilities are subject to large risks and timing variability. So, I guess that I would respond by saying that, if the extreme rigor applied to defeasance transactions is reasonable, how can a much laxer standard apply to a “defeasance” of a pension liability? The simple truth is that the accountants have collapsed in front of political pressure, from both governments and companies, and there is no logic to their position.

      Your comment about China’s surplus males is interesting and chilling. I know that, like me, you are a fan of evolutionary psychology. The tendency of unattached males to aggression, along with the response to overpopulation in Rwanda that you cite, are good examples of evolutionary holdovers in human behaviour. Sometimes, reason can overrule these tendencies. Let’s hope that this is one such case.

      No real comment about the allocation of Senate seats, except to say that, given the general tendency of less densely populated states to vote Republican — perhaps another manifestation of evolutionary psychology? — I would prefer to let this particular sleeping dog lie. Although this system occasionally throws up some outrageously stupid, “pork barrel” policies like the ethanol subsidy (or agricultural subsidies in general), the alternative would be far worse.

  2. David
    May 14, 2015

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    The pensions issue is definitely worrying and such a clear example of procrastination on a country-wide level.

    In respect to China, I am happy to not be a part of those odds. That being said, I would assume the imbalance isn’t bad for the top tier females. If anything, they accrue more benefits with their increased relative value, unless they decide they are too good for any partner.

    • Roger
      May 14, 2015

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      Reminds me of something that I have often said: being an American soldier in Europe immediately after WWII must have been a pretty good gig. Lots of money and a very attractive ratio of females to males. Even you, Hirschie, would have had a good shot….

  3. Dave Anderson
    May 16, 2015

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    I wonder how much you could think the pension situation is parallel to the situation of life insurance companies in the early 1980s, when the fast increase in interest rates engineered by the Federal Reserve had caused life insurance reserves – which were heavily invested in long term bonds to match the obligations of the life insurance policies – had declined dramatically in value. The result was that the insurance companies were almost entirely bankrupt on a mark to market basis. However, they all recovered in the long run as their franchises continued and they clawed back from the hole that they had fallen into. I wonder if we could gain any insight from comparing these two sets of long term liabilities and the havoc created by unexpected interest rate changes. Obviously, the pension plan problem is the reverse of the life insurance problem, in that the value of the long term promise made by the life insurance companies is reduced by high interest while the value of the annuity promised by the employers is increased as interest rates go down. But, it seems like the comparison is interesting.

    • Roger
      May 18, 2015

      Leave a Reply

      I am not really familiar with the situation with the life insurance companies in the early 1980s, but it does sound like there might be some major differences. If the bond portfolios were long duration in order to match long duration insurance liabilities, then it sounds like they did have an economic hedge — long duration and fixed on each side of the balance sheet — although it also sounds like they did not have an accounting hedge, since it appears that the accountants forced them to MTM the long-duration assets without allowing them to MTM the long-duration liabilities. That is one difference. The other difference is that, although the insurance companies might (or might not) have been running a duration mismatch, they weren’t running a risk mismatch. The pension funds have risky assets — equities, hedge funds, real estate, private equity, etc. — which they are using to fund fixed liabilities; they are strongly encouraged to run this risk mismatch by the accounting treatment I have described, which allows them to reduce their liabilities by the expected return on their assets. That’s great….if it works out. This accounting treatment also encourages systematic underfunding, since they can take credit for their expected future investment earnings (which may or may not materialize), and overpromising benefits (since they can, at least from an accounting perspective, ignore the real cost of the promises they make). In other words, the accounting treatment encourages the worst tendencies of governments (and some corporations) to “kick the can” down the road in the hope that strong investment performance will bail them out. Or that they won’t be around when the problem becomes unavoidable. All in all, a bad policy for which we will suffer shortly and probably sooner than we think.

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