Notes From a Native Son: Fooling Some of the People All the Time
Pensions policy has been the most talked-about of all social policies in the late 20th and early 21st centuries. To be now discussing the subject in relation to Barbados is like going back in time, but it is a necessary discussion to have, given the reluctance of decision-makers to even learn the basics of the subject. But before doing so, a brief history: state pensions as the term is now understood in policy discussions go back to 1898, when Bismarck introduced the benefit in Germany, with a state retirement age of 65. However, in those days, longevity was about 45, so it was unlikely that most working Germans would reach retirement age, and if they did, live very much longer. But, post war, due to improvements in medical science, nutrition, and a reduction in hard, physical work, global longevity has now expanded by leaps and bounds with people in developed countries now living in to their 80s and 90s. What this means in real terms, is, for example, someone coming out of university at the age of 23, working for 42 years and retiring at the age of 65, has on average 15 or more years to live. With a growing population, there were on average about four to five workers for every retired person at the turn of the last century, making the pay-as-you-go system viable. However, combined with the demographic time bomb, in which there are now about two workers to every pensioner (Japan at present, China by 2030, and most developed nations, with the exception of the US, by 2020), this is no longer viable.
In 1981, under the brutal General Pinochet, the Chilean military government embarked on one of the most progressive reviews of state pensions in the world. This was followed by most democratic countries, leading to a series of state-backed pensions, geared to meet this challenge. In New Zealand we got the KiwiSaver, in Australia compulsory superannuation, in the US 401(Ks), in Britain National Employment Savings Trust (which is semi-compulsory), and many more.
The Barbados model is different, either through being clever, or being too clever, but it has similarities to the Singapore scheme, which included a number of other linked schemes, including social security sand the Central Provident Fund, the scheme that has driven Singaporean development. Merged with the state-backed Barbadian pension scheme are a number of other benefits, including the unemployment benefit scheme and the sugar workers’ provident fund, both of which are social security funds. I shall leave out these peripheral schemes which only add to the confusion.
In a vain attempt to clarify the confusion surrounding the NIS, in the latest issue of the central bank’s Economic Review, there is an article on the scheme, written by Anonymous, which, implicitly, is the official view of the fund and its performance. It has again perpetuated the view expressed by its chairman, Dr Justin Robinson, in London a few weeks ago, which was supported at the time by a Cabinet minister. Setting the outline of the article, in the abstract the author sets out the arguments that s/he intends developing in the body of the article and, to say the least, it is a rather unorthodox interpretation of a state-run pension fund. However, despite good intentions, there are a number of aspects peculiar to the Barbados scheme.
The NIS Defence:
The article sets out to explain why the NIS has made substantial growth since the 1980s and “examines how the fivefold increases in its surpluses have been invested in government securities and other forms of local sovereign debt.”
Here I want to explain two key myths about the author’s views of the national insurance scheme and a possible uniqueness (or ignorance) of how ordinary state pension schemes are structured and managed. The first ‘myth’ is the bold claims that the scheme has invested its fivefold surpluses in government securities and local sovereign debt.
One of the principles of investing is modern portfolio theory, that is diversification, which the NIS either does not observe, or is not aware of.
Put simply, by diversifying a portfolio – by asset classes, geography, stocks, etc – under-performance in one asset class can be balanced by a good performance, or even over-performance, in another. By over-investing in Barbadian gilts and, presumably, those of other other Caricom governments, (if this is what is meant by local sovereign debt), the fund is being badly managed, in my view, which I will explain.
The Barbados national insurance scheme is a hybrid scheme, which means that while its main funding comes from pay-as-you-go, a smaller part of its funds come from its investment performance. By pay-as-you-go it is meant that deductions from the pay packets of this generation of workers will go towards paying the pensions of those who are already retired.
During periods of high employment, contributions will clearly be higher, while with unemployment at 12 per cent or so, contributions will not only be lower, but social security (ie hardship) payouts will be higher. What the chairman of the NIS, Dr Justin Robinson, calls a ‘surplus’ is the rather strange belief that the fund has enough cash to pay out benefits for eight years or so to current beneficiaries. I have told him this is a serious misunderstanding of the actuarial mathematics of pension funding, but clearly the myth still pervades.
The triennial actuarial assessment of the fund will stress test the fund for its future obligations, not just based on the current obligations over a short period (therefore the myth of a surplus) but of future obligations, ie the current cohort of workers reach retirement age there must be enough funds to pay their pensions and future generations. So, the stress test is based on obligations 25, 30, 40, 45 years ahead, with inflation factored in and an assessment of the future of employment and economic growth over that period, including mortality and longevity assumptions. So, the idea of a ‘surplus’ is simply wrong.
Further, the article talks about rebalancing in a rather vague way, but according to Dr Robinson, when the DLP government came to power, the scheme had a 75 per cent investment in government gilts and other securities, which, for the reasons already explained, is ludicrous. However, it is now 65 per cent (or 68 per cent), which in real terms, is more or less the same in financial economic terms, although politicians and junior researchers (and anonymous authors) will like to claim a minor rebalancing victory. But the uniqueness, or ignorance, of the role of a state-backed pension is explained in the very introduction: “Over the years, the national insurance scheme’s role as a major financier of government operations and as an age of macro-economic stabilisation has become increasingly important.” No. No. No. This is both policy and economic nonsense, which is made worse by being published (anonymously) in the official journal of the central bank, which means it has been officially endorsed.
It is not the role of any state-backed pension scheme, not even in Barbados, to be a major financier of government operations, nor to be an agent of macro-economic stabilisation. The role of the NIS – and all state-backed pension schemes – is to provide retirement incomes for its beneficiaries. Nothing more, nothing less.
As to managing the NIS as a macro-economic stabiliser, maybe this is what governments, BLP and DLP, have turned the fund in to over the years, but macro-economic stability is a function of monetary policy ie the central bank and ministry of finance. Then the article throws in a straw man: that recent public discussion has been about the amount of money invested in government gilts and other projects, and has this level of investment changed over time?
Again the anonymous author is wrong. People have been fuming about ‘investing’ in Four Seasons, which is different. Recent public discussions have been about the incompetent administration of the NIS, as is evidenced by the Auditor-General’s last few reports, and about the lack of a transparent investment strategy at the NIS. From where I stand, there is no investment strategy. Had there been one, hopefully it would have been on the fund’s website. But, with a rhetorical brush and wave, the author has dismissed the need for a proper explanation of the source of the ‘surplus’ and stuck to his mythical surplus argument.
Since the other two funds are hardship funds with no contributions, and since the author has claimed this revenue growth or ‘surplus’ is also non-contributory, and since investment returns account principally for these increases, then how does the author account for the minority part of the returns? Quite clearly, the NIS investment team, or its executive managers, have performed something magical to bring in this extra cash. The truth is it is fiction, and they know it.
By far the great weakness in the functioning of the NIS, part from its flawed structure, is its lack of a sound public accessible investment strategy. So, in quoting the broad guidelines of the International Social Security Association two key principal objectives, security and the prudent management of risk, the anonymous author has provided the weapon with which to slay his intended discursive giant.
Security as it is generally understood in pensions policy is the awareness of the fund meetings its obligations, that of providing a retirement income for its beneficiaries; and by prudent risk, it means precisely that, investing cautiously in order not to meet that objective. Nothing the NIS does indicates that it has any understanding of good investment strategy or of the prudent managing a portfolio. It is arguable that by outsourcing the management of three mandates to (presumably, since it is not made clear) three active managers is not in itself cost-effective, and because there is a lot of administrative fog, we cannot enter in to a discourse about total expense ratios, benchmarking returns nor indeed asset allocation. What we can say, however, from the outcomes, is that whatever the policy, it is not cost-effective. Further, the objective of the scheme should not be to achieve maximum returns, again proving that the author does not understand investment theory.
To maximise returns means taking huge risks, which contradict the ISSA guidelines. A pension scheme, by definition, should be more cautious, that is why the scheme’s investment strategy should have a high proportion of gilts (but not all from the same economy). In a short blog, it is like urinating against the wind talking about basic investment strategy for a state-backed hybrid pension scheme, if the decision makers are ignorant of the wider arguments, or are just not interested in the reality. Presumably they will not be the ones waiting in the long queues for their pensions in their old age, having secured a government-backed public sector pension. (By the way, the University of the West Indies either has, or in the recent past has had, a huge investment in the UK, including the collapsed Equitable Life. Someone should ask them about that. A Jamaica-born, London-based journalist has written the definitive PhD on Equitable Life. It makes a good read).
Financier of Government:
Sometime ago I drew attention to the fact the NIS was being used as a piggy bank by government, to which a very senior politician objected and took me to task. Now this anonymous author is telling us that the NIS is a financier of government – not just an investor – which tells us all we need to know.
At its simplest and most basic: a state-backed pension fund should not be, and is not intended to be, a financier of government. That is lesson 101 in the theory of public finance (see: The Theory of Public Finance, by Richard Musgrave, 1959). Although theory has moved away from Musgrave’s observations, nowhere in modern public finance theory does it say government should dip in and out of the pension fund to finance its programme. The author, in his own way, has proved the point. He states: “Over the years, the NIS has become the largest single purchaser of domestic government securities….” Then it goes on to make international comparisons, with the Canadian scheme investing 23 per cent of its fund in Canadian gilts, Trinidad 24 per cent, Bahamas 45 per cent Barbados 68 per cent , Cyprus 93 per cent, Singapore 95 per cent and the US 100 per cent.
Ignore Cyprus for the moment, as it is in greater turmoil than Barbados, the reason for the high investments in Singapore is that it is one of the most successful countries in the world, with a Central Provident Fund, which is the vehicle that has lifted Singapore from being a virtual swamp in 1965, when it became independent, to being one of the top four nations per capita in the world. With the US, and the dollar being the global reserve currency, they can afford to play fast and loose with their current account.
Analysis and Conclusion:
There are many other differences to the scheme as is understood by most experts outside the Caricom ring, which as I have said does not make it better or worse, just different. For example, the NIS allows some workers to take early retirement, which is rather unusual. With a state retirement age, there is usually no compromise on this. If someone, through illness or choice, wants early retirement, then he or she must depend on a private or occupational pension, savings or social security, but certainly not the state pension. This is not made clear in the article, nor on the website, which is a pity.
Further, the emphasis on a so-called surplus, which the organisation and its senior executives are clearly proud of, has accumulated in a rather strange way, and explained in even stranger terms. If pay roll contribution rates are based on the likely costs, and are in principle non—profit-making, then mere contributions should not lead to a ‘surplus’. If, however, the surplus comes from investment dividends, then quite clearly we need to see the evidence.
We want to know about the scheme’s investment style, its asset allocation, its stock picking, and who manages these funds; are they active or passive, what are the benchmarks, the annual management charges, the total expense ration? We need a full breakdown of total costs, which in any case should be on the website.
What evidence is already in the public domain, tells a totally different story: one of incompetence, of political bullying, of administrative incompetence, of bad investment strategies. We know that try as they may, they cannot get their books up to speed for the annual Auditor General inspection, that they invest in massive commercial white elephants (Four Seasons) and in office blocks which will not make any real returns for a number of years (Warrens).
We want to know who it has outsourced its investment management to, and the terms on which it has done so, and who to; we also want to know the mandates, if these are actively or passively managed funds. Unless we know the extent of the investments then we cannot debate with any certainty.
We also need a full breakdown of its portfolio, its geographical spread and the reasons justifying this spread. We want to know if the investment returns meet the performance goals, both short and long term. We also want to know what is its accumulation and decumulation policy, and what actuarial assumptions form the basis of this policy; what risk and cost controls are in place to deliver equitable benefits to stakeholders across generations, given the pending demographic time bomb. Is there the in-house expertise at the NIS to monitor, research and advise on global equity and gilt market trends?
The lack of expertise, especially when it comes to charging, can lead to a massive loss when compounded over generations. We need cost analysts, something ordinary actuaries are not, to determine the annual management cost of intermediation – custodians, brokers, fund managers, stock lending, foreign exchange, depositaries – all of which add to the final bill the national insurance scheme has to pay. In this case, ignorance can be very costly.
Finally, ordinary people must not allow themselves to be outfoxed by people with titles. They only have to reflect on the rise and fall of the Long-Term Capital Management, a lesson in chutzpah and academic arrogance, founded by John Meriwether, a big hitter in Wall Street, and supported by two Nobel Prize winners of economics. It collapsed because with their PhDs and Nobel Prizes, they got the mathematics wrong. So was the case of Professor Alberto Micalizzi, with a PhD in finance from Imperial College – one of the top ten universities in the world – and backed by Dr Nicos Cristofides, an Imperial professor, in running their hedge fund. Dr Micalizzi has been banned for life from working in UK financial services by the Financial Services Authority. His famous last words were that he did not understand the maths. Beware of experts.