Matchmaking

Being a successful matchmaker in the dating arena is notoriously difficult. The algorithms of tech companies have not cracked this nut, since predicting what creates sparkling chemistry between two persons is very difficult based on a set of observable data points. A seemingly perfect match on paper has little predictive power because emotions are complex (not complicated) and depend on the situation. These challenges also hold for politicians and economists dreaming about matchmaking between pension savings and investment needs in the local economy.   

The harsh reality is that many governments don’t have fiscal space to do the necessary investments in infrastructure and housing. Given the high level of public debt, the politicians hope that pension providers will be able to plug this financing gap. Some governments naïvely believe that nudging pension providers to allocate to private market funds will jumpstart economic growth and solve the financing problem, the Mansion House Compact in the UK is an example of that.

Surely, there must be more intelligent ways to match pension savings with long-term public financing needs. Could there be a win-win situation here, or is this just a pipe dream?

Start with the WHY

From an economist perspective it seems straightforward. Pension savings exist because workers have deferred some of their current consumption for retirement. These savings are ideally invested in productive assets that generate economic growth and produce an investment return. The economic growth benefits today’s workers and the investment return increases their purchasing power in retirement, creating a self-reinforcing feedback loop.

The key word here is investing, but pension savings are mostly used for buying assets on secondary markets speculating in that the price will increase over time. This has produced a good return on pension savings since the asset appraisals in secondary markets have been much higher than the economic growth. The downside of this approach is that the self-reinforcing feedback loop is broken since most of the savings are not invested in productive assets.

This basic conclusion is not controversial, as a society we need to get some of the pension savings invested in productive assets that will generate economic growth. The challenge is not the why, but the how.

The ecosystem

Legislation and regulation largely define the ecosystem in which pension providers operate. Unfortunately, most governments act like an octopus with split brain disorder where each of the tentacles is not aware of what the others are doing. The saddening part is that each of the tentacles produces policies built on good intent, but this combined policy cocktail acts as poison for the self-reinforcing positive feedback loop.

Financial regulation measures risk as short-term volatility and strongly favours assets traded on liquid, secondary markets. Regulation aiming at consumer protection focuses on price competition and encourages transfer rights. This strongly nudges pension providers to hold assets traded on liquid, secondary markets. Then there are numerous policies covering industry, housing and infrastructure that scream for long-term investments in productive assets that generate economic growth. A somewhat independent central bank with a well-oiled money printer in the basement adds to the complexity.

The financial sector has adapted to the increasing pressure on charges by consolidation among both asset managers and pension providers. The obvious way to reap the benefits of the economies of scale and meet the downward pressure on charges is to construct asset portfolios that tracks a benchmark on liquid secondary markets.   

Reintroducing an old animal

We know from biology that an ecosystem tends to remain in a dynamic balance. Think, for example, of the foxes and rabbits’ cycles that we learned about in school. This dynamic balance is disrupted when an invasive species is introduced or the local climate changes. At that point, the ecosystem will adapt to the new situation, and a new dynamic balance will emerge that lasts until the next disruption.

Perhaps the solution is simply to reintroduce an old species into the ecosystem, make some amendments to the financial regulation making long-term investing more regulatory capital efficient and at the same time review policies around market competition.

To finance public housing and infrastructure projects over their full economic life, we could reintroduce the inflation-linked asset-backed annuity loan. This could take the form of an asset backed loan with a high rating and/or backing by municipal, regional, or national governments.

Financing public housing

Anyone living in a growing city is painfully aware of the chronic housing shortage. A former colleague cleverly said, “I am not working for my employer, I am working for my landlord”. The local or regional governments are often overstretched financially so the question is: is it possible for pension savings to finance new public housing?

With an annuity loan, the local government receives the funding for building public housing. The annuity loan is amortised over the building’s economic life, which eliminates the need for refinancing and potential nasty future surprises for the local government. To avoid that this annuity loan ending up on the local governments balance sheet, it could be set up as a stand-alone asset-backed loan where the future rent incomes match the annual loan payments. As rent income from the buildings follows inflation, the annuity loan should be inflation-linked.

For pensions in payment, an inflation-linked annuity loan constitutes the risk-free income investment as it delivers stable purchasing power for a given number of years. This is common sense and echoes the reasoning in the Merton and Muralidhar paper “SeLFIES: A New Pension Bond and Currency for Retirement”. From a purchasing power perspective, nominal government bonds are a very risky while in most financial regulations they are labelled as risk-free.

Thinking like a matchmaker

We should stop with naïve pipe dreams such as the Mansion House madness and instead address this problem like a matchmaker. Although we cannot predict what would create the sparkling chemistry between pension savings and public investments, we can start by removing some obvious obstacles by reforming the policy cocktail so that it doesn’t act as poison for the self-reinforcing positive feedback loop…