The flaws of asset liability management
What passes for meeting liabilities today is a fiction - a convenient one for governments wanting to engage in financial repression, says Ashmore Investment Management's Jerome Booth.
On retirement, pensioners want purchasing power, which is not the same as a fixed number of dollars, pounds or euros, or for that matter reals or RMB. One only has to consider the impact of a decade of inflation, as happened, for example, in many countries in the 1970s, to appreciate the difference.
Taking domestic inflation into account helps stem the gap between nominal values and purchasing power, which an investor can do by buying inflation-linked bonds. But (a) such bonds may not track the basket of consumption goods a retiree wants; (b) whilst inflation linkers can protect against short-term spikes in yields, they, like other bonds, do not protect against sustained higher real yields, including those associated with high inflation periods; (c) the market for these bonds remains small relative to other government bonds; and (d) were the market much larger, then the government's ability to manage its debt service would be reduced, creating a credit deterioration and higher yields. This fourth argument is a macroeconomic one - governments use inflation to erode their debts, but cannot do so if the debt is all linked to inflation. The objective of creating a larger inflation-linked market to protect savers may come into conflict with the ability of a country to afford paying for the standard of living its retirees want.
Because of the problem of widespread rise in yields in high-inflation environments (point b above), it is common to hedge against inflation risk by buying other assets likely to go up with inflation. This includes equities and real estate. Since we cannot foresee the future perfectly, this inevitably means thinking through major future potential losses due to a broad set of circumstances.
In a globalising world, economies are becoming more open, and relative prices are changing fast. In particular, emerging countries are taking more market share of production and consumption in ever more goods markets. Faster than average productivity growth in emerging countries should arguably increase their competitiveness and hence trade shares and pricing power; but perhaps more clearly, greater numbers of consumers in emerging markets will determine the relative prices of the items they purchase in international markets. More than 85% of the world's population live in emerging markets, and disposable incomes there are growing rapidly.
It is not possible to be accurate in any assessment of future purchasing power. One needs to take into account trends in demographics and income distributions and hence consumption patterns; factor cost and production trends; shifts in technology; the rate of institutional developments in the emerging world enabling more stable governance and greater capital formation and competition; and uniformity of global market prices for related goods. The post-2008 reality in the developed world changes the relative power of governments to maintain competitive advantages for their companies - it levels the playing field. Emerging market companies are in many instances going to face fewer disadvantages compared with the past in terms of quantitative restrictions, quality standards, trade taxes, subsidies and the impact of tax and other policies on factor costs. For all these reasons, whilst accurate measurement is difficult, the trend towards greater emerging market purchasing power is clear.
Pensioners' liabilities are their future cost of consumption. This is increasingly going to be largely determined in emerging markets. Even if someone retiring buys domestically produced goods, these goods may be priced in a global market and the bulk of competing production and consumption may be in emerging markets. Already oil and various commodities are priced in emerging markets. This will extend to many more goods (though probably few high-end technology goods).
What passes for meeting liabilities today is a fiction - a convenient one for governments wanting to engage in financial repression. Fiduciaries may claim to be meeting liabilities by focusing on nominal future payouts, but arguably are not looking after the best interests of the owners of the capital they are responsible for if they are not taking into account global purchasing power trends. The focus on contractual nominal liabilities is engrained in regulatory structure also, but is likewise not looking after the best interests of future pensioners and other savers. The government's goal of wanting to capture savings pools to finance itself is potentially in conflict with the objectives of savers, but over the long term the government's interests are also not served if the population is needlessly impoverished in old age through an absence of national investment in the emerging markets. Having pensioners not being able to live off their pension may, of course, also rebound onto dependence on the public purse.
Legislation may and should change this - mandating pension funds to take account of purchasing power may only be a question of time. Fiduciaries may even care to get ahead of such a possible change.
Jerome Booth is head of research at Ashmore Investment Management