Monday, 31 January 2011

Book Review: Pension Revolution by Keith Ambachtsheer

Why should an individual investor read a book about how to fix the pension system that is addressed to pension fund managers and legislators who make the pension rules?

1) To become an informed, opinionated citizen on a topic that is sure to affect you in a significant way, e.g. most recently in Canada, taking a position on the short-lived proposal to expand the CPP and the substitute federal proposal to start something called Pooled Registered Pension Plans (my take here ... written before I read this book, though reading it has only reinforced my opinion)

2) To get ideas to manage your own retirement income, such as probable investment returns, the risk premium for equities over bonds and most uniquely, the importance of matching the time horizon and riskiness of liabilities with assets / investment portfolio. Ambachtsheer doesn't intend to address the needs of individuals and he never explicitly says that the same principles should apply to individuals and to pension funds but they seem highly pertinent to me. As a foundation principle for people like me who must manage a personal pension fund of RRSPs/RRIFs/LIRAs/taxable accounts for themselves, the "match assets with liabilities" phrase makes much more sense than "match bond allocation age".

In other book reviews I have several times objected that the book title or sub-title doesn't deliver what it promises. Not this time. "Revolution" is not too strong a word. Ambachtsheer advocates drastic across the board change. He says corporate defined benefit plans were a disaster waiting to happen from their origins (what better supremely ironic example could there be than the fact that the very company that set the pattern for corporate DB plans after World War II - General Motors - in large measure was scuppered by the liabilities of its DB plan?). Corporate DB plans are good for neither companies nor employees, being riven with inherent unresolvable conflicts. Defined contribution plans are fatally flawed as well, for different reasons but the end result is still bad, an incapacity to deliver a good pension in retirement.

The Optimal Pension System - Revolutionary wearing-suit-and-tie Ambachtsheer (he is the director of the University of Toronto's Rotman International Center for Pension Management) proposes a solution, called TOPS (The Optimal Pension System) with the features below. The book dissects the issues that bedevil our existing DB/DC pension system and tells why and how his TOPS can be viable replacement system. TOPS includes:
  • auto enrollment and set minimum contribution rate
  • auto-pilot savings-investment process - no un-necessary choices (e.g. pick one of 20 mutual funds) for individuals to make
  • auto-pilot conversion of financial capital into deferred life annuities all along during a working career (instead of suddenly needing to decide what to do with a RRSP at retirement)
  • single -purpose pension plan co-ops (unlike DB plans where corporate goals and constraints interfere and DC plans where financial industry profit motives interfere)
  • good governance and organization design (like appointing a board based on ability to help achieve the pension mission, not to represent a union or an employer), which he figures can add 3% per annum to returns!!
  • economies of scale (yup, size matters and he's got the data to prove it - less than $2 to 3 billion - as of four/five years ago when he wrote the book - is too small)
Though much of this looks a lot like the CPP to me (yes, I am still on that hobby horse), Ambachtsheer cites a few other examples that comes close to his ideal - the Dutch national pension system e.g. one provider is APG and the USA's TIAA-CREF.

Investment Environment - Ambachtsheer devotes about 70 pages to investment topics that should interest every individual investor - the stocks for the long run question and the equity risk premium (ERP), which he says predictably varies up and down (metrics like P/E and dividend yield giving reliable indicators of future returns). His rule of thumb formula for the expected ERP gives sobering results these days: (market dividend yield + 80% of future real GDP growth - yield on real return bonds = 2.4% + 0.8*2%(?) - 1.2% = 2.8%. Ambachtsheer does not believe in the Efficient Markets Hypothesis. He thinks instead that skilled investment professionals can add considerable excess returns, especially over the long haul. He poo-poos people like Burton Malkiel (strange that Malkiel still writes a glowing blurb for the book at the front!) who apply simple mechanical investment rules and find no out-performance and then conclude that EMH works just fine - "Highly effective pension and endowment fund management teams know that there is considerably more to to generating excess return over time than applying simple decision rules to buying and selling stocks and bonds."

What's Good for Pensions Would be Good for the Economy - The book puts forward the intriguing idea that pension funds can exert positive influence on companies and on the economy through their long term investment perspective as knowledgable, activist shareholders with considerable clout. Ambachtsheer argues that better-managed pension funds will recognize that what he calls long horizon risky investing brings the biggest returns and in turn that depends on investee companies focusing on long run sustainable growth instead of short-term next quarter results.

How Much We Really Need to Save - It is a shock to read that the riskless creation (i.e. buying only real return bonds) of a riskless lifetime inflation-adjusted pension would require a 25% or more pay deduction rate sustained for 35 years. Failing that strategy, we can buy into equities for probable higher returns but we have to accept investment risk and that could mean taking a lower pension. We also learn that the most expensive pension feature by far - and thus the one that pension providers (whether governments or corporations) are most likely to cut back in cases of under-funding - is inflation protection. Boomers should not be surprised if and when inflation-indexing gets cut, since there has been no change in our pension system since the 2007 publication of the book. Everything in the book is as relevant and topical today as then.

Unless inflation goes up in a huge spike upwards as in the 1970s, the current 2% or so rate will eat away slowly and surreptitiously at living standards of retirees. Unfortunately, most often it takes a sudden crisis to provoke fundamental change. Ambachtsheer does not attempt to forecast the likelihood of change in pensions. He only plays the role of the technician who tells us what is wrong and how to fix it.

The biggest downside of the book is a lot of repetition. The same ideas are presented over and over with a bit of new material in each of the very short (5-6 pages each) 45 chapters. The book also lacks an index, so it is hard to find subjects again, even when one takes extensive notes during reading, as I do. A consolidated reading and reference list would help too, though key papers and books, such those on the investing ideas, are referenced within the text.

The publisher Wiley Finance listing for the book includes the table of contents.

My rating: 4.5 out of 5

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