Pension Funds in Trouble

Pension funds are in more trouble than most people realize. This became clear when English pension funds suddenly found themselves squeezed during the latest market turmoil coming out of the UK.

It took a hundred billion pounds of central bank intervention to pull the pension funds out of the mess. But why was that? How was it that something as big as pension funds could go from seemingly stable to the verge of collapse in a matter of days?

The short answer is financialization. Pension funds have lost sight of their true purpose. Instead of providing a steady income for their clients, they are engaging in monetary alchemy where some win at the expense of other. The pension funds found themselves on the wrong side of big bets that went sour when interest rates suddenly went vertical.

One way of looking at this is to compare the true purpose of pension funds to how pension funds are operating in financial markets today.

In simple terms, pension funds have no other purpose than to provide food, clothing and shelter for their clients. To do this, they need to hold productive assets that provide this, and the safest and most direct way to do this is to own these assets directly.

If this had been the case the recent market hiccup would have been of no consequence to the pension funds. Their farms, factories and flats would have continued to provide for their clients regardless of interest rates and other monetary issues.

The same would have been true if the above-mentioned assets were held indirectly through holding companies run soundly, with little exposure to financial markets. The revenue provided by shares in companies that provide food, clothing and shelter would have been unaffected by the turmoil. No pensioners would have been in danger of not getting their share of the productive capacity of the UK.

The focus of pension funds should be on the productive capacity of their assets. The only thing that should matter should be the revenue stream created by their assets. People paying into pension funds would thus buy into this productive capacity, while those who've reached retirement age are provided for by the sum of money coming into the pension funds through dividend and not-yet retired clients. Ownership of the pensions fund and their productive assets should in this way be rotated from those at the end of their lives to those yet to be retired.

At the root of this type of saving schemes, we find productive capacity and a straightforward way of rotating ownership from one generation to the other. However, this simple idea has been lost. Instead of focusing on productive capacity, pension funds today focus on asset prices.

The idea is no longer to secure sufficient productive capacity to provide for clients, but to amass sufficient financial assets to pay for the productive capacity of others. The problem here, is that price and value is not the same thing. Prices of things can go up without anything of value having been created. Hence, pension funds may find themselves owning things that appear to have value but are in fact bubbles.

The sound way of looking at pensions is to pretty much ignore the price action of assets. If a factory doubles in price or halves in price, no value is gained or lost unless the productive capacity of the factory has changed. Pension fund managers may choose to sell factories that they think are priced too high and buy factories that they think are priced too low. But this should always be done based on productive capacity. However, that's not how things are done.

Pension funds own debt instruments and shares in companies, many of which are non-performing or running at a loss. Very little of what they own contributes directly to the economy in terms of products and services essential for their clients' wellbeing. The assumption is that the price of their assets will cover the cost of acquiring the products and services provided by others. However, this assumes that someone is willing to buy the assets held by pension funds at current prices, and it was this assumption that was suddenly challenged in the UK and forced the central bank to come in as a buyer of last resort.

But nothing has been fixed. Pension funds are not in possession of the productive capacity required to feed their clients, and this problem isn't fixed simply by elevating asset prices through central intervention. The money pumped into pension funds in order to prop up their asset prices is nothing but monetary inflation, and the cost of living is likely to go up in response. Instead of pension funds defaulting to their clients, prices of goods and services go up for everyone.

There is no way of fixing this problem, short of handing productive capacity directly over to the pension funds, and that's not going to happen. Pensioners get a haircut, or everyone gets inflation. No other solution exists.

Hot air balloon

By Kropsoq - photo taken by Kropsoq, CC BY-SA 3.0, Link