There has been much talk about the influence of investment funds on commodity prices and suggestions that these investments may need to be regulated. We argue here that investing in commodity markets is just one aspect of the broader retirement dilemma we are all faceing, and that regulation of investments in commodity markets may not be the answer.
Clearly, low interest rates, the decline of the equity markets and the need to save pose difficult decisions. Coupled with our society’s penchant for early retirement, the seeds for the next financial crisis may already be sown. Let us explain.
The harsh reality is that the current crisis led to large losses for many if not most pension plans. In response to the economic woes, central banks have further cut already low interest rates. For example, the U. S. Treasury 30-year bond rate has declined from around six per cent to around 3.5 per cent over the past decade while inflation remained virtually unchanged.
What does this mean for recent college graduates investing in a risk-free pension plan? With a 30-year expected working life plus a conservative 20-year retirement, these graduates should expect benefits will decline by 47 per cent unless contributions are increased.
For those fortunate enough to be members of a defined benefit plan, the required contributions from employers would therefore almost double. But as we see in the auto industry, obligations of this type put the economic well being of the employer at risk.
There are, of course, ways to compensate for this decline in investment rates. For example, graduates could work an additional 10 years AND increase their pension contributions by 16 per cent. This is one of many combinations of increased work life and increased contributions that would offset the decreased investment returns.
Increased saving means to reduce current consumption , which —which –ironically — -is exactly opposite to what is needed in today’s economic situation.
The notion of working longer and consuming less is unpalatable to many and leads individuals to pursue the alternative: investing in riskier assets that promise higher returns. Among the riskier assets investment funds have pursued are in the commodity markets.
Modern portfolio theory, which Stanford University’s William Sharpe won a Nobel Prize for in the 1990s, states that holding risk constant, the returns from a well-diversified portfolio will be higher. This has been proven repeatedly. Andy Sirski, previous editor of this publication, using layman’s language advocates the same in his “five legged stool.”(stocks, bonds, cash, real estate, and commodities)
All farmers understand this and practice it by growing not just wheat but numerous other crops. Eliminating investment fund participation in commodity markets would have the same result for society as a mandate to grow only wheat would for individual farmers and across the Prairies. By definition, this means there will be close links between the financial, commodity and even real estate markets.
Another cornerstone of modern portfolio theory is the direct relationship between the riskiness of a portfolio and its return: An investor who wants higher returns must accept more risk.
By definition, risk is the possibility of not just having to accept lower than promised returns, but also the possibility of losing some or all of the original investment. Thus, the riskier pension plan must expect, at times, to lose part of its principal, much like what has happened recently.
The second and perhaps more important issue is what this collective quest for higher returns — and the resulting higher portfolio risks — means for the markets. Pension plan assets currently amount to roughly $20 trillion. Adding sovereign wealth funds and retirement savings via mutual funds makes that $40 trillion of investible funds. And all of these are invested following much the same strategies. Virtually all have investments in commodity markets.
There have been repeated comments that the current problems originate from too many investors “running for the movie theatre exits” at the same time, which has led to the inevitable market decline. The flip side of that coin is that these same investors originally all piled into the same assets, in the process propelling the market upward. The quest for high returns — and the attendant assumption of higher risk — ends up creating bubbles and ensuing crashes.
It is probably not a coincidence that the increased consumer spending and lower savings rate and the desire for early retirement over the past generation or two were accompanied by an increasing number of financial crises. The economic literature shows 38 such crises between 1945 and 1971. By contrast there were 139 crises between 1973 and 1997 (Eichengreen and Bordo.)
Until government and society at large are willing to address the underlying issue, namely that pursuit of early retirement and high consumer spending lead to riskier investment decisions by a significant segment of the population, all the talk about more regulation of financial practices and institutions cannot change one fundamental fact: We must be ready for occasional, even repeated, financial crises. Calls to restrict investments in any one asset class such as, like commodities, are missing the point..
We, as a society, have the choice between sweating longer at our jobs, or sweating over the health of our pension plans. As the biblical curse goes, “By the sweat of your brow shall you earn your daily bread.”
Richard Pedde retired from the financial services industry to a farm near Indian Head, Sask. ; Rolf Mirus is Professor Emeritus and Academic Adviser to the Western Centre of Economic Research, School of Business, University of Alberta.