Extend and Pretend

“A reliable way to make people believe in falsehoods is frequent repetition because familiarity is not easily distinguished from truth. Authoritarian institutions and marketers have always known this fact.” – Daniel Kahneman

Extend and Pretend is a phrase that encapsulates a desire to bring forward gains into the present, whilst deferring costs or risks into the future. It refers to the practice of Banks during the mid-2000’s of refusing to accept losses on loans (mortgages for example), by allowing borrowers to pay back over a longer time-frame, thus avoiding having to book loans as non-performing in the short-term, but in the process storing up even greater risks into the future. It came back to haunt the financial system in 2007-09, leading to the biggest financial crisis for at least 70 years. The policy never ends well in any sphere of life.

If we look solely at equity capital markets, it appears all is well (or better than that!), but things are not so rosy when one glances at the state of the pension funds backed by these same firms. Two articles last week, one on the UK and another in the US highlight this issue in quite stark terms. BBC News reported last week that BT will cut 13,000 jobs (though net, it amounts to 7000, as some will be re-hired) and moving from its current London HQ to try to save £1.5 billion. It will also borrow £2 billion and pay it straight into the BT Pension scheme to “cover” the estimated £11.3 billion deficit.

A number of thoughts occur – why has BT allowed its workforce to swell to 108,000 people in total (pre these cuts) in the first place? The job losses will focus on “middle management” and “back office” roles, whilst the new jobs will be in “customer service” (which will be much lower paying). The company is moving to another part of London (rather than moving out altogether), but why do they need to be there at all? (Has nobody heard of teleconferencing at BT?). The pension trustees have agreed to buy bonds issued by the firm to cover some of the pension scheme deficit directly from BT, but that involves massive credit risk – what happens if BT defaults? So we have the spectacle of warm words from BT’s executives (none of whom are in the pension fund themselves according to the Annual Report), trying to put a positive spin on the situation to persuade the remaining employees that there is nothing untoward going on. Meanwhile, the Directors have pledged to keep paying dividends to shareholders at current levels for 2 more years; so shareholders (which of course includes the Directors) will be OK. Extend and Pretend.

Meanwhile in the US, a small startup founded in the 1930’s (Just Born), has just lost a court case that forces the company to maintain unreformed a pension plan that is massively underfunded and thus completely unsustainable; it is entirely possible that the company will be bankrupted by this decision (leaving the employees without a job OR a pension). Amazingly, it turns out that it is the very Union that wants to force higher contributions from the Company for the Pension fund, that is the organisation that is running it (the Union President is the Chairman of the Fund itself!). So, the mismanagement of the pension scheme (by the Union) has been “rewarded” by the court’s ruling and it is the company that has to foot the bill. As long as the Union can escape responsibility, however, they presumably hope the soon-to-be redundant employees won’t notice. Extend and Pretend.

We have now reached a situation whereby many firms are essentially large pension schemes with a relatively small-scale business operation attached to it. And in their desperation to try to present events in a positive light, they are resorting to increasingly controversial measures to hide the truth (mainly from their own employees). In the US, GE has a $31 billion pension deficit, having spent $45 billion on share buybacks over the last few years to placate investors, whilst they basically ignore the plight of the pension fund (and thus their employees).

But it isn’t just Corporations – the $37 billion Harvard Endowment fund has just reported in its 13f filing that it has acquired a massive exposure to just 3 stocks (Apple, Microsoft, and Alphabet) representing 72% of its total equity holdings. This is an enormous concentration of risk, presumably in an attempt to address funding concerns but potentially to forestall (for now), the prospect of large contribution increases, (which is beginning to appear likely at Calpers). Japan’s Post Bank, long known as an extremely conservative institution has this week announced plans to set up a $1.5 billion Hedge fund (which will be able to sell Japanese company shares short). This can only be an attempt to boost returns (without it seems, much regard to risk), though maybe not quite so “unorthodox” as the Dallas Police and Fireman’s Pension Scheme’s asset allocation. States such as Illinois are going to need bailouts (by tax-payers of course) if they are not to go under, whilst there are growing concerns about the state of pensions funding in Germany and France as both demographics and zero interest rates conspire against sustainable returns.

At the individual level the situation is just as dire; both the Pensions Advisory Service and the DWP have reported that Britons are not saving enough for a decent retirement (and 20% of the population are saving nothing at all), leaving the prospect of mass poverty in old age. Half of those not saving enough are reportedly earning over £34,500 per annum, which rather belies the excuse that they don’t have enough to do so. In the US, according to a Northwestern Mutual survey, 1 in 3 Americans have less than $5,000 in retirement savings, which is corroborated by other surveys done in recent years. What will citizens on both sides of the Atlantic do? They can’t ALL rely on the State system, as it will very soon be bankrupted if enough claimants come forward; are they ALL expecting an inheritance (or to win the lottery)? Both the UK and the US governments are in no position to bail them out either, as they are as insolvant as their populations. Extend and Pretend.

A similar situation applies to the Central Banks (apart from the US) – neither the Japanese nor the European Central Banks are showing any signs of ending their QE programmes, as they are perhaps beginning to realise that they have become the market; who will buy the zero interest rate bonds when they stop doing so? All that they have achieved is to keep European (and Japanese) governments on “life support” but if Central Banks stop buying their bonds it will all collapse. There has been no real economic reform in Europe (or Japan), but we now have a Global Debt to GDP ratio of 224% (according to the latest IMF calculations). Mario Draghi’s term as ECB President ends in 2019, so he will have no incentive to change that policy, leaving it to the next incumbent to sort it all out. Extend and Pretend.

We are in an age where nobody appears willing to face up to unpleasant realities; there appears to be a preparedness to do anything short of what is actually required. The funding deficits are now far too big to be closed simply via another Tech-led market melt-up, but many appear unwilling to accept this fact.

What to do? The first thing is NOT to be one of the above. There is no alternative but to invest early and often or become one of the poverty-stricken. Markets cannot help an individual who won’t help themselves and so getting the “investing habit” is a pre-requisite for long-term financial security. It requires a long-term perspective, to take advantage of the benefits of return compounding etc. and the patience to see it through to the end. It is not guaranteed to succeed, but failing to do so IS certain to fail.

The only question is whether enough people will take action soon enough to prevent future catastrophe. On this, the jury is still out, but inaction is not an option nor a solution.