Monday, 18 April 2016

How QE Killed Your Pension

I recently wrote about how the idea that rising house prices made people wealthier was baloney. But, a similar idea is put forward that the cause of black holes in pension funds has been the various crashes in stock markets over the last twenty years. It is equally baloney.

In the UK, the fact that millions of people cannot afford to buy a house, or to move to a better one, is itself proof that rising house prices make people poorer not richer. The same is true of the fact that these higher house prices have caused rents to rise. Latest data from the US, where house prices crashed by 60% in 2008/9, but have been rising again more recently, shows that there has been a marked slow down in people putting their houses up for sale, because they cannot now raise the additional funds to move up the housing ladder to a more expensive house, as those more expensive houses have become ever more out of reach.

The idea that pension funds have suffered because of stock market crashes is quite obviously false, because stock markets are currently near historic highs. The Dow Jones is 70% higher than in 2000, when it was 1300% higher than in 1980. The S&P 500 has trebled just since 2009. If high stock market valuations were what was needed for healthy pension funds, then those funds should be in rude health. But, they are not. The reason they are not healthy is not because stock markets have been low, but because they have been sky high!

To understand why its necessary to understand the point that Marx makes in Capital III, and in Theories of Surplus Value, that capital is not revenue. Capital is a source of revenue – profit and interest – but is not itself revenue.

If I own £1 million of productive or commercial capital, in the shape of buildings, machines, materials and labour-power, then, if the general annual rate of profit is 10%, I can obtain £100,000 of profit from this capital. If I do not have to share it with a money-lending capitalist, or a landlord, or the state, I will thereby obtain a revenue of £100,000. I can spend it to fund my own consumption, with no detriment to my capital, which will remain £1 million, and operate to produce £100,000 of profit again, next year.

On the other hand, if I sell 10% of the components of my capital, so that it now only has a value of £0.9 million, this capital will now only produce a revenue of £90,000, this year and every subsequent year.

If I own £1 million of money-capital, but have no desire to engage in production, I can lend this money-capital to an industrial capitalist who does want to engage in production or commerce. I might make a straightforward loan to them, or I might lend them money-capital in return for share certificates, or in return for bonds.

If the general annual rate of profit is 10%, the industrial capitalist will not be prepared to pay me 10% interest to borrow this money-capital, because that would wipe out their profit. How much they will pay, the rate of interest, is determined by competition, by the demand for and supply of this money-capital.

The interest I receive on this money-capital is again a revenue. If the rate of interest is 5%, I will obtain £50,000 p.a. in interest, and I can consume this revenue with no detriment to my capital. It remains £1 million, and will provide me with £50,000 of revenue again next year. But, again, if I consume £150,000, I will have consumed £100,000 of my capital. It is permanently reduced to £0.9 million, and so will then only produce a revenue of £45,000.

This is the difference between the consumption of revenue and the consumption of capital. Pensions are a form of revenue, and they are funded from the revenue produced by the pension fund. As illustrated above, that revenue comes in the form of dividends paid on the shares of companies held by the fund, and the interest paid on the corporate and government bonds held by the fund. If the fund owns land and property, which it leases, the revenue may also come from the rent it obtains from these leases.

There are regulations which determine what kind of financial assets pension funds can hold, and in what proportions, so that they can ensure over a forty year period, that they will obtain the revenues required to be able to pay out pensions to members of the fund over that period.

So, the important issue here is not whether stock, bond and property markets have soared to high levels, but whether those financial assets are able to produce sufficiently high revenues to be able to cover future and potentially rising pension payments. If stock markets double, and the nominal value of shares in the pension fund similarly double, this does not benefit the pensions of the members of the fund. The fund could increase its payments to pensioners by selling some of the shares or bonds it holds, and whose prices have risen, but, as described above, this would actually be to consume capital not revenue, and in doing so it would thereby permanently reduce the capital of the fund, and consequently reduce its ability to produce revenue. It would mean meeting the needs of current pensioners at the expense of future pensioners.

The reason it does so, is that set out earlier. If the fund currently owns 10 million shares, each paying an average dividend of £1, it produces a revenue of £10 million per year. If it sells 1 million of these shares, it will now only receive dividends on the remaining 9 million shares, i.e. £9 million, and it will receive this lower amount of revenue not just this year, but also for every subsequent year.

The 10 million shares may have been previously bought for £100 million (their historic cost), and this may double to £200 million, as share prices rise, so that, in selling the 1 million shares the fund obtains £20 million (representing a capital gain of £10 million) but, once consumed that one off capital gain has gone, whilst the reduced revenue from the capital continues year after year.

The fact that the share or bond price has risen has no bearing on the amount of dividend or interest that is paid, because that depends on how much profit the companies make whose shares are held in the fund. The interest on the bond is fixed in advance. So, not only does the price of the share or bond have no bearing on the payment of revenue produced by either, but, in terms of yield, or rate of interest, it has an inverse relation to it. As the price of a share or bond rises, so the yield falls.

Moreover, it makes no sense for a pension fund to cover its pension liabilities by consuming its capital, because it needs, over the longer term, to increase that capital, to increase the quantity of bonds and shares it holds, so that it obtains a larger mass of revenue from them. A pension fund may need to sell some shares that are not producing as much in dividends as others shares, or in companies that might go bust, but only to use that capital to acquire other shares in producing higher levels of dividends. Similarly, it may want to sell shares in order to buy bonds, or vice versa, depending on which offers the potential for higher yields.

But, it makes no sense to liquidate capital to cover revenue shortfalls, because that simply exacerbates the problem. (This is also what is wrong with the idea that lies behind historic cost pricing of productive-capital, for the basis of calculating the rate of profit.)

It can be seen then why QE, and other measures to pump liquidity into financial markets, has killed workers' pensions, and created the huge black holes in those funds' ability to cover future liabilities. As the number of people joining a pension scheme, and who are entitled to a pension from it, rises, so this additional revenue must be produced by the fund. Moreover, because the level of pensions will rise over time, the revenue required to cover these higher pensions will also increase. There are only two ways this can be achieved, in the long run.

Either companies become more profitable, so that the amount they pay out in dividends and bond interest can rise, without damaging the need to invest in additional capital to expand the business, or else pension funds have to accumulate additional shares and bonds. In the first case, the pension fund would increase its revenue, because each of its existing shares and bonds would pay more dividends and interest. In the second case, it would increase its revenue, because although each share and bond continued to pay the same amount, the fund would own more shares and bonds.

Provided the rate and mass of profit rises, therefore, and this is reflected in higher dividends and interest payments, a pension fund will see its revenue increase, even without increasing its capital. That happened in the 1990's, so that many pension funds had more than enough revenue to cover their pension liabilities. It meant that some employers took pension holidays from making their contributions into the schemes. For private sector companies, that also boosted their profits, as a result of these lower costs. Local Authorities, under pressure to cut spending, also took prolonged pension holidays. Its another reason that future funding shortfalls than resulted, along with the fact that capital gains made during the period were consumed, thereby undermining the capital base of the funds.

But, the higher profits that made possible these higher dividends and interest payments had another effect. They provided a basis for higher share and bond prices, which thereby acted to reduce yields. Lower interest rates themselves cause a rise in share, bond and property prices via the process of capitalisation. The problem then is fairly obvious. The pension funds need to increase their capital, in order to produce higher levels of future revenue, to cover increasing future pension payments. But, as the prices of bonds and shares rise, those funds can buy fewer and fewer of them, with the regular pension contributions made by their members.

A declining quantity of shares and bonds bought, and added to the fund's capital, therefore, means a declining rate of increase in the fund's revenue. As the prices of shares and bonds rise, so also the yield on them declines, for the reason set out earlier. The pension fund, therefore, suffers both because rising share and bond prices mean it can buy fewer and fewer of them, and because the yield on the shares and bonds it does buy is declining.

The answer to that should have been, during the 1990's and early 2000's, for pension contributions to rise proportionately so that the funds could then continue to buy the quantity of shares and bonds required to provide the necessary future revenue. But, either employers would have had to have funded that directly by much higher employer contributions (whereas they were, in fact taking contribution holidays), or else workers would have to increase their own pension contributions, which would have meant they needed higher wages to fund those contributions. In reality, what either option amounts to is the fact that much higher prices of stocks and bonds, caused the cost of pension provision to rise sharply, just as much higher property prices caused the cost of shelter to rise sharply, and this increased the value of labour-power accordingly.

However, this was a period when wages were being squeezed not raised. Workers were screwed both because house prices were rising sharply, also causing workers to have to borrow on ever more massive levels to cover mortgages, and because the funding of their pensions was being decimated by soaring bond and share prices. Their wages failed to rise to cover either additional cost.

I have not included here the additional costs that arose as a result of the financial deregulation introduced by Thatcher, which not only opened the door to the pension mis-selling scandal, but also created the conditions discussed previously whereby up to 60% of workers contributions were swallowed up in a variety of commissions, and back handers, given to people along the chain, prior to the contributions being invested. As financial bubbles were inflated, so too were all these commissions and back handers, which unlike all the other financial scandals have not yet been dealt with.

Whilst rising rates and masses of profit in the late 1980's, and through the 90's, provided a basis for rising stock markets, and falling interest rates, that was not the case with the subsequent inflation of asset price bubbles. Property bubbles had been inflated from as early as 1960, often for overtly political reasons, but the real inflation of the property bubble began in the 1980's, when prices quadrupled. They have been reflated on several occasions since then. Similarly, after the Stock Market Crash of 1987, the US Federal Reserve and other central banks have repeatedly pumped liquidity into financial markets to keep asset price bubbles inflated.

It has been that which has been the main factor in stock and bond and property market prices since 1987. It has driven those prices to ever higher levels, not only making property and pensions ever more out of reach of workers, but also increasingly diminishing yields on those assets, so that workers are now also unable even to obtain nominal amounts of interest on their savings. It has been a wholly pernicious activity.

In the recent scandal over tax avoidance, revealed in the Panama papers, the Tories, responded that many ordinary people have money invested in pension funds, which have money invested in offshore funds. That is undoubtedly true, and workers whose money that is have no more knowledge of it than they do about how the rest of their contributions are used. It is why we need to introduce the fundamental democratic right of workers to have direct, democratic control over their pension funds, and for that huge amount of money-capital to be taken out of the control of the bankers and financiers.

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