Equities are the only sensible foundation for private pensions

Their massive long-term outperformance occurred despite world wars, the Depression and the global financial crisis

Martin Wolf 

British pension arrangements have allowed the older generation to extract all the risk-bearing capacity of private sponsors, so moving the younger generation into permanent insecurity © Chris Ratcliffe/Bloomberg

“Never make forecasts, especially about the future.” 

Nobody knows who said this first. 

The point, however, is that we have to make forecasts, or at least guesses, about the uncertain future. 

Of nothing is this truer than long-term investments for delivering security in old age. 

The problem — inescapable, but fundamental — is that the sensible way to do this is to invest in risky assets. 

The risks cannot be eliminated. Someone must bear them. 

The question is who this should be and how it should be done.

The tragedy of British pension arrangements is that the attempt to force safety on private arrangements is forcing them into collapse. 

Worse, it has allowed the older generation of pensioners to extract all the risk-bearing capacity of private sponsors for their benefit, so moving the younger generation into permanent insecurity. 

This is a scandal.

A question, however, is how risky investment in “risky” assets actually is. 

The evidence on this is encouraging. 

The work of Elroy Dimson, Paul Marsh and Mike Staunton in successive Credit Suisse Global Investment Yearbooks shows that over the past 120 years diversified portfolios of equities in the corporate sectors of high-income market economies have done staggeringly well.

The geometric mean annual real return in these economies has been 5.4 per cent. 

In the US, the mean return has been 6.6 per cent. 

In the UK, it has been 5.4 per cent. 

A pound invested and reinvested in the UK market in 1900 would have become £572 pounds by 2020, after adjusting for inflation. 

A dollar invested in the US market would have become $2,291, on the same basis. 

But a pound invested in UK government bonds would have become £10.40 and a dollar invested in US bonds would have become $12.50. 

The only guarantee the bond market gives is one of poverty.

Economists call this gigantic divergence an “equity risk premium”. 

The word “risk” reflects a quasi-religious belief that this divergence reflects rational adjustment to risk. 

Properly risk-adjusted, expected returns were the same. 

But attempts to justify this belief mostly seem far-fetched.

One justification is that wars or revolutions can ruin equities. 

This is true. 

But they also destroy bonds. 

Moreover, the massive long-term outperformance of equities in the major markets occurred despite two world wars, communist revolutions, the Depression, hyper-inflations, the great inflation of the 1970s and the global financial crisis of the 2000s. 

Of course, a global thermonuclear war or catastrophic climate change would be worse. 

But bonds would not bring safety.

Nothing would. 

Global disaster is not insurable.

People like the Nobel laureate Robert Shiller and the British economist Andrew Smithers argue that, while stock markets do oscillate, their returns are mean-reverting in the long run. 

In hindsight at least, such mean-reversion has been striking, notably in the crucial case of the US. 

This supports the view that holding a widely-diversified portfolio of equities is far and away the best long-term investment strategy in our uncertain world. 

If one is as clever and skilled as Warren Buffett, the returns from attending to signals of under- and over-valuation have been staggering.

Whether one can rely on this for the future is debated. 

Moreover, there is an obvious problem: that of the volatility noted above. 

The variability of annual equity returns has been somewhat higher than that of bonds. 

Far more important, stock markets can deliver negative returns, from peaks, over long periods. 

Currently, the cyclically-adjusted earnings yield on the S&P 500 is only 2.6 per cent. 

This is at crash-warning levels, by historical standards. 

Should a prolonged bear market occur, equity valuations might collapse. 

The valuations of the mid-1960s did not return for 30 years. 

The big threat, then, is that, as John Maynard Keynes allegedly said, “the market can remain irrational longer than you can stay solvent.”

In effect, there is a shortage of speculators able to prevent equities from remaining durably mispriced. 

The bankruptcy constraint binds markets.

So, equities may offer a free lunch. 

But you must be able to wait for the meal. 

This creates an opportunity and a danger. 

The opportunity is for an investor with a sufficiently long time horizon to make extraordinary returns. 

In a well-ordered world, multi-generation pension funds ought to be such investors. 

The danger is that such funds (and still more so individuals investing on their own) will exhaust their room for manoeuvre before their investments pay off. 

Fears of a huge bear market, not unrealistic at current valuations, might force them into the bond or cash traps. 

How to handle these dilemmas will be the subject of my next piece on pensions.


Why convertible bonds are the asset class for the times

Fast-changing conditions call for flexible forms of capital

In the middle of March last year, as the coronavirus pandemic was taking hold, a private-equity boss in America was asked how his industry would deal with the shock. 

The businesses owned by buyout firms would first look to raise debt wherever and however they could. 

Drawing equity from private-equity investors would be a last resort. 

“I think you’ll see the same in public markets—a lot of convertible issues,” he said. 

Sure enough, there was soon a rash of big convertible-bond sales by cruise lines, airlines and retailers.

A convertible is a bond with an option to swap for shares of common equity. 

Last year $159bn-worth were issued worldwide, according to figures compiled by Calamos Investments, an asset manager. 

This was around twice the value of convertibles issued in 2019. 

So far this year around $100bn-worth have been issued. 

An asset class that had fallen out of fashion is back in vogue. 

That is because convertibles are well-suited to fast-changing conditions.

To understand why, start with some basics. 

A convertible bond has the usual features of a garden-variety bond: a principal to be repaid on maturity, an interest-rate coupon paid once or twice a year and so on. 

In addition the issuer grants the bondholder the right to convert the principal into a fixed number of shares. 

This number, known as the conversion rate, is typically set so that it would be worthwhile to exercise the option only if the share price rose by 30-40%. 

The option is thus “out of the money” when the convertible is issued. 

A company with a share price of, say, $15 might set the conversion rate of a $1,000 bond at 50. 

At that rate it would begin to make economic sense to swap the bond for equity only if the share price reached $20 (ie, $1,000 divided by 50). 

In exchange for the equity option, convertibles pay a lower rate of interest. 

A rule of thumb is that they have a coupon roughly half that of a regular bond.

Convertibles may be complex securities, but in some circumstances they have clear advantages over straight debt or equity for both issuers and investors. 

This is the case for unproven firms in capital-hungry businesses. (Until recently Tesla was a big issuer of convertibles, for instance.) 

The founders of such firms are often reluctant to issue equity, because it dilutes their ownership. 

They would prefer to issue debt. 

But bond investors might demand a steep interest rate to compensate for the risk of default. 

Convertible bonds can be an ideal compromise. 

Investors are willing to accept a lower interest rate in exchange for a piece of the equity upside. 

For business owners, convertibles are less dilutive than straight equity. 

New shares are issued later at a much higher price, if at all.

Around 60% of the volume of issues so far this year is by firms that have been listed for less than three years, says Joseph Wysocki of Calamos. 

But old-economy cyclical firms are issuers, too. 

Some, like Carnival Cruises and Southwest Airlines, used convertibles last year to raise “rescue” finance at lower interest rates and without immediate dilution. 

Others are using them to finance investment: Ford Motor sold $2bn of convertible bonds in March, for instance.

This flurry of issuance is quite a shift. 

The market for convertibles was previously rather moribund, even as high-yield bonds and leveraged loans enjoyed a boom. 

The absence of meaningful inflation meant that long-term interest rates steadily fell. 

Bond investors enjoyed healthy capital gains. At an aggregate level, the trend in American corporate finance was to swap equity for debt, and not the other way round.

Today’s challenges are different. 

A big concern is that inflation and interest rates are at the start of an upward trend. 

A world of high inflation would be a trickier one in which to raise capital by issuing corporate bonds. 

The nominal value of the bond at redemption would be a lot lower in real terms. 

By contrast, convertible bonds offer some protection. 

They are “nominal assets which come with an embedded call option on a real asset”, writes Dylan Grice of Calderwood Capital, an alternative-investment boutique. 

The option to convert to equity affords the bondholder a degree of indexation to rising consumer prices.

Convertibles have already proved their worth. 

They were almost tailor-made for the circumstances of spring 2020. 

Big changes call for flexible forms of capital. 

And it is easy to imagine further economic dislocations on the horizon. 

Convertibles are the asset class for the times. 

Are US Corporations Above the Law?

By siding with major food corporations over six Malian former child slaves who were seeking compensation under US tort laws, the US Supreme Court has sent a dangerous message. Apparently, US corporations will not be held to the same standards of decency and human rights abroad as they are at home.

Joseph E. Stiglitz, Geoffrey Heal

NEW YORK – Adam Smith, the founder of modern economics, argued that the pursuit of private interests – profits – will invariably promote the common good. 

That may be true in some situations, but obviously not always. 

Just as banks’ pursuit of profit led to the 2008 financial crisis, it was Purdue and other pharmaceutical companies’ greed that produced the opioid crisis, and Texaco’s support of the Franco regime that helped the fascists triumph in the Spanish Civil War.

This litany of perfidy could easily be extended. 

But among the worst abuses committed by greedy corporations today is childhood slavery. 

Chocolate lovers around the world may not know it, but some of their guilty pleasures may have been produced by child slaves.

Nestlé, Cargill, and other food companies facing such allegations have avoided answering for them in open court. 

Because they or their subsidiaries are headquartered in the United States, they have been able to argue that they are not accountable for misdeeds committed in faraway Africa. 

They do this knowing full well that there is no effective legal system in the countries where children are being exploited.

Moreover, even if a legal judgment was to come down against these companies abroad, they would pay little. 

They would simply move their operations elsewhere, and it would be hard, if not impossible, for a small, poor country to enforce any judgment rendered.

These issues were all in play in a case before the US Supreme Court this year. 

In Nestle USA, Inc. v. John Doe I, et al./Cargill, Inc. v. John Doe I, et al., the court ruled against six Malians who were seeking compensation from Nestlé and Cargill for their suffering as former child slaves. 

Rather than ruling on the merits of the case, the court issued an 8-1 decision on the narrower legal question of whether an American firm can be held accountable for injuries done to others abroad. 

The US Alien Tort Statute, the court held, cannot be applied “extraterritorially,” because that would amount to an extension of US law beyond US boundaries.

Of course, the US operates extraterritorially all the time, such as when it punishes foreign companies for violating its sanctions against Iran. 

The difference in this case was that it was American companies (or those working on their behalf) who were being called to account. 

By ruling in their favor, the court avoided the question of how companies engaged in unlawful behavior abroad ever could be held accountable. 

In what court would they be tried if not a US one?

In the absence of any accountability, US corporations have little incentive to change their behavior abroad. 

If they can get our favorite chocolates onto store shelves at a lower price by using suppliers who exploit child labor, those without moral compunctions – a category that evidently includes these companies – will adhere strictly to the logic of market competition and do so.

So, who will protect the children? 

At stake in this case was one of America’s core values: human rights. 

It is clearly in America’s interests to show the rest of the world that its companies abide by its values, especially at a time when police brutality against African-Americans is in the international media spotlight.

Together with Oxfam, we submitted an amicus brief to the Supreme Court arguing that it is in America’s economic interest to hold US firms accountable for wrongful conduct wherever it is committed. 

We believe that corporate social responsibility pays off in the long run – for consumers and companies alike – in countries that insist on it.

After all, countries and companies with good reputations can attract more capital and better workers than less ethical competitors can, and their products will appeal to an increasingly conscientious generation of consumers. 

Younger workers are especially sensitive to what their employers do and stand for. 

That is why many companies have taken a stand against voter-suppression laws and embraced targets to reduce greenhouse-gas emissions.

But far too many companies are still driven by short-term profits. 

While lawyers for Nestlé and Cargill were working diligently to spare them from accountability, both companies issued boilerplate statements condemning child slavery. 

But if that is where they stand, why didn’t they want to lay out their case in court?

Surely, their well-paid lawyers would be more than a match for the Malians’ representatives. 

If the companies lost, it wouldn’t be because they lacked adequate counsel.

How can we ensure that companies don’t do abroad what they would never attempt to do at home? 

Globalization has forced this question onto the agenda as Western companies have expanded their reliance on poor countries with very limited legal frameworks. 

Extraterritoriality is not the issue. 

What matters most is that we end the race to the bottom. 

The US should be assuring the world that it and its companies stand for decency, without any double standards.

In the meantime, Cargill, Nestlé, and other companies that have allegedly been culpable in human-rights and environmental abuses abroad must be tried in the court of public opinion. 

Their untiring effort to evade accountability for their actions speaks volumes.

Joseph E. Stiglitz, a Nobel laureate in economics and University Professor at Columbia University, is a former chief economist of the World Bank (1997-2000) and chair of the US President’s Council of Economic Advisers, was lead author of the 1995 IPCC Climate Assessment, and co-chaired the international High-Level Commission on Carbon Prices.

Geoffrey Heal is Professor of Social Enterprise at Columbia Business School.