Thodrov (2024)

01/04/2022

Checking in on the retirement crisisObviously, we have been preoccupied with two major crises and their fallout over the last 13 years, so we may be forgiven if we lost track of another crisis that is looming in the background: the global retirement crisis. In 1995, the World Bank published a major analysis of the state of retirement systems around the world, which warned that around 2030, the social security systems in the United States and other industrialised countries would be running out of money.

More prominently, a 2002 report by Richard Jackson, which was sponsored and then heavily promoted created an entire wave of investment reports on the topic. These reports focused on how the demographic changes and the retiring baby boomer generation are going to deplete social security and public pension systems and how we all have to save more in our private savings vehicles to overcome the shortfall in public pension benefits.

20 years after this important report it might be a good idea to check in on the retirement crisis and its current state.

First, the bad news. The projections for the funding status of public pension benefits around the world have hardly changed over the last 20 years. I have gone through the long-term projections of the Social Security Trust Funds every year since 1980 and in each and every one of these projections the trusts are projected to run out of money sometime between 2030 and 2035. The same seems true for state pension benefit schemes in other countries like Switzerland. The year when they will run out of money has been remarkably constant and for most countries in Western Europe is sometime in the first half of the 2030s (though there are some exceptions).

Then there is the mixed news. Going back to the 2002 report sponsored by Citi, we can compare the current state of government spending on pension benefits with the spending that was projected for 2020 twenty years ago. The chart below shows that for the United States and the UK the projections made two decades ago were pretty good and if anything too optimistic. Pension benefit spending over the last twenty years in these countries has increased more than anticipated.But note that the three countries shown in the chart with the most severe demographic challenges and some of the most generous pension systems in the world (Germany, France, and Japan), have pension benefit spending that is much lower than anticipated. For these countries, the retirement crisis is less of a crisis today than it was twenty years ago.

And this brings me to the good news (sort of). Countries with less sustainable pension systems have engaged in significant pension reform over the last twenty years, while countries like the UK and the United States that had less generous and thus more sustainable pension systems, to begin with, have not. This shows once more that demographics are not destiny because demographic projections that point to a major crisis in the distant future typically do not include the reaction of people to these crises. In the case of the retirement crisis, governments have kept costs under control by cutting benefits, increasing the retirement age, and increasing contributions.

But before you start complaining about the massive tax increases and benefit cuts that are coming our way in the late 2020s, let’s look at a real-life example from the United States. Did you know that in the early 1980s the Social Security Trusts were projected to run out of money sometime between 1981 and 1983? The government of Jimmy Carter had less than five years to prevent US Social Security from failing.

So, in 1977 Congress enacted a law that would increase payroll taxes for social security and disability starting in the 1980s and increase the maximum taxable income for social security. Between 1978 and 1983, the social security payroll tax increased from 10.1% to 10.8% and the maximum taxable income for social security purposes doubled from $17,700 to $35,700. But since that wasn’t enough to stabilise the trusts, President Reagan created a National Commission for Social Security Reform headed by Alan Greenspan. In 1983 Reagan signed the recommendations of this commission into law. The changes made were a continued increase in payroll taxes to 12.4% in 1990 and an increase in the retirement age to 67 by the year 2027. In total, an increase in payroll taxes by 2.3% over a decade and an increase in the retirement age over several decades managed to get the Social Security Trusts into a healthy surplus that lasted several decades.

Today, the payroll taxes for social security still stand at 12.4% and the maximum taxable income has essentially increased with inflation since the Reagan reforms.

Obviously, the demographic challenges waiting for us in the early 2030s are more extreme than the ones in the early 1980s, but this example shows one thing that is often overlooked by fearmongers. When it comes to retirement systems, small changes can have a large impact. All it takes to delay the retirement crisis by a couple of decades are a small increase in payroll taxes of 2% to 4% and an increase in retirement age by a couple of years. And my gut feeling is that if politicians can kick the can down the road with such small measures, they will do just that. So here is my prediction for the retirement crisis: Absolutely nothing will happen until at least 2028 and then governments in the United States and the UK as well as other countries will raise the retirement age to 70 years and increase payroll taxes by a couple of percentage points (just a little bit so as not to cost them too many votes). And we’re done. Then our children and grandchildren can take care of the rest in 2060 or 2070 when most of us are dead or long retired anyway.

31/03/2022

Getting on the same wavelengthLook at the figure below. It is an excerpt of a paper that measured the performance of effective teams vs. individuals in several tasks.

Team performance vs. individual performance in different tasksIt shows that for most tasks, teams performed significantly better than individuals. The only exception was a typing exercise where individuals performed better because teams constantly had to look up where other team members were and wait for slower typers which slowed down the whole team. Teams don’t always perform better but for creative and complex tasks that aren’t well defined, they almost invariably produce better results.

And because our modern knowledge economy is mostly dealing with tasks that require creative solutions to difficult, ever-changing problems, businesses are constantly putting more emphasis on their employees’ ability to work in teams.

But how do you form an effective team? I have discussed previously that having star players in a team or individuals who are much better than everybody else doesn’t work. In fact, it may be counterproductive to the team’s performance. In Germany, there is a popular book called ‘Die Teamlüge’ (‘The team lie’ in English) which compiled lots of empirical evidence when teams are worse than individuals.

Teamwork isn’t a panacea, but if you can form effective teams, there is strong evidence that it improves outcomes in most complex tasks of today’s business environment. But how do you form an effective team? How did the researchers in the study above form the teams in their experiments?

It is instructive to note that the participants in these experiments were incentivised differently. In the individualistic setting, participants were told that their performance is measured based on their individual contributions and that they were competing for a bonus pool against other individual participants. Hence, participants were incentivised individually and correspondingly behaved in an individualistic manner without much identification as a member of a team, though notionally, they were part of a team of workers trying to solve problems. If that sounds like your current work environment and the performance measurement system at your company, it’s no accident. The vast majority of businesses claim they are team-oriented, but then run incentive schemes that are based on the measurement of individual contributions. Every employer I ever had claimed that the bonus pool at the end of the year was not just defined by my own performance but also the performance of my team, and my division, but while personal performance indicators were clearly defined and measured monthly, the team performance and its weight in the overall bonus pool were never disclosed and never properly defined. But if you don’t know what the team’s performance is and how it can be influenced, you are not going to change your behaviour. What gets measured gets done, but unfortunately, almost all companies only measure individual performance.

To make up for the shortfall, companies then create team events and make employees participate in team-building exercises, which in my view are a waste of time and money because they have no permanent impact on the behaviour of individuals the moment they go back to a workplace and are confronted with individual targets.

Now compare this individual incentive scheme to the team incentive scheme where people were asked to name their team and the team was incentivised as a team with the bonus split up between different teams based on the team performance. Within each team, the team bonus was then split up evenly between all participants. Hence, it wasn’t about competing with other individuals in your team and outside your team. There was nothing to gain for an individual by outperforming other team members. On the other hand, there was also nothing to lose by underperforming and slacking off except that a team member who didn’t pull his or her own weight would drag the whole team down and face the social pressure from the other team members. And if you truly feel like a member of a team, then that peer pressure is enough to make you feel guilty and perform to the best of your abilities.

As a matter of fact, there is a way to measure if team members truly feel part of a team (though one that is not practical in a business setting): Effective teams show increasing coherence of their brainwaves. Measured by EEG, members of a team who strongly identified with the team showed increasing synchronisation of their brain activities. They were literally getting on the same wavelength.

And how do you do that? I doubt that a team incentive structure on its own will do the trick. But complement it with daily rituals that foster team building and you might get there. We know from effective sports teams that synchronised physical activities can be powerful tools to foster team spirit. Whether it is exercising together, dancing, or singing together, all of these activities have been shown to foster a feeling of belonging with fellow participants. Getting into a huddle where you literally stick your heads together with your teammates and turn your back to everyone else is another technique to increase team cohesion. And having a team name, a team symbol, etc. all help as well.

Business has a lot to learn from sports teams in my view when it comes to building successful teams. And when it comes to building a team identity through songs, logos, etc. nobody does it better than Liverpool FC. Love them or hate them but watch the video below and you will realise what a powerful force of identification a song like “You Never Walk Alone” is. Also, check out all the different team building activities the players perform during one of the most legendary comebacks in football ever.

30/03/2022

How important are intangibles? Very!Amongst professional value investors – or at least the ones that have survived to this day – it is by now well-known that traditional value measures like price/book-ratios have become less informative for future performance. I have written here that this may be to a large part due to the rise of intangible assets on the balance sheets of so many companies. Stripping the balance sheets of companies from these intangible assets helps improve the value factor.

The main problem with intangible assets is that hardly anyone really knows how to value them. And I presume that gave Dion Bongaerts, Xiaowei Kang, and Mathijs A. van Dijk from the Erasmus University in Rotterdam an idea. If these intangible assets are so difficult to value, then they may give rise to systematic mispricing driven by always changing perceptions of these intangibles. Companies with lots of intangibles on their balance sheet should have stronger growth since these intangibles often arise from R&D investments and acquisitions of other companies. If investors systematically underestimate the long-term growth potential driven by these investments and acquisitions then companies with a larger share of intangibles should have higher returns than companies with a lower share of intangibles. In other words, measuring the amount of intangibles relative to tangible or total assets would be a measure of growth. Of course, if investors systematically overestimate the future growth created by these intangible assets the reverse would be true and a higher share of intangibles would be an indirect measure of value.

Examining the stocks in the Russell 3000 excluding financials from 1989 to 2019 shows that intangibles as a share of total assets has much larger predictive power than one would expect. A portfolio that invests in the 20% stocks with the highest intangible asset ratio and shorts the 20% companies with the lowest intangible asset ratio created an average annual performance of 4.6%. Over the same period, using the same stocks, the value premium was -0.3% per year and the quality (profitability) premium was 3.5%. In other words, the intangible factor was better at explaining stock returns than value or quality. As usual, the returns were higher for small cap stocks than large cap stocks, but even in large caps, it was 3.2% per year.

Looking at the relationship between the performance of value strategies and intangible asset strategies, the research showed a negative correlation of -0.58. Thus, investors seem to systematically underestimate the profit growth generated by intangible assets. This also opens up the possibility to combine the value factor with the intangible asset factor in order to stabilise the performance of traditional value strategies. A pure value strategy relying on price/book-ratios alone would have had a return of -0.3% per year and a volatility of 11.5%. Mixing this long-short portfolio with the long-short portfolio generated by the intangible asset ratio 50/50 created a portfolio with an average annual return of 2.1% and a volatility of 4.8%.

As usual, there is much research that still needs to be done. We need to examine if the intangible asset ratio also works outside the United States, how much returns are reduced by transaction costs and if there are smarter ways to combine this factor with the traditional value factor, etc. It’s early days, but if I’d be running a value portfolio I’d be looking at this more closely.

29/03/2022

Healthy, wealthy, and wise
If you are working as a financial planner or advising private clients, you know that that there are two interrelated systematic problems in their behaviours. First, most people tend to save too little for their retirement and old age and consume too much. Second, most people tend to live longer than they think they will. The combination of these two biases means that far more investors run out of money at old age than need be and many face old age poverty.

Unfortunately, we no longer live in the age of almshouses, and even if we did, hardly anyone would want to live in an underfunded asylum for poor people. It is simply degrading.

A new study by researchers from the University of Glasgow sheds light on how these two biases reinforce each other and which investors are particularly prone to fall into this trap. Based on the US Household Survey, an annual large survey of US households eliciting their beliefs about all kinds of economic and social conditions and outcomes, they compared how long someone who is 50 years old thinks he (or she) is going to live and compared the results with the actual survival rates from statistical tables. Below, you can see the results for people aged 50 who were asked what the probability of living to age 75, 80, or 85 is (left hand side of each chart) and for people aged 75, 80, and 85 who were asked what the probability is that they live another 15 years. The black lines show the true probability of living to that age as time passes and people turn from 55, 60, 65, etc. The blue lines show the subjective estimates of what the likelihood of survival to this age is. The charts may look complicated, but the difference between the black lines and the blue areas show that younger people (aged 50 to 70), drastically underestimate how likely it is for them to live to old age. Meanwhile, older people (age 75 and over) overestimate the likelihood that they will live another 15 years.The problem is that this kind of misperception about life expectancy influences the decision to save for later quite significantly. If you are in your fifties and think you are going to die sooner than you can expect, you are not going to save as much as you need for retirement. And if you are 85 and think you are going to live to 100, you are going to spend less than you realistically could. The result is that people tend to save too little during their working life and too much during retirement.

But what drives this misperception of life expectancy. In short, it is your health, or rather your perception of your health. The chart below shows the deviation in savings rate from the optimal savings rate of people in good health (green bars), moderate health (yellow), and poor health (red). A positive bar means that the savings rate of these people is higher than it needs to be given their life expectancy and living standards, a negative bar means that their savings rate is lower than it needs to be. The horizontal axis shows the amount of cash people had in their savings relative to all other Americans.At all ages, the people in poor health save too little and sometimes far too little. At ages 50 and 60, most people who perceive themselves to be in poor health save 10% to 20% less than they need to, while people in good health tend to save too much, though typically only a little too much. This difference in savings behaviour translates into vastly different wealth outcomes as can be seen below. People with poor health accumulate less wealth and run out of money sooner than people in good health.How can you avoid falling into that trap yourself or help your clients fall into that trap? In my view, the study shows that there are more benefits to regular health checks than one might expect. A regular health check helps a person get an accurate assessment of their health and thus reduces the bias in subjective life expectancy. Second, it helps detect severe illnesses like cancer earlier and thus reduces the probability to face a situation where such illnesses can end life prematurely. And third, it makes people save more for the future and improve their financial quality of life simply because people who get health checks more often feel healthier and are more inclined to make wise money decisions. ‘Healthy, wealthy, and wise’ may be true, though as a night owl, I doubt that ‘early to bed and early to rise’ has anything to do with it.

28/03/2022

How to lower your cost of capital using ESG

As ESG investing becomes more popular, companies with poor ESG credentials face rising costs of capital, either because their cost of debt increases (banks already incorporate ESG factors in their lending criteria and charge lenders with higher ESG risks more) or because their cost of equity capital increases. On the latter one, though, the evidence is very weak or non-existent.

One thing we know is that divestment campaigns don’t affect the cost of equity capital of a company. In theory, divesting from a certain industry should push the share price lower and thus increase the cost of equity capital. But a recent study confirmed once more that the price impact of divestment or low ESG credentials is on average zero. The study looked at the share price impact of inclusion in a widely held ESG index, in this case, the FTSE4Good index. In the United States, stocks that are included in the FTSE4Good index on average experience a return boost of 0.24% from that inclusion – too small to be significantly different from zero and certainly not meaningful for investors. Getting a good ESG rating and being included in ESG indices does nothing to reduce your cost of equity capital and as a result, divestment campaigns do nothing to meaningfully influence the share price or the cost of equity capital either.

But there seems to be a way how companies can meaningfully reduce their cost of capital using ESG data: By becoming more transparent. A team of researchers from PanAgora Asset Management and Google Research investigated the amount of ESG data disclosed by companies and its relationship with ESG ratings and the cost of capital. As it turns out, disclosing more ESG data helps a company reduce its cost of capital and improve its ESG ratings.

On the ratings side, this is probably a bad thing, because it indicates that most ESG ratings still aren’t looking under the hood of a company but instead simply take ESG data at face value and then compare it to the data retrieved from peers of a company. If a company’s ESG data is better than that of its peers, the company gets a better rating and that’s the end of it. If a company doesn’t disclose the data but its peers do, the company will face a worse ESG rating. That many smaller companies don’t have the resources to generate this data and disclose it then creates a large cap bias in ESG investing that I have written about before. I don’t like ESG ratings for many reasons, but this simple box-ticking exercise that is all too common with ratings agencies is one key shortcoming of ESG ratings.

However, on the cost of capital side, it makes sense that companies that disclose more data have lower costs of capital. After all, an investor wants to know what is going on in a company and if a company is more transparent about non-financial risks, that should reduce uncertainty in investors and hence lower the cost of capital. There likely is also a behavioural bias at play insofar as investors who get more ESG data seem to perceive a company as greener and less risky. But there is also a fundamental component where companies that publish positive ESG news get rewarded by the market and companies with negative ESG news get punished. But whether it is a psychological or a fundamental effect, the result remains the same. Companies can actively reduce their cost of capital by becoming more transparent about their ESG risks.

Thodrov

01/04/2022

31/03/2022

30/03/2022

29/03/2022

28/03/2022

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