From the earliest age, we love to connect the dots. On any holiday charter flight, a child with furrowed brow is concentrating hard, drawing lines between numbered dots on a page. Dots that look random and meaningless until the carefully drawn pencil lines finally reveal an etching of the three bears staring in disbelief at Goldilocks asleep in Baby Bear’s bed.
Life is a bunch of dots. It always has been. Some people are better at seeing the picture than others.
A man in ancient Greece lowers himself into a steaming bath. Dot. The water level rises. Dot. The man knows it always rises by the same amount when he gets into the bath. Dot. It rises by a different amount when his wife, Erika, gets into the same bath. Dot.
“Yo! ‘Rika, maybe there’s a Principle.”
A 19 year old geeky kid who’s good at programming (and extraordinarily good at connecting dots) creates a simple site so his other sad geeky friends can congregate online to discuss the relative merits of the girls on campus. The site goes wild with activity.
In a couple of hours it overloads the university’s servers. Dot.
He writes some more code so that they can all post cool stuff about themselves and share pictures and “status updates” online. Within a few weeks there’s so much activity it melts the servers of several universities across the US. Dot.
Hey, maybe everyone on the planet – not just sad geeky people – would like this site.
It wasn’t the first time someone had built an online platform for a student community. But it was the first time anyone connected the dots.
Now, those connected dots are worth $100,000,000,000 give or take.
It’s not always about creating the dots; usually, it’s about connecting them. Each dot is nothing special on its own. It’s the connecting up that unleashes the deep magic.
Plenty of folk knew about m. They were also familiar with E and c. They were three dots. Only one guy connected them and showed that E=mc2. That matter and energy are really just different manifestations of each other!
In this insanely fast-moving, tectonic plates shifting, technology-driven, austerity-ridden, 2012 world, it is more vital than ever to connect the dots.
The thing is, dots just look like dots until someone connects them. Some people are great at connecting dots. Others simply refuse to see the picture even when someone else connects the dots.
Take Kodak. The iconic brand invented the digital camera for crying out loud. Dot. No messy, hassly, inefficient, expensive film development required with digital photography. Dot.
People can take loads more great pictures than they can with film. Dot.
Phones can double up as cameras. Dot.
But Kodak didn’t like that picture (they were all tooled up for a world of glossy Kodak film) so they pretended it wasn’t there; as if the dots were just dots. So Sony, Canon, Nikon and Apple connected them instead.
Now Kodak is in Chapter 11 insolvency. Which is what can happen when you don’t connect the dots but someone else does.
Random Pension Dots
Back in 2003, there were a bunch of random dots:
Regulation and accounting rules suddenly forced companies to treat the highly volatile pension deficit as a real and present debt on the sponsoring company’s balance sheet. Dot.
The major driver of pension deficit volatility was the liability side of the equation, not the assets. Dot.
Only a significant investment in long-dated government bonds (or, better still, interest rate and inflation swap contracts with similar mark-to-market effect) matched the liabilities. Nothing else. Dot.
Real interest rates began to fall, more or less steadily. Dot.
Pension liabilities are measured using real interest rates. As real interest rates fell, the liabilities rose. Steadily and a lot. Dot.
By 2005 there were a heck of a lot of dots waiting to be connected.
Amazingly, many pension funds and their investment advisors looked at those dots through a Kodak lens. They didn’t like the picture, so they behaved as though it wasn’t there.
When you asked them why they waited to hedge, they typically replied that better times were ahead. This turned out not to be the case.
And all the time, someone else was connecting the same dots and purchasing the very hedges they should have purchased.
What’s done is done. (Or, more accurately, not done).
Now here are some more random dots:
Corporate sponsors are slowly suffocating under the weight of their underfunded, unhedged plans. It is an agonising way to go. Dot.
Corporates cannot take much more of this. The very life blood is being drained from their essential corporate activity- which is already under severe strain due to particularly austere economic conditions created by Greeks, Bankers, Germans, French, the Government, Californian Mortgages, Sir Fred (sic), et al. Dot.
The real yield is now negative and is clearly NOT floored at zero. Dot.
Often, prices rise even when you don’t think they should. Gold, Oil, Gilts, houses in South Kensington. It’s a function of supply and demand. Dot.
The price of gilts and swaps is still rising. Dot.The UK government recently decided (because it can) to print some money (£50bn) and has gate-crashed the gilt-buying party. Dot.
New regulations from the EU are about to force pension plans to manage risk intensively. Some people think it is a good move. Others think it is a dumb move. It doesn’t really matter who thinks what. The new regs are coming. Dot.
There are not many remaining investment safe havens, but gilts are still widely considered to be among the safest of safe investments. Foreign investors (Greek, Saudi, Libyan, Egyptian, Chinese, Russian, Italian, Spanish, Irish, Portuguese etc) prefer gilts to their own government debt. There is still plenty of demand for UK government debt. Pension funds, the UK government, everyone else are all still buying gilts. Dot.
These austere conditions are not about to go away anytime soon. Profligate ouzonic countries are not about to start behaving like efficient Teutonic citizens. Besides, it is almost certainly, tragically, too late. The ship has hit the rocks and is capsizing. It may take a bit longer, but soon it will be on its side, sliding off the edge of the Euro reef. Dot.
Technological innovation is altering the corporate landscape more quickly than at any point in history, including the Industrial Revolution. Corporations cannot predict who will shortly put them out of business by connecting dots. In 2012, it must be terrifying to be CEO of Iconic Brand PLC. Dot.
Lone individuals with A Great Idea can now severely disrupt the establishment. And to do so costs, er, nothing. Dot.
Those are the dots.
Now here’s an emerging picture.A truly perfect lightening storm is arriving for the pensions industry and the clouds are dark and heavy.
If you run a pension plan (or a corporate sponsor of a pension plan), there is no choice but to implement an effective risk management strategy. Every day you delay, the risks increase exponentially.
The next couple of years will herald the rating downgrades (and, in some cases, the insolvency) of iconic brand corporations that failed to connect the dots.
Either they will be technologically obsoletized (new word) or the cost of their pension deficit bill will take them under. Or both.
For some, there is still time to address the situation; but not much.
Those are the dots.
That is the picture.
4 comment on “Connect the dots…”
February 19, 2012 | 4:42 am
That was an entertaining post and it made me think of my toddler old son. He likes nothing more than to connect the dots and look in awe as a picture of a car, a truck (sorry..a lorry), a bus or anything mechanical with wheels is revealed.
But even when it is obvious that the unfolding picture is of an elephant, he'll still try to convince me that maybe, just maybe it's going to be a bulldozer… Next picture… Now, what is obviously going to be a giraffe, might actually be a crane! -the mechanical variety. He'll stick with that thesis until he is about to connect dot number 87 (out of 89).
If only the problems faced by pension fund advisers were equally trivial. They are facing a picture in which real rates are not going to rise and that picture as you say is getting uglier.
I think there is a whole set of behavioral biases that are influencing the thought processes of investment managers and advisers:
-'Anchoring' (they still remember when rates were much higher),
-'Confirmation' bias (they are actively seek information that supports their view that rates will rise and hence it's better not to do anything for now),
-'Regret' (for not having acted long ago, and possible future regret if they act now)
-'loss avoidance' (speaks for itself, but also the manager becomes risk-seeking in order to avoid the loss and that is not usually optimal)
-'herding' (everyone is in the same boat, so they'll sit on their hands as long as others appear to be doing the same).
There are probably other biases that cover the mental dynamics that are in play here but these are the ones that come to mind.
All you can do as a consultant is show them the picture as it looks now, and point out the cognitive and emotional biases that are preventing them from seeing what the picture might end up looking like.
Good luck with that….
February 19, 2012 | 8:59 am
Essan, many thanks for that comment. Excellent observations around the behavioural biases that affect pension plans. Cognitive disonance is definitely at play too: "We have held this position for so long, we simply cannot change our minds now. To do so would be inconsistent."
February 23, 2012 | 7:12 pm
Dear David: This is a great post, best I have EVER seen on this whole pension issue, just clear and easy to understand, you're a great writer mate! I am a Brit and occasionally do read articles on the whole pension issue. If you go to our Daily Telegraph, you can see quite a bit of angst on the whole subject: http://www.telegraph.co.uk/finance/personalfinance/. Inflation in the UK is even higher than in the US, and hence the return on bonds is even more of a negative real return. From what I've read, it seems like all of these pensions were based on plans for 8pc returns ad-infinitum. Of course, that was fantasy. Now, its time to pay the fiddler and a lot of good people are going to suffer because of this. Again, great article David. Peter
February 23, 2012 | 9:29 pm
Hi Peter, thanks for your kind comments. This whole thing is yet to play out and it could get very messy. Stay tuned. Dawid