Appearances can be deceiving

In the world before Columbus, the Earth “appeared” to be flat.?In the world before Copernicus, the sun “appeared” to revolve around the Earth. Appearances can be deceiving. For example, companies prepare accounts as if money holds its value over time.?It doesn't.

If you think short-term, then long-term inflation “appears” not to matter, so there would be no point reporting financial projections (like pension liabilities) in constant spending power terms.?Doing so would "appear" to be complicating the issue with an unnecessary intellectual exercise.

I disagree. With apologies to Wittgenstein, how would pension liabilities “appear” if every item in the financial report was stated in constant spending power??

Inflation is real. Financial information about the distant future that doesn't grapple with this reality is potentially meaningless. Are na?ve extrapolations of retirement savings mis-selling time bombs waiting to explode? Compounding investments at 4%, 5%, 6% nominal, on a generational timescale, looks pretty silly when inflation is running at 9%.

And inflation indices are path-dependent. It takes sustained periods of deflation to put the toothpaste back in the tube. The same issue affects the decumulation slope of the retirement income mountain.

At Pathway, we show financial projections in constant spending power. When investors ask "what inflation rate are you assuming?" The right answer is "none, we ignore it."

It's tempting to say something like 2% or 3% just to make the conversation "appear" simple; even though this adds complexity to the 10,000-scenario, path-dependent stochastic model that underpins our business.

We find assets that yield 5% (+inflation) and sell them to institutions holding gilts that yield negative 1% (+inflation). Since inflation sits on both sides of that equation, you can simply ignore it. That's what we mean by keeping it real simple.

Let's get back to Wittgenstein's counterfactual: In such a world:

• Undiscounted pension liabilities (A) would be remarkably stable and the need to hedge them would seem less urgent
• Meanwhile, scheme assets (B) would either out- or under-perform inflation, from one year to the next
• A minus B would be the Deficit (or Surplus)
• Changes in the Deficit between accounting periods could be decomposed into meaningful categories, like cash contributions and investment performance on the asset side, and benefit payments together with changes in longevity on the liability side?

To my friends with actuarial degrees, this is not rocket science. In fact, we're talking about a trillion pound DB pension industry.?With a modicum of technology, manipulating and restating data to achieve Wittgenstein's perspectival shift should not be hard.

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Why does any of this matter? ?Well, corporates jump through extraordinary hoops to protect their accounts from the “appearance” that pension liabilities are volatile.?They are not.?A dozen eggs will cost whatever a dozen eggs will cost in thirty years’ time, irrespective of wild gyrations in today’s gilt yields.?

Hedging the mere "appearance" of volatility, using artificial and fragile derivatives, might be an expensive waste of time.?A well-written footnote in the financial statements, a page in the quarterly results presentation, and a word or two passing from the CFO to the equity analysts would the trick.

Let’s get real:?Strip out the "appearance" of volatility, then you reduce the business of liability-driven investing to that of finding ultra-long dated inflation-linked assets.?If those assets offered real yield enhancement, all the better.?There would be no need for leverage, no derivative overlays, no cash collateral, no emergency margin calls, no Bank of England intervention, no front page news and no defenestrating Chancellors.?

Pension investing would be extremely boring – in a good way.

What’s that, you say??Inflation-indexed assets with yield enhancement are hard to find, at scale, in an industry where a billion here and a billion there is scarcely real money. ?Ahh, I respond, here’s one I baked earlier.

Watch this space.

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Chief Financial Officers affected by these issues should feel free to get in touch.

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Ike Udechuku | Cofounder and CEO | Pathway Points

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