The financial power of a mixed currency state pension.
Over the next few episodes, we are going to teach you how to extract the core value from a multi-currency portfolio of state social pensions. We are going to start with an example pension portfolio based on several single and couple scenarios where the participants have gained exposure to the USA, UK and Australian pension systems. The reason for this selection is my own familiarity with the detail rules, and the fact that such a portfolio exhibits a balance of two global reserves and a semi-reserve currency. I am going to demonstrate for you several principles of hidden value in such a portfolio and hopefully convince you that you would like such an arrangement too.
Firstly, in any portfolio we are always concerned with the key aspects of value, risk, diversification and convexity. Our pension assets are unique amongst financial assets in that they are natural inflation hedges, all being indexed, and thus provide a natural inflation hedge in our overall financial portfolio. When inflation is strong and other financial assets are getting damaged, our pension portfolio steadies the ship with its' inflation indexing. So, let's get on and define these characteristics. We will talk about this more, later, when we introduce non-state pension elements to our financial frolicker portfolio.
To value any asset we have to choose a basis. The correct basis for any asset that will eventually be converted to cash and spent is the currency in which it will be spent at the purchasing parity and time value of the time at which it will be spent. The concept of asset value is inseparable from inflation and currency numeraire for a global frolicker... Today we will be showing total portfolio valuations in each contributing currency, across a historical back-test of exchange rates for the past 50 years to exhibit the kind of volatility and stress that naturally occurs with time. This allows us to see very clearly how the spending numeraire affects the value of our pension mix at any particular time and over time.
The risk in a multi-currency portfolio over time is that we have stored our savings in the wrong currency or that we are spending in the wrong currency. Ideally we would like to save in the most under-valued currency (with respect to the near future) and spend in the cheapest currency (with respect to the recent past). Why? Well, we would like what we save to become more valuable as the currency we save in appreciates and we would like what we spend in to be cheap via currency devaluation compared to our recent savings history. Currency sets exhibit quite serious volatility across the cycle - generally in the range of 40-70%. This volatility is increasing with each business cycle as financial fragility in the western world is becoming a serious macro problem.
The convexity in our portfolio is a statement that the volatility of exchange rates as described above is a non-linear value opportunity. It has optionality. We can achieve positive convexity by saving and spending in the right currencies across the right periods of time, and we can cost ourselves negative convexity by getting it wrong. The convexity in our positioning is realised whenever we choose to convert one currency into another, at any time other than immediately upon receiving the money.
Diversification in our multi-currency portfolio is the degree to which holding several currencies rather than one delivers a hedge against adverse movements in one currency. We will be able to see this very clearly in our tables presenting the total value of our portfolio in various currencies over time. It will be very clear that converting all our pensions into one currency as we receive them is generally not a good idea.
Now that we have defined the characteristics we will be discussing, let's take a look at several pension scenarios for singles and couples...
Let's start with a single male turning 67 on the 1/1/2024. We will consider two cases. In scenario S1, This gentleman receives a full usa social security ($3 800usd/month) and a full british social security ($11 500 gbp/year), alongside a residual australian pension. In scenario S2, this gentleman recieves a half full usa social security ($1 900/month) and a full british social security and residual australian pension as in S1. (This second scenario could be a realistic average case or a case where the usa social security was the spousal benefit from a working wife who was a full beneficiary.)
We now have to explain what we mean by a residual australian pension. In several countries such as Australia, the pension is based on years of residence rather than contributions and is means-tested for both your other assets and income. In the presence of significant other pension income this leaves a residual. We will see that the residual is an important convexity feature as exchange rates bounce around over time.