The Very Special Social Pension Portfolio of Financial Frolickers - Asymmetry and Convexity and all that jazz!

In this episode, we are going to start to analyse portfolio construction across a set of social pensions held by our happy frolickers.  The key concepts that make portfolio construction of social pensions different from portfolio construction of vanilla financial assets are asymmetry and convexity.  Let's dig in...

Asymmetric features are features where the payoff or value function provides additional contingent cash coupons not to the hands of the beneficiary, or modifies cash coupons to the beneficiary on a contingent basis.  Typically, positive asymmetry involves a retirement social pension to ex-/spouses, or survivior benefits to ex-/spouses or child dependents. This resembles an insurance claim more closely than a financial share of ownership in an asset.  Negative asymmetry reduces the value to beneficiaries via asset and income tests and interactions with other pension assets.  Once again, i am going to outline these classic benefits and perils using my exemplar portfolio.  Let's frolick!

The Australian social pension is a very sad exhibit of just how negative asymmetric features can be.  In the case of spouses both of retirement age, there is a combined benefit and a combined income/asset test.  The net effect, in the presence of moderate levels of supplementary income or asset wealth, is generally to reduce the combined payout significantly, or eliminate it.  The social pension is reduced by $1 for every $2 of supplementary income over a low threshold or asset wealth over a quite moderate threshold.  If one spouse is not of retirement age and still working that typically destroys the value totally.  If the spouses have combined assets (including private pension accounts) excluding only their primary home, within moderate bands or higher, value destroyed again.  In australia, building a private pension account and investing with moderate returns through your working life might simply be replacing your social pension with your own hard-earned cash, and you will have denied a social pension to your spouse too.  The kind of interest rates we have had the last 15 years and the annuity rates they have implied have really broadened the range of private account wealth that simply became a drawdown that would otherwise have been met by the social pension.  That is not financially clever.  That is some pretty serious negative tax and social convexity frolickers, and you would have been better off not worrying about positive tax convexity, not building a private pension account, and taking the after-tax liquidity into a house or your lifestyle or economic activities.  You build your wealth on top of income support, not so as to eliminate it.   Don't be a patsie.  Learn to say 'no' to grandiose claims of tax convexity ... and pension brokers.

How is that tax convexity vs liquidity tradeoff looking now frolickers?  You just went without the cash for 40 years so your government did not have to give you a social pension.  That is not smart frolicking.  Sorry, but it's not.  It is no wonder pensi0n brokers are so motivated to tell you about tax convexity and how under-invested you are is it?

Now, with sensible planning the aus social pension is very valuable.  For non-working housewives and breadwinners who did not put together a private pension, and have very modest retirement incomes and assets it is a gift to the household of 45 000aud.  That is smarter frolicking.  Guess how big my private pension pot is in australia?  That's right frolickers.  You could spend it on two decent overseas holidays and get it gone.  This frolicker understands negative asymmetry...  A right sized australian frolicker probably targets retirement assets at somewhere around the limit of what he can have and draws a full social pension, unless he really believes he can make so much money he is prepared to walk away from 45 000aud given to him and his wife every year, for still being here.  Anything extra should be in the family home or gifted to the kids.  Assets tests hurt people with assets, not people with kids with assets.  

Those private pension pots are more like an invitation to shoot yourself in the head than a mere red herring in australia.  That is, unless you really believe that asset returns of 8% actually happen in economies that grow at 2% over 40 year terms.  I certainly do not - and you should not either.  What actually happens is that politicians run ponzi schemes as hard as they can for as long as  they can - and then crash corrections happen.  The sequence of returns is a very vicious redistributive gamble.  I call to your mind the dot com crash, the GFC, etc ad nauseum.  Surely, somebody will smugly remind me of housing.  Don't be smug - be patient, that crash is here now too despite the best efforts of baby boomer politicians to make sure their generation owned everything in town, their kids were slaves and their grandkids semi-slaves.  That is the nature of big macro ponzi-schemes run for one generation by one generation.  Financial ponzi ends in financial catastrophe each time - and your age will randomly determine how you fare on your private pension bets, not so your social pension.  It is a defined benefit.  It is not path dependant on the state of the economy over your 40 year betting game.

On interactions with other social pensions Australia is again pretty miserable as they are treated as income.  They too will reduce your pension by 1 dollar for every 2, if you live in australia, but by 1 dollar for every dollar if you don't.  The australian government is not fond of sending money overseas basically.  For the global frolicker, the australian social pension is very quickly a tear-away and throw-away coupon, without knowledgeable planning that puts its rules first in portfolio construction.  With careful planning it is a 28 000aud a year cash coupon to a single reducing to nil as his income reaches 58 000aud.  For couples you can roughly double it and reduce by 20%.  For the financially savvy, it is best thought of as an option collar strategy on income between 28-58 000aud, with a short call option composed of an asset test which must be allowed to fall out of the money.

The USA is the opposite end of the spectrum.  Spouses get half benefits, irrespective of assets although there are income tests if you continue to provide labor after retirement age.  Survivors get full benefits up to 150% of the benefit amount.  This is strong positive asymmetry.  Interactions are serious here too.  Primary beneficiaries lose benefits dollar for dollar if they have foreign social pensions unless they have contributed in the usa for 30 years.  Spouses however are exempt.  The american spousal asymmetry is a very serious feature.  I consider myself very fortunate to hold that particular social coupon.  It will change my life, no less.  The direct pension is actually far less valuable than the spousal pension once other social pensions or usa govt worker pensions are in the portfolio.

The UK is simple and nasty.  No income or asset tests, no interactions, and no spousal benefits.  No particular interactions on other social pensions.  It is an extremely useful second direct social pension because of its lack of negative asymmetry.  It is valueless to spouses and children.  In 2016, the british government trumpeted its pension reform of raising it very marginally in value, and quietly destroyed spousal and survivor benefits.  So much for democracy in action.  They really value housewives and child-rearing in britain - manifestly.  If your husband works all his life and dies relatively young the state will happily let you starve.  Oh yes, those great and good of the british political class, steeped in land ownership in the 10th century as it is.  Bunch of....

However, it is a very inexpensive pension to buy once you are offshore.  Every cloud has a silver lining.  British clouds have very dim silver linings often.  I was pleased to find this one.

Let's now talk about the convex features of social pensions.  Convexity in a feature simply means that the payoff is not linear.  The key convexities in social pensions are the longevity insurance feature - total payout depends on lifespan, the inflation hedging feature through annual indexing, the vastly under-used feature of deferral, and an assortment of special bolt-on features of a cash and non-cash type that social pensions are gateway benefits too.  These special benefits can include housing, health, and utility/transport benefits and so can hold significant secondary value.

The primary pragmatic reason why social pensions must form the core of your retirement planning from early on in adult life is the simple fact that most people do not acquire the kind of wealth that leaves them completely riskless of depletion if they live to a ripe old age.  Funding life from 67 to 75 is a different game to funding life from 65 to 105.  The convexity offered by the longevity coupon of social pensions is an asset you need to have, and the lower your terminal wealth the more of it you need.  Resetting your risk preferences higher in retirement to deal with a low invested wealth generally ends very badly.  You want a good base longevity-guaranteed income component.  Social pensions pay until the day you die, and then often to your family.  They are pure pots of gold in your 90s, and after you pass if your spouse survives you.  The longer you live the more you get.  The longer he or she outlives you the more they get.  The longevity coupon of a social pension cannot be replicated any other way than by annuitising your private pension pot.  Why would you bother, in light of the following features?

The secondary pragmatic reason why social pensions are a necessary core of your retirement portfolio is their inflation indexing.  Inflation is a recurrent economic theme.  It always will be.  It is economic cancer on wealth and the value of the monetary unit.  Hedges are extremely rare and difficult to construct.  Your social pensions are a key portfolio asset in this regard.  They are positively correlated to inflation shocks when everything else you own or earn is negatively correlated.  You want as much of that stuff as you can lay your hands on.  If you suffer an inflationary decade in your 50s or 60s when you are too old to labor again at the end of it and have no time left to build wealth, the destructive impact of that inflation shock late in your labor life can be absolutely fatal to even moderately successful wealth building.  It changes the game, badly, at the end of the game.  This path dependence feature of inflation shocks is nasty.  ... and that is why social pensions insure against it.  Get some more of them!  Do not bother asking your pension broker how you can add an inflation coupon to your private pension account - you can't, and he could not care less.  He wants the fees and he is selling you tax convexity poses to get the fees.

The next convexity is what i like to refer to as a bonus coupon for conservative investors.  In many major social pension systems you have the option of deferring your claim from age 67 to age 70.  When you do this you typically get roughly a 15-25% cash bonus on your monthly payment.  Of course you have to support yourself from age 67-70.  However, it is a risk-free investment, and it carries the longevity coupon and the inflation coupon and the survivor coupon for the rest of your life.  That is turning bronze to gold, the financial frolicker way.  If you are in solid health at 67, you should make absolutely sure that you have the cash reserves to live until 70 and defer your social pension portfolio.  That emergency reserve you get told to keep in life - here is where you blow it away.  You will not need it again.  If you have to go live in some cheaper location - do it.  It is not fun to not be able to afford the grocery bill in the 90s as inflation spurts again frolickers, not after those medical/pharma bills that are going crazy too.

I also want to mention the convex value of a social pension as a gateway benefit to a range of other cash and non-cash benefits.  In some countries, rental assistance or mortgage assistance are tied to receipt of the social pension.  In some, utility bills get subsidies, and in some public transport passes and health benefits are provided.  There are often senior cards that provide a range of amenity cost discounts to improve life for the senior community, cheaply.  If you have a bit of a global itch, having senior benefits in several countries allows you to keep frolicking for longer.

In the next episode, we are going to talk about how to construct and structure your transition to a full claim on your social pension portfolio.