Disputations about transformations

Anthony Asher and Kevin Fergusson presented a paper Maturity Transformation is an Oxymoron: Ways to Match Pensions and Long-Term Assets at the 20/20 All-Actuaries Virtual Summit on 17 August. The problem identified by the paper is that there are currently insufficient long-term assets available to fund pension benefits, but that they can be developed.

Peter Worcester was asked to review it, and found himself in furious disagreement with some of the opinions. This article highlights the main points of dispute.

Maturity transformation

Not surprising, the first point was whether maturity transformation can be described as an oxymoron. Peter started with a standard definition:

Maturity transformation is when banks take short-term sources of finance, such as deposits from savers, and turn them into long-term borrowings, such as mortgages. … They take short-term sources of finance, such as deposits from savers and money market loans, and turn them into long-term borrowings, such as mortgages.[1]

He went on to say that this is just the normal business of banks. Provided there is a matching of the maturity profile of assets and liabilities, there should be no inherent asset/liability risk. Such asset/liability matching is usually obtained by a combination of futures markets and floating rate assets and liabilities.

Anthony’s response was that while the interest rate term can be matched, the cash flows are not available to meet cash withdrawals in a crisis. It is liquidity risk not interest rate risk that is at stake. Informed commentators quoted on page 3 of the paper (who include Economics prize winner Robert Merton) agree that the liquidity risks created by the banks’ “maturity transformation” is unsustainable without government or central bank support. If it were absolutely necessary to the functioning of the economy, there might be some argument to give the banks this support.

The argument of the paper, however, is to show that it is not necessary because super and pension funds can provide the long term finance. Peter responds that liquidity risk is an inherent risk of all banks and deposit taking institutions. Even superannuation funds have this issue if members wish to move their balances to another fund for a variety of reasons. But Anthony counters that good management provides for a variety of market value adjustments or for the temporary freezing of withdrawals in such circumstances.

The use of the word Oxymoron

Anthony concedes that Peter has a point in suggesting that the use of the word Oxymoron is usually intended to imply that the argument being proposed is ridiculous. The paper intends to create an alternative paradigm to the standard definition of banking and the title is intended to make this clear.

Social purposes

Contrary to first impressions, the paper is not about more regulation but identifies appropriate underlying investments for pensions, and suggests that the idea:

  • offers opportunities for Schumpeterian entrepreneurs to disintermediate the banks;
  • requires the empowerment of pension scheme trustees, by making them more independent of financial service interests, and more accountable to their members. Democratic election would be more in accord with genuine capitalism, which Peter particularly espouses, in giving control of assets to their ultimate owners, but this does not require legislation;
  • should lead to regulators be empowered with the responsibility to facilitate markets developments that require co-ordination across the financial sector. This is currently a problem in that competition regulation prevents market participants from developing ways of collaborating to improve the function of markets. Underlying the last suggestion is the view that regulation should, consistent with the other requirements of justice[2], and interfere as little as possible with the liberty of those regulated. It is thus the opposite of wanting to impose on anyone.

Pension Scheme Needs

The paper starts by showing the cash flows required by a group of new pensioners has a term of three decades and that this is the appropriate way to model cash flows and discuss asset/liability management issues.

Public schemes

Peter responds, that any ongoing pension scheme has new members replenishing those who leave the scheme due to death or other reasons. This is particularly true of unfunded, compulsory government Pay As You Go (PAYG) schemes – as long as the population size is not declining. He then goes on to say that the issue of inter-generational wealth transfer raised in the paper is relevant. When an individual is born, they are born into a society with substantial infrastructure already in place which had been paid for by earlier generations.

The point made in the paper is that the inter-generational equity debate germane to the public pension “crisis” caused by declining populations. If the retiring generation has paid for sufficient infrastructure that is generating benefits for the working generation, then it is fair (equitable) to ask them to pay for it. The paper therefore suggests that the cash flows shown in the national accounts as “consumption of capital” can explicitly balance the pensions being paid. Some of the reduction in pension benefits, currently being made, may therefore be unfair, while some of the benefits may also be unfair if sufficient investment was not made at the time.

Private funds

The paper points out that both employer sponsors of defined benefit (DB) and the members of defined contribution (DC) funds are continually seeking ways to avoid the volatility that arises from investing in liquid assets. Peter suggests that this is the Holy Grail of employers, employees, retirees and governments; and that it has never been proved to exist, and in the lifetime it is unlikely. He points out that there are two possible ways forward:

  • Match assets and liabilities as far as possible, and keep valuing both at market values. If they are matched then the market value of the assets and liabilities should move in tandem, and thus remain matched, or
  • Do away with market values, and use some kind of book values.

He suggests that the second alternative is “Flying by the seat of your pants and hoping for the best.”  Anthony would not disagree with this although things that actuaries had developed fairly sophisticated adaptations to book values to ensure that they could be “matched” with cash flows.

Long-term depreciation

The key to the development of appropriate long term investments is to understand the nature and size of depreciation cash flows in the economy. Peter responds that whilst depreciation is an important number in a set of corporate accounts, it is also a non-cash item.

The arguments in the paper hang on showing that failure to see depreciation as a significant part of free cash flow is a common misunderstanding. Certainly, profit is determined by deducting expenses from revenue, and cash flow is determined by adding back depreciation because it is a non-cash item – as a deduction from cash flow to determine profit. But this is because it belongs to free cash flow. Or put another way, the free cash flow consists of depreciation and profit. 

The paper suggests that this misunderstanding has meant that the cash flows from depreciation have been missed in the discussion about agency risk of free cash flow. For those who have missed the development in finance theory, a paper by Michael Jensen in 1986[3] led to a widespread view that managements are tempted to poorly invest free cash flows, and that the antidote was to load up with debt. Actuaries may well be familiar with the “lazy capital” version of the argument.

Peter accepts that IABs would be useful, but believes that agency risk is very much a secondary or tertiary issue, and does not add a lot of value to this discussion.

Funding of new CAPEX

If companies are loaded with debt, then the major factors determining CAPEX are the prices prevailing in the Capital Markets for both equity and debt at the time a company intends to purchase some new capital equipment.

Peter believes that this is normally the position. Anthony accepts the evidence of the finance academics that managements of less indebted companies use their free cash flow to invest in projects that are not subject to the disciplines of the market.

Other sources of cash flows

The paper identifies two other sources of potential cash flows for pensions:

  • dividends, which are widely used, but are – as currently being illustrated – unreliable
  • home loan repayments, which are currently absorbed by the banks, and which could be redesigned as “salary linked mortgages”, as suggested by Anthony in earlier papers.[4]


Peter does not think that they are relevant for funding pensions, although there is a current problem of an absence of financial instruments of appropriate term.

Indexed Annuity Bonds

On IABs, Peter and Anthony are in agreement that IAB’s are an excellent solution for funding retirement incomes:

  • They would be better as annuities rather than bullet repayments.
  • There would be a need for new primary and secondary markets in such bonds
  • That having at least 4 layers of intermediary between the members of pension funds and the investments that match their investments creates conflict of interest, and that the rent seeking that arises is an obstacle to more use of the instruments.


Unnecessary liquidity

There is however disagreement about investors’ need for liquidity in all markets. Both agree that unnecessary liquidity in a market lowers the cost of capital and hence the returns to investors.

Peter however argues that liquidity is absolutely essential due to at least 2 very different reasons:

  1. In the event that a pensioner dies, it would be preferable if the remaining income could be capitalised, sold, and returned to the pensioner’s estate or to the fund itself.
  2. External Shocks to the Capital Markets necessitate liquidity. A topical current issue is that while COVID 19 lockdowns have been in place, most people have been working from home. As this may continue, the impact on office building rents may lead to cash flow problems for property companies and mature superannuation funds.

Anthony’s response to the first point is that, in a life annuity, the remaining assets are re-distributed to survivors and continue to be paid as an income. To the second, he suggests that the ability to get needed liquidity is aggravated if people are able to sell long term assets that are not needed.

Could IAB’s become more popular?

Peter is of the opinion that (sadly) little can be done to overcome conflicts of interest, short of government subsidies. Anthony is more of an optimist, hoping to plant seeds. He takes comfort from a snippet from Keynes: “Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” 

[1] – https://moneyweek.com/glossary/maturity-transformation
[2] – Anthony understanding of justice is set out in section 2 of https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1027372
[3] – https://ukdiss.com/litreview/study-on-profit-versus-cash-flow.php
[4] – Asher, A (2011a) “Salary Linked Home Finance: Reducing interest rate, inflation and idiosyncratic salary risks”, Australian Actuarial Journal 17.1: 117-148

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