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Towards asset-based welfare policies
SUCCESSFUL social welfare policies distinguish between routine life-cycle demands and unpredictable events. Successful policies encourage people to prepare for routine events by saving and insuring. The government remains the insurer of last (not first) resort by building financial and other buffers to stand ready to help deal with major natural disasters, economic or financial crises, and 'black swan' events. Successful policies minimise moral hazard and demands for the taxpayer or religious charity-financed assistance.
Historically, owners of equities have earned a higher return on their savings than those saving in bank deposits and similar low-risk financial products. Life is risky and taking risk gets rewarded.
Research shows that the better educated and more affluent are more likely to invest in equities. In addition, they do so by using efficient, well-diversified and low-cost investment products. In contrast, the lower-educated and poorer save in low-risk bank deposits. Not surprisingly, the educated and richer get richer, while the poorer get trapped, as they settle for low returns on their hard-earned savings.
Policymakers should encourage individuals and families to accumulate financial savings and deploy them efficiently to reduce inequality, promote growth, and undermine support for destabilising political 'populism'. A close to universal participation in capital ownership reduces support for economically and socially destructive policies to "spread the wealth" by taxing, or - in some extreme cases - confiscating the returns to physical, financial, and human capital. Low taxes minimise tax-induced distortions, encourage job creation, work effort, and give the poor hope of a better life. Universal ownership of equities ensures that the entire society shares in the returns to capital.
By diversifying our holdings of equities internationally we can raise national income, reduce income volatility, and reduce vulnerabilities to shocks. Such diversification makes it possible for local households to earn some of the profits earned by firms in other countries and regions, where equity premiums are higher than in our domestic market. Broad-based domestic ownership of foreign assets encourages economic openness, and discourages self-destructive economic protectionism.
Governments can pursue a range of policies to increase self-reliance and individual saving among the population. These range from encouraging individuals to explore certain prudent consumer expenditure, savings, and investment choices, help them make better-informed decisions, influence specific decisions, encourage and nudge people to make the "right" choices, all the way to legal mandates that impose or prohibit choices.
Today many countries could easily raise financial security, self-reliance, awareness and literacy, and strengthen national long-term fiscal and economic sustainability. Why not encourage every resident to save in a separate trust fund account? The account could be set up by the national pension fund and invest in globally diversified indexed portfolios (possibly modelled on Vanguard's Total World Stock Index Fund Admiral Shares, VTWAX). Why not mandate that all taxes due from those under the age of 30 be contributed to such a trust fund account to help provide the young with seed capital for life?
Centralised administration and management within the existing national provident fund or social security administration would allow all households to benefit from the low administrative costs offered by such investment platforms. The annual expense ratio of the US-based VTWAX, a retail index fund, is 10 basis points (0.1 of 1 per cent) of the net asset value (NAV), a fraction of the 96 basis points charged by similar US-based funds.
Mandating a specific broadly diversified investment portfolio anchored to a well-known index or set of indices depoliticises the investment process and reduces management and trading costs.
The reform gives every person currently excluded from the equities markets - mostly the poor - an instant opportunity to become a global shareholder, earn equity premium, share in the profits of many of the largest publicly traded corporations, all at a minuscule management cost.
The poor get the benefits accruing to the better educated and affluent investors without wasting time trying to become financially literate.
Some sceptics will question the viability of this proposal.
To succeed, the new trust fund would need to be safeguarded from political pressures, including pressure to divert assets towards discretionary domestic uses at some future time. Therefore, it would be important to provide the highest legal private property protections possible to the individual accounts held in the trust fund, pre-determine the fund's investment strategy, and invest the fund's assets primarily offshore, in markets with well-established protections for private property and foreign investors.
Some could argue that the proposal would increase inequality because it would benefit the better educated and the better off. To address this challenge, policymakers should aim to include as many households as possible in the programme through a mix of multi-channel educational and advertising campaigns, the use of proper defaults, and financial counselling. Mandating the programme could be considered. For example, a share of the employee's future salary increases could be dedicated to the trust fund.
Some could criticise the investment strategy. If indexing were to be applied broadly it would result in economic underperformance. The misallocation of capital could limit the flow of equity and debt financing to startups and unlisted companies. However, if such a programme was rolled out in a relatively small country, its flows to international equity and bond indices would not affect the allocation of capital to any meaningful extent. In addition, a share of the portfolio could be allocated to other than the traditional equity and bond indices, such as pools of private equity and real estate trusts.
Critics would highlight possible complexities related to the rules for using the accumulated funds. Some flexibility would be warranted while ensuring the main objectives of the programme - increasing long-term self-reliance and returns to saving - is preserved.
Critics could argue that many low-income savers-investors could prefer to see their savings placed in lower-yielding bank deposits or other types of investments because of their risk aversion or dislike of volatility. High-risk aversion among some savers could be addressed by offering more balanced investment products, such as a mix of global equities and short-term bonds, to allow lower-income, beginner savers to gain familiarity with the international financial markets while ensuring the required comfort level.
Last but not least, the financial industry could argue that the expansion of government's reach into asset management would harm private finance and reduce employment in finance. However, the programme would not stop private asset managers from providing competitive products and services; its main target audience would be those who are currently underserved by finance and unlikely to be offered efficient saving-investment products by the asset management industry.
In any case, the process of indexing and reducing employment in active portfolio management is already well underway and spreading globally if only because investors have learned that active management is unlikely to outperform indexing, in particular after asset management costs are subtracted from portfolio returns. Finance will continue to develop at a very healthy pace where it does offer genuine value such as broadly defined private equity.
- The writer is an economist with over 35 years of professional experience in academia, international financial institutions and a major international investment bank.