There are problems with the current financial system. There are few places where this is more clearly demonstrated than in the state of underfunding of the world’s pension funds.
Keep in mind this is not just affecting some amorphous mass of people, but it affects our teachers, police officers, firefighters, and government officials in addition to our universities. This is the infrastructure that is necessary for capitalism to work. In short, if we don’t address this underfunding crisis, we will see a weakening of the infrastructure we need for our markets and societies to function properly. But the situation is not hopeless. We can address this problem and, in least in 50% of the cases, effectively solve it. To understand how we can address the coming pension crisis, we need to understand a few proposed solutions and then understand how a few innovative groups have started using technology to merge the best of these solutions.
The Yale and Canadian Models
In the pension, endowment, and sovereign wealth fund world, there are two main ways that people have tried to solve this underfunding crisis. The first is often referred to as “The Yale Model,” and it focuses on finding exceptional “alternatives” (hedge fund, private equity, and similar assets) managers that can deliver outsized returns. The plan was, unsurprisingly, pioneered by Yale University and has been found to work best for groups like Yale that have great contact networks that enable them to find managers. The next solution is called “The Canadian Model” and was pioneered by certain pension funds in Ontario, Canada, and it involves the pension funds taking over tasks that they previously hired external managers to do. These are two polar opposite solutions to a problem. As it turns out, they both have shortcomings: first, there are only a few alternatives managers who genuinely can outperform the market, and it is hard to evaluate them. Second, it isn’t easy to find enough experienced investment professionals to implement in-housing investment management, and it is also expensive to hire those people. The technology-based solution to both these problems is something that I call “the Mountain Range Model.”
The Mountain Range Model
I call the solution emerging the Mountain Range Model because the two places where the model is starting to be adopted in the United States are in cities of the “the Mountain States” and “The Range,” specifically Salt Lake City and Austin, Texas. The Mountain Range Model looks to merge the best of the Yale and Canadian Models using technology to in-house most of their investment management tasks in a central core. This core is then supplemented with a technological infrastructure that allows alternative managers, referred to as “satellites,” to be integrated and monitored. This “core and satellite” plan has been championed by pensions such as Utah Retirement Systems and Texas Teachers and endowments such as UTIMCO (the University of Texas) and Salt Lake City-based foundations. Not surprisingly, these are some of the best-run and funded (relative to liabilities) investment groups in the United States.
With the Mountain Range Model, we see innovation from areas far from the center of the established financial and technological industries on the Coasts, but this is logical and follows precedent. In the last revolution in finance, “The Risk Revolution,” Eastern financial groups proposed “proprietary solutions,” which were inevitably to throw more money at the problems. In the face of massive Eastern budgets, a small group of relatively resource-constrained UC Berkeley academics off the beaten track freely communicated and collaborated with other West Coast institutions such as Stanford, Wells Fargo, and Jefferies. As a result, a West Coast solution emerged and eventually helped to redefine the financial world. I’ve recounted this earlier in my blog.
Times have changed, and the Coasts are not the place to look for those solutions because they keep throwing money at the problems just like the East Coast financial firms did before them.
This money comes from increasing taxes. Not surprisingly, the situation only worsens because politicians always find new ways to spend while not addressing the pension problem that keeps on festering under the surface. That’s one of the reasons the taxes keep getting higher on the Coasts as the problem keeps getting worse. Luckily we don’t just have to only look to California and New York for solutions, but we can look globally, and those solutions have emerged in “The Mountain Range” of Utah and Texas.
The Mountain Range as the New Frontier
For my money, I believe the next wave of innovators finance will emerge among the iconoclastic companies addressing open-source software and crypto/blockchain in Salt Lake and Austin, working with the innovative local asset owners. If these groups learn to work together, they just might create a new infrastructure that helps solve one of the biggest problems facing the developed world.