March 21, 2018

Why some actuaries are getting pension schemes wrong

We have been told that many of the commentators on the USS crisis are behaving like 'amateur actuaries' who don't really understand what they are talking about. We need to be put straight by real actuaries. But actuaries are not all the same. Some of the comments that have been made by actuaries fail to address the central issues in the valuation. They are unthinkingly following the conventional wisdom that is enshrined in some of the relevant regulations. But because those regulations are wrong headed, being based on flawed financial economic theories, they miss the point.

The pension regulations, as they now stand, and as they are applied, expose schemes to much more risk than is warranted by the underlying economics. Pension schemes have to deal with it at great expense. It is a large component of their so-called deficit. This is particularly true of the funding rules that require mark-to-market accounting.

The reason is that the valuation methodology deals with capital values: it requires a comparison of the value of the investment portfolio at market prices, with the liabilities, capitalised by using some hypothetical assumptions.

But the truth is that pensions are cash flows. A pension is a monthly cash payment for life. That is quite different from a capital sum. Likewise the means to pay a pension is a flow of income, which is not at all the same as the market value of the fund's investment portfolio. Stocks and flows are fundamentally different concepts, a point that is drummed into every first year economics student.

A valuation of a pension scheme should be a simple question of whether, in the future, the income will be enough to pay the pensions. But that is not the way it is done. Comparing capital assets with capitalised liabilities is a proxy valuation using very noisy variables. This approach introduces risk in a big way because asset prices are excessively volatile.

The evidence - ignored by modern finance theory - is that the prices of assets, such as equities, real estate or bonds, tend to be far more volatile than the underlying income they yield, in dividends, rent or interest. Evidence from academic studies suggests that the measure of volatility of asset prices is roughly in the region of four times what it should theoretically be. Therein lies the source of much of the risk: the use of the wrong indicators.

And this effect is huge because it leads actuaries to use risk measures (probabilities obtained from the gaussian or normal distribution) calculated using standard deviations maybe four times too large. The valuation methodology that is so close to the heart of many actuaries today is flawed and its application has harmed the provision of pensions to millions of people. The USS is the latest in a long line of schemes that have suffered.

This argument, of course, assumes that the scheme continues open indefinitely, supported by its sponsor. It is different for schemes that are expected to lose their sponsor. They will need to be self sufficient and the value of the assets will be important in that they will have to be sold in the market to pay the pensions.

It is worrying that regulation seems to focus so much on the latter case. It would surely be much better for society if it promoted the continuance of pensions schemes as open to new members in the future.

Why has this situation come about? It is due to changes in thinking in the profession prompted by government. It is also due to changes in thinking about nature of the economy, in particular the increasing belief in the benefits of marketisation. The actuarial profession was criticised for various failings in the past which led to various enquiries, most significantly that by Sir Derek Morris, which reported in 2005, one of whose criticisms was: "an insular and inward looking approach to syllabus development in the past, with too few links with other academic disciplines and developments in academic actuarial science, which led the Profession to become out of touch with the latest thinking in other disciplines e.g. stochastic modelling and financial economics".

Financial economics is an ideal field of applicaiton of actuarial skills in statistical methods since it is an axiomatic system in which every financial asset is characterised simply in terms of metrics of risk and return, enabling the use of powerful tools to make statements about risk. But it is only a theoretical model, and can be shown that its assumptions are an oversimplification of reality. But it is such a beautiful model, and which produces such clear results, that it is hard for practitioners not to forget its weak empirical foundations. It is also too easy to apply it outside its zone of applicability. It is, for example, highly questionable whether it can be applied to the kind of analysis of the USS that are being discussed, simply because the scheme is so very large, that any changes to it would have macroeconomic and market changing effects. The measures of risk and return of different portfolios surely cannot be relied upon to hold over the major changes envisaged by such as Test 1, derisking etc. that are being discussed.

Financial economics has changed the way investment is regarded by its followers. It teaches that there is no long-term premium and all investment is merely short-term speculation with more or less risk. This is empirically rejected by very many studies but it is nonetheless maintained as a belief by many of those in positions of influence over the management of pensions.

Not only actuaries but government also has adopted the financial economics way of thinking. The Pensions Act 2004 brought in strict mark-to-market valuation which has had the unintended consequence of increasing the risk of schemes and led to many closures. There needs to be a rethink.


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