All entries for Wednesday 20 May 2015
May 20, 2015
The pensions regulations place a paramount responsibility on trustees to try and secure the best returns for the members. This has been used as an argument against those who argue that pension funds should not invest in unethical activities such as armaments manufacture, fossil fuels, racism and apartheid, tobacco, and so on. Campaigners have always been told that the only thing that really matters for the trustees is their fiduciary duty and to bring in ethical considerations will go against that.
The same logic ought to govern the overall approach to managing the scheme and not just to the choice of which companies to invest in (assuming the argument is true which I do not - the Church of England investment fund does very well despite having a strong ethical basis). Yet the USS trustee is following a strategy that is not demonstrably in the interests of members just as if it were choosing certain investments for non-financial reasons. If, for example, it decided to divest from cigarette manufacturers, that could well result in lower returns to the fund if the cigarette shares did well. On the other hand, it could make no difference or even benefit the fund if the shares did badly. There is no certainty but the pension fund trustee makes a decision based on what he or she believes.
There is an analogous situation in relation to the whole management strategy at the USS where the trustee is following financial models which have been shown to be wrong rather than their fiduciary responsibility. Whether following the financial models that currently dominate the thinking of the current USS leadership will deliver better returns than pragmatically taking a view about the future or not is a matter of uncertainty. But there surely must be a basis for a legal challenge to a trustee who bases his or her strategy dogmatically on models that have been shown by academic economists and mathematicians to be flawed.
One example is the idea that risk can not only be measured but also managed. That is a very dangerous idea whose consequences we saw during the banking collapse of 2008 when such measured failed. Measures of risk proved to be chimera: of use only when there was little risk but to be unreliable when they were really needed.
Another example is the belief that it is possible to borrow and lend indefinite amounts at the so-called risk-free rate of interest. That might be a reasonable assumption for a small pension scheme worth a few million pounds but is very misleading for a massive scheme as big as the USS, not only the largest pensions scheme in the country but also big enough that its behaviour affects market prices and to have macro-economic effects.
The idea that the returns on an investment can be expressed in terms of its mean and variance, and that the variance measures risk, is not true as a general statement. This is true in the special case where the returns have a so-called Normal (Gaussian) distribution but the statement is not true in general. And it has been demonstrated (by the mathematician Benoit Mandelbrot and others - see Mandelbrot and Hudson, further references to follow) that returns are not normally distributed so it is imprudent, not to say dangerous, to use the model when making real decisions affecting peoples lives. (An excellent critique of financial economics more widely and its role in the 2008 crisis, see Yves Smith, Econned.)
This prompts the question: why, then, do some pensions professionals continue to use models that are flawed and could be dangerous; is that not imprudent? It is a good question to which there is no satisfactory answer. The most likely reason is that the normal distribution is mathematically rigorous and analytically tractable and therefore convenient to use. Results based on it can be described as scientific, objective and so on, and also modern, so there can be an idea of progress. The use of the model has been described as rather like a drunk who has lost his keys in the street and looks for them under the lamp post because that is where the light is.
But that is precisely what the USS trustee is doing. They like to follow the model because it enables them to assume a direct link between risk and mean return. This is the thinking behind their so-called `de-risking proposal' that members are being asked to agree to. Their proposal is that the USS investment strategy is changed (slowly over years) to a lower risk/ lower return portfolio with members agreeing to compensate for the lower return with reduced benefits and higher contributions. But there is no evidence that this will make it more likely that the trustee will be able to pay the pensions promises when they come due. There are compelling arguments that the best strategy could well be to invest to maximise the long-run return. Some actuaries argue against the de-risking idea on precisely these grounds.
There are other examples of the introduction of flawed financial models by the USS trustee which can be challenged. There is an idea among some that assets are only to be considered as random variables following a random walk process. (Again usually based on the application of the normal distribution to ensure analytical tractability.) But investments in real productive assets such as company shares are governed by the real economy. Yet we are told that investing in real productive assets is too risky. Yet long-term we know that there is a substantial so-called equity premium by which shares outperform bonds. A long term investor like a pension fund should be allowed to invest long term since its liabilities are long term. And investment in equities can be seen as contributing to future economic growth if it leads to capital formation.
There is a belief in the idea that markets provide information better than any individual person can. This economic idea, related to the so-called 'efficient markets hypothesis', has been shown to be a fallacy by leading economists (eg Grossman and Stiglitz, American Economic Review, 1980 and others) yet this - what should be authoritative evidence - is ignored by pensions professionals such as the current USS management. Thus, for example, the only way to forecast inflation in the distant future (vital for calculating the pension liabilities) is to look to the market and study the differences between index-linked gilts and others. We are told that such estimates are 'objective'.
And so on. The use of financial models which are flawed in either statistical theory or economics seems to be widespread (though thankfully not universal) in the administration of pension schemes, of which the USS is becoming a leading culprit.
Yet the USS is the pension scheme for the universities. Its members include experts who understand the reasoning and the evidence behind the pensions theory and financial models. We can therefore challenge flawed thinking. We should not accept the suggestion, made, I believe, by someone close the negotiations that such thinking is 'economic orthodoxy'.
I am not a lawyer but I believe there are grounds for at least considering a legal challenge to the trustee on grounds relating to fiduciary responsibility. There is a motion to the forthcoming UCU Congress from the Lancaster University branch calling for such a legal challenge. It is to be hoped that it gets passed and the union takes the necessary action.