May 03, 2015

Required reading about pensions: why are there no error margins in valuations?

This article, "Why are error margins ignored in LDI?", in the latest edition of IPE Investment and Pensions Europe, should be required reading for anybody involved in - or with an interest in - occupational pension schemes. It argues that, in order to be of practical use in guiding decisions, valuations of assets and liabilities should be estimated with a margin of error. This point - that is good science but actually little more than common sense - is directly relevant to the current debate about the universities pensions scheme, the USS, whose trustees seem to be ignoring it completely.

The article says that pension schemes rely too much on financial mathematics for valuations, with its precision leading to a false sense of certainty, and fail to learn the lesson from experimental physics: that margins of error in measurements are just as important as the measurements themselves. We could also say that it is a problem in economic thinking due to too much reliance being placed on the idea that competitive markets are in equilibrium - leading to a belief in precise valuations taken as having the status of fact. Such thinking forgets that in the real world there is everywhere statistical error, which is often a very wide margin. An approximate figure with a wide margin of error is often a more accurate description of reality than one presented with spurious precision.

The article begs the question: why is this issue not being actively discussed by everybody involved in running pension schemes, actuaries, accountants, trustees - and the regulator and the government?

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