The intellectual basis for the neoliberal regulatory regime for DB pensions

The methodology that is used for the valuation of pension schemes in the UK is based on theoretical financial economics. The paper that argued for this approach to be applied to pensions is by Exley, Mehta and Smith: The financial theory of defined benefit pension schemes, published in 1997. It is a very long paper and has been hugely influential.

A critique of it (together with a very readable account of actuarial principles) can be found in the attached paper by Simon Carne simoncarne_truth.pdf.

It argues essentially that the approach to pension scheme valuation traditionally used by actuaries leads to inconsistencies relative to a strict use of market prices. The theory is that no one individual actuary can know the prices of assets better than the market.

This is logically flawed because it is a circular argument. The market consists of many human beings all of whom must behave in the way that is being criticised: that is, they must strive to do better than the market in order for the market to work. If all market participants all simply acknowledged that they could never beat the market, and decided to follow it, as this paper recommends, then market prices would become arbitrary and the theory would collapse.

A second criticism is that the argument is entirely in terms of a priori deductive theory and there is no consideration given to the empirical evidence to support it - that is, whether it actually seems to work in practice. Faced with the commonplace evidence that asset prices are very volatile - because their supply and demand depend on many other factors besides the theoretical model of the expected present value of future earnings - one cannot avoid being highly sceptical. The theory is offered as being based on fundamental economic principles which one would expect to lead to robust values that would vary only when parameters of the model change, rather than varying when those parameters do not change.

The effects of economic and political shocks that are essentially due to other factors can be much more important in explaining the volatility - thereby undermining the theory. Irrational factors that reflect herd instinct by investors can cause large swings in asset values that are nothing to do with a rational judgement about the expected future return on those assets.

Dennis Leech : 18 Nov 2014 02:06 |  Comments (0) |  Report a problem