All entries for January 2015

Worrying dogmatism of the USS trustees

The reply to Jane Hutton, Saul Jacka and colleagues by Bill Galvin (USS chief executuve) on behalf of the trustees reveals a dogmatism that is very worrying. The letter shows a view of universities which fails to recognise their unique nature. But worse than that, he displays a belief in failed economic ideas that in itself constitutes a form of imprudence, not to say irresponsibility. He is utterly dogmatic about the efficient markets idea despte all the economic evidence against it.

First he repeatedly refers to universities as if they are companies. He writes, "The level of prudence [in choosing the discount rate to calculate the liabilities] is determined by the trustee's view of an appropriate long-term level of reliance on the scheme's sponsoring employers." Strictly correct, but is it really necessary to talk like that when the employers are all well established universities that have been around for many years and will continue to be so. It is a truism that the employers will continue to exist long term.

Later he writes, "The trustee is of course aware of the Pensions Regulator's ("tPR") guidance around prudence in actuarial valuations and it considers the overall level of prudence it is proposing is appropriate. According to a presentation prepared by the actuarial advisors to Univeristies UK, Aon Hewitt, the level of prudence in USS's current proposed assumptionsis is below the median, and in fact within the 25th percentile, where prudence is measured relative to tPR's reference liabilities." Once again, the fact that he is dealing with universities, that are in practical terms public sector institutions, is ignored and he compares them with private companies. There would be nothing wrong with USS being at the bottom on this measure - indeed it ought to be expected.

But this just puts up the liabilities. It is not itself going to lead to failure. My second point is much more fundamental in that it shows that the trustees' theoretical beliefs could have catastrophic consequences.

Bill Galvin reveals a belief in the idea that markets are efficient in the sense that prices contain all the necessary information. He refers to market-derived information as objective. He suggests that it is wrong for experts to try and make forecasts of the key parameters needed to estimate the liabilities but should only use market information. He writes, "You express concern that gilt yields are currently particularly low due to quantitative easing by the Bank of England." He then goes on:

Those long-dated [gilt] yields take into account any market expectations for yields to increase (for example following a reversal of the quantitative easing policy). The trustee takes the view that it is not appropriate to try to 'second-guess' the economic markets by assuming a yield which is higher than that determined by the market (incorporating its expectations of any future increases).

Later on he writes:

...the RPI inflation assumption is derived relative to the implied market expectations for future inflation levels, rather than focussing on historic or current inflation levels. Again, the trustee feels it is appropriate to use an objective measure such as this as a starting point, rather than trying to otherwise predict future changes.

That the chief executive of the scheme should display such a naive belief in the superiority of financial market is extremely worrying, particularly given what happened in the crash of 2007/8 when many financial institutions lost a lot of money by using the same logic.

Bill is expressing a belief in the efficient markets hypothsis which says that competitive markets are informationally efficient in that nobody can beat the market. Therefore prices contain all the information about the assets.

He also seems to be expressing a belief in the strong form of the EMH in which markets take account of information that is not publcily available (such as future Bank of England interest rate policy). He does the same again later:

The current CPI rate is based on national data based on observed price changes over the last 12 months, whereas the market-driven inflation rate measures the market's expectations of future long-term inflation, allowing for many variables, such as expectations of future economic growth and monetary policy. Therefore the gap between these two items is in no way an indication of the appropriate level of inflation risk premium.

But it is extremely unwise to just follow the market as he does.

The Nobel-prize-winning economist Joseph Stiglitz has long argued against the EMH. He and Sanford Grossman proved as long ago as 1980 that competitive markets cannot be informationally efficient and therefore the EMH cannot hold. (Grossman and Stiglitz, "On the Impossibility of Informationally Efficient Markets", American Economic Review, 1980.)

The argument is quite simple. Each market participant acts on their own information when trading. The market prices incorporate all this information in equilibrium, where no trader can make money by buying or selling. But then no trader has any incentive to provide the informaton (by buying or selling) so the market does not provide the information. It is a paradox. Like so much else in economics that we teach (the paradox of thrift, the tragedy of the commons, the voting paradox) the theory entails a fallacy of composition.

If all market traders (in gilts and equities markets for example) behaved like the USS under Bill Galvin - just following the market passively - then the market would not provide 'objective' informaion; there would be nothing in the market reflecting expectations of future inflation, Bank of England policy or anything else. Market prices would become arbitrary or random. They could be driven by Robert Schiller's and Alan Greenspan's 'irrational exuberance' for example.

Bill Galvin's approach is imprudent, not only in its likely effect on the USS as a result of believing in something that is not true, but also in the possible effects on the financial system when market participants like pension funds believe it to be efficient.

We should not talk about the EMH as being economic orthodoxy, as some have suggested. It is nothing of the kind. It is a theory that has grabbed the imagination of a subset of pensions professionals and is convenient to them. But it is a fallacy.

Dennis Leech : 26 Jan 2015 02:51 |  Tags: Pensions Uss; |  Comments (0) |  Close comments |  Report a problem

Correspondence between actuarial scientists and USS trustees very revealing

In November my colleagues Jane Hutton and Saul Jacka and a group of other leading statisticians, financial mathematicians and actuarial scientists wrote to the USS trustees with a detailed critique of the assumptions they were proposing to make for the valuation.

The reply from USS chief executive Bill Galvin, is very worrying in the thinking it reveals. The rejoinder from the experts is here. (It is also published on Jane Hutton's webpage.)

Bill Galvin reveals a market-fundamentalist perspective. He says that calculations of some of the parameters that underly the deficit - like deriving inflation expectations from market prices - are 'objective' and therefore superior to anything else. One should use market-based measures to forecast rather than observed trends. This is insisting on a theoretical model of how the market works and is akin to a religious belief.

What is particularly worrying is that this view of the world is very individualistic. It focusses on the fund alone as a single entity in relation to the market which is seen as operating independently. But in reality the market comprises many other investors. If they all follow the best practice that Bill Galvin advocates in treating market prices as 'objecitve', then who is there left to make the market work? For a market to work the way thhis efficinet markets theory tells us it should it is necessary for all market participants to behave as 'economic man'. They should be actively looking for investment opportunities at all times, buying and selling assets to achieve the optimal portfolio.

Galvin's approach therefore embodies a fallacy of composition. If all market participant behave as the USS under Bill Galvin - assuming the market to be efficient - then the market will surely not be efficient.

The investment strategy therefore is little more than following the herd. Marlet prices will have a large arbitrary component reflecting factros such as 'irrational exuberance' or random factors.

I thnk this is fundamental. It is a symptom of a common form of myopia that curently is endemic in much economics: to see the world as if it consists a single individual - household or firm - like Robinson Crusoe's island. This is the source of a many of the problems that have affected macroeconomics that have been widely discussed. (See for example John Kay.)

Dennis Leech : 24 Jan 2015 02:56 |  Tags: Pensions Uss; |  Comments (0) |  Close comments |  Report a problem

Nothing orthodox about belief in efficient financial markets

We should not call the efficient markets theory economic orthodoxy. It is a theory that originated in the Chicago school of economics - a very particular instituion whose theories are often regarded as highly controversial by economists - that (at least s far as the pensions industry is concerned) has turned the minds of part of the actuarial profession. Some of them have discovered that it is a way of avoiding some of the problems that have befallen the profession in the past for which they have been criticised. Adopting a strict mark-to-market approach to valuation assuming markets are inherently efficient is a perfect route to a successful actuarial career if you can carry the trustees and stakeholders along with you (by telling them it is orthodoxy). You can then take all the credit for success while having a perfect cop-out for failure ('it wasn't due to my failure of judgement it was the market').

You don't have to be an anti-capitalist to criticise it. Here is what Warren Buffett thinks about it (this is just a flavour):

http://thereformedbroker.com/2014/01/03/that-time-buffett-smashed-the-efficient-market-hypothesis/

There is much criticism of it revealed by the merest googling. There are many articles in the financial press and also in the economics literature. Here is one in today's Telegraph online:

http://www.telegraph.co.uk/finance/comment/tom-stevenson/5562355/Investors-are-finally-seeing-the-nonsense-in-the-efficient-market-theory.html

This article says: "So, increasingly few people still believe that markets are wholly efficient and that is a good thing. "

Unfortunately Bill Galvin i(USS chief executive) seems to be one of them. This is what he recently wrote in a letter: "...the RPI inflation assumption is derived relative to the implied market expectations for future inflation levels ... the trustee feels it is appropriate to use an objective measure such as this as a starting point rather than trying to otherwise predict future changes." (My emphasis)

He interprts the data according to his theory of how expectations are formed by market participants, hence they are 'implied' and the results he gets are 'objective' (they are actually the result of behaviour by human beings which is what a market is).

This is blind faith. Suppose the market is affected by 'irrational exuberance' or randomness of some form. By interpreting the data according to the theory to get so-called objective measures he will go badly astray.

Maybe we are witnessing this already in the high volatility of the valuation.

Dennis Leech : 22 Jan 2015 21:01 |  Tags: Pensions Uss; |  Comments (0) |  Close comments |  Report a problem

Worrying economics of the USS trustees and UCU negotiators

Today's Times Higher Education quotes Jimmy Donaghey, chair of the UCU superannuation working group, and 11 higher education committee members as saying in a letter, “the reality of us changing what is regarded as economic orthodoxy…is an immense task”. On that basis they are apparently willing to swallow the belief that the estimated deficit has suddenly increased to £20 billion without needing any explanation for this 66 percent increase in a few montths beyond 'market conditions'.

For trade unionists to argue thus is remarkable. First there is no such thing as economic orthodoxy. Economics is a very diverse field and it is unhelpful to refer to the market fundamentalism of the USS trustees as orthodox. And these ideas have been controversial for a long time and widely criticised ever since the financial crash of 2007/8.

Secondly their position is absurd because advocates of the orthodoxy they are referring to regard trade unions as a form of market imperfection and tend to argue in favour of 'flexible labour markets'. The whole point of trade unions is to challange laissez faire market orthodoxy. There is nothing unrealistic about that.

But there is a much more serious point here. That is that the economic ideas underpinning the approach to the USS valuation are deeply worrying in themselves because they are self-contradictory and will lead eventually to another crisis.

The trustess argue that the key assumptions about things like asset values and liabilities should be taken from market prices because thses are 'objective'. The idea is that the market price of an asset, say a company share, will inccorporate all the information about the future returns expected to come from owning that asset. The price of the share is taken to incorporate all the information about the whole future of the company. (In its purest form the theory even assumes that the share price also incorporates private information.) But for that to happen the other particpants in the market place must actively optimise their decisions about buying and selling all the time. Then an investor like the USS can free ride on their efforts.

But this is a self-contradictory theory. If the other participants all decide to take the same view of the market prices as being objective - and why not since that is the best thing to do according the trustees - then obviously the theory does not work. Market prices will be arbitrary because all market traders will be passively following rather than active participants.

Another example is in the way the USS forecasts inflation. It looks at the prices of government secutiries with different maturities and gets what it considers an objective estimate from that. But this only works if the rest of the market does not behave the same way. If all market participants do the same as the USS then this approach is pretty arbitrary and will result in volatile and incrreasingly arbitrary valuations. Maybe this is what is behind some of the volatility we are seeing in the valuation of liabilities.

This is a very serious point. It has been said many times that financial institutions have learnt nothing from the crash that cost us all so much and they are carrying on with 'business as usual' with inevitable consequences. Many economists have been saying this in the Finanical Times and elsewhere.

It is not simply a matter of "the reality of us changing what is regarded as economic orthodoxy…is an immense task”. The belief in this orthodoxy is not only a threat to the USS - because actually the orthodoxy does not have a place for defined benefit pension schemes at all, since they are another market imperfection in the way of perfect equlibrium - but actually a danger to the whole macroeconomy. It is simply creating the conditions for another crash.

Dennis Leech : 22 Jan 2015 10:26 |  Comments (3) |  Close comments |  Report a problem

UCU members should vote NO in the e–ballot on the future of USS

I hope members will vote NO. What the employers are offering is fundamentally not in the long term interests of the union members. Nor is it in the interests of the institutions which wish to offer good pensions as part of an attractive remuneration package. The pre-92 universities surely do not want to be in the position where they are offering pensions that are inferior to the post-92 sector.

We have been challenging the methodology by which the USS is valued. The trustees have made assumptions about the distant future that are overly pessimistic in the name of prudence. But if prudence is taken too far it means members have to pay huge sums to compensate undermines the whole basis of the scheme. Most of the deficit (if not all) is caused by this. We are told the deficit is thought to be about £12 billion - but over £5billion is due to a policy of 'de-risking' that we are being asked to agree to. This means we agree to the USS adopting a policy of not investing long term as it always has tended to in the past in order to get the best income - but instead investing in low-yielding government bonds (gilts). So we are having to pay for this. The rest of the deficit is due to overly prudent assumptions - expecting high inflation in the future, higher salary growth than in the past, increased longevity (the employers pension forum were found out to have made outrageous claims about life expectancy in the USS increasing faster than ever into the indefinite future and were forced to withdraw by Warwick statisticians), continued poor economic growth, continued very low interest rates, etc. If they can think of a risk they put it in and charge for it.

The UCU commissioned a report from First Actuarial that proved that if the scheme is valued on an ongoing basis (like the TPS) it might very well not be in deficit. They asked for further information. The negotiators however seem to have ignored this report and have apparently accepted the trustees' agenda. Certainly they have said nothing about it in their email to members. We should be negotiating on the basis of the FA report. Our negotiators should be asking for the data that FA have asked for in order to carry out a proper valuation on an ongoing basis.

Dennis Leech : 21 Jan 2015 11:11 |  Tags: Pensions Uss; |  Comments (0) |  Close comments |  Report a problem

The USS deficit is primarily about ideas more than money

The USS dispute is primarily a matter of ideas and ideology rather than simply money. The deficit - a hypothetical monetary magnitude - depends fundamentally on what is assumed about the future of higher education, specifically that part of it in the pre-92 sector.

This has been shown in many of the employers' individual responses to the UUK consultation (including Warwick, LSE, Imperial, Cambridge, Essex, Aberdeen, Oxford) that the deficit is only as large as the trustees claim it is because they are making assumptions that are far too pessimistic. And the letter a group of leading actuaries wrote to the trustees showing that there may not even be any deficit at all if the right - while prudent - assumptions are made.

But the most significant demonstration of this of all is the report by First Actuarial, prepared for the UCU, that focused on the central role in the valuation of the key assumption concerning the future of higher education itself.

They showed in effect that if the pre-92 university sector is assumed to have a future - not unreasonable one would think - such that its pension scheme the USS has an ONGOING BASIS (rather than the limited period of only15-20 years secure lifetime assumed by the trustees) then the deficit could well turn out to be negligible if only the accounting could be done on this basis. The report is a comprehensively researched and carefully argued study (and the only one that bases its analysis on projected income and expenditure estimates for the indefinite future).

The deficit is therefore ideological in essence.

The trustees (led by USS chief executive Bill Galvin) are following a different ideology and are manipulating the deficit accordingly by making overly prudent assumptions. They have assumed too high salary growth, too much inflation, overestimated increases in longevity, underestimated economic growth and assumed that very low interest rates will continue indefinitely. If there is a pessimistic assumption that can be made the trustees have made it. Some of their assumptions are contradictory (such as very rapid salary growth combined with continuing recessionary conditions). By making appropriate assumptions about future trends there is enormous scope to find there is a deficit if that is what you are looking for. Or not. Such is the power of compound interest!

That begs the question: what has changed since the scheme was supposed to have been sorted out in 2011 when the recovery programme was implemented. It can hardly be true that life expectancy has increased since then, and economic growth has resumed, salary growth stagnated, inflation fallen.

The big change is that the government has withdrawn. The USS originally had a trustee representative of the funding councils, alongside those representing UUK, UCU and independents. When the scheme was set up the assumption was that the government via HEFCE could act as guarantor. And it was at that time axiomatic that these universities would pretty much continue to exist indefinitely and therefore the pension scheme would have an ongoing basis. The government seat was abolished by the coalition, presumably as part of the marketisation madness of David Willetts; and that far-reaching constitutional change was made with a minimum of fuss, its announcement being buried away in the 2012 report and accounts as a fait accompli. It was not even mentioned in the chairman's report.

So the USS now finds itself as a pension scheme for a group of institutions operating in a market, the future nature of which they know nothing about, and this uncertainty is the source of the deficit figures. We can say that the deficit is a result of the government's marketisation obsession together with the ideology underlying the valuation methodology preferred by the trustees.

The trustees' deficit is not money that is having to be paid. In fact the scheme is not in deficit in the ordinary sense: it makes a large surplus every year of over a billion pounds which is invested long term. The trustees' deficit is an idea.

Dennis Leech : 20 Jan 2015 20:18 |  Tags: Pensions Uss; |  Comments (0) |  Close comments |  Report a problem

Why have the UCU negotiators rejected the advice they commissioned on the USS?

It looks like the USS negotiators have scored a huge own goal by accepting the employers' agenda on the future of the USS.

What is hard to understand is why they went to all the trouble of commissioning a report from First Actuarial and then have apparently ignored its findings. In their circular to members they say they have challenged the valuation methodology used by the USS trustees. No doubt they have done so in the meetings. But then they seem to have simply swallowed the trustees' arguments rather than stick to their guns.

The problem seems to be that they are used to negotiating within a 'space' where there is a range of outcomes, such as surrounding salaries. But it is not like that here. It is a black and white issue of whether the USS continues (with or without minor changes) or whether it is prepared for eventual winding up. The trustees want the latter, led as they are by the independent appointees and the USS chief executive who view the USS as just a big private sector scheme no different in its governance principles than Tesco or Marconi. There are many people in the pensions industry who view the DB principle as dead and all that remains for the trustees of such schemes is to close them making sure there is always going to be enough to pay the legacy pensions.

What is worrying is that our negotiators make no mention of the First Actuarial report. It shows - very clearly with compelling evidence - that if the accounts are done by treating the scheme on an ONGOING basis, and all the key 'technical provisions' - that is the assumptions about future inflation, interest rates, life expectancy, salary increases, etc - are reasonably prudent (rather than loaded to make things look as bad as possible as the trustees have done) then the scheme could well be sustainable.

The ongoing assumption is perfectly reasonable if we believe the pre-92 universities have a solid future. That removes the need for 'de-risking' (the biggest component of the deficit and entirely mind-forged).

The report makes the point that in order to do the accounting properly for an ongoing scheme more information is needed and they pose a series of questions for the trustees. Our negotiators should be asking for those questions to be answered because the indicative calculations in the report suggest the scheme might not be in bad shape.

The First Actuarial report is not of course an isolated contribution that criticises the trustees' assumptions. But it does spell out the dichotomous nature of the issue: ongoing or self-sufficiency (ie getting ready to close) basis.

There are real grounds for concern about the management that has been put in place. I have some criticisms of the chief executive Bill Galvin (who was previously the head of the Pensions Regulator). I believe that the market fundamentlism he evidently fervently beleives in - the idea that forecasts underpinning the technical provisions should always be derived from market prices to the exclusion of all other information - because markets are by definition efficiient - is a form of imprudence in itself and likely to lead to further economic crises. I will write at greater length about this.

Dennis Leech : 18 Jan 2015 13:39 |  Comments (0) |  Close comments |  Report a problem

Is the USS de–risking deficit based on sound thinking about the universities' intentions?

The Universities UK (UUK) did a survey of what is known as the sponsor covenant for USS. That is it asked its member institutions how much they could afford in contributions, whether there was any possibility they might leave the scheme, and such like. They wanted to be able to quantify this source of risk. Ths is obviously vital for the future of the USS. If institutions cease to be members, or to contribute for whatever reason that has major cost implications for the scheme.

In their report Response to the Universities Superannuation Scheme Consultation on Technical Provisions and Recovery Plan of 2 Dec UUK referred to this as follows:

1.6 The sheer range of responses to this consultation – and previous consultation exercises as part of the valuation framework – means that the majority view will not satisfy all employers, and indeed some structural aspects of the USS (such as the exclusivity clause, and the lack of control over benefits and investment strategy at an individual institution level) are causing real concern for some. In our response to the March consultation exercise we said we would welcome a further review of mutuality and potential sectionalisation. The diversity of institutions’ views expressed in recent consultations makes it imperative that this review takes place sooner rather than later. We suggest that this review commences as soon as the 31 March 2014 valuation process is completed.

This is a major part of the case for 'de-risking' that is costing over £5 billion of the deficit that members (including those same institutitons) are going to have to pay.

I find this particular part of it amazing:

"some structural aspects of the USS (such as ... the lack of control over benefits and investment strategy at an individual institution level) are causing real concern for some."

This leads me to wonder if these universities thought properly about what they have said before pressing the 'send' button. Have they investigated in practical terms what sort of pensions they will provide and what the cost will be? I am almost tempted to think that their response to the survey has been filled in by someone with limited understanding of how pension schemes work. And also that they have not properly considered how the information would be used in relation to the future of the USS.

They say they want to have control over benefits and investment strategy at an individual institution level. It is hard to believe they would want welcome such control. They would find providing good pensions a lot more expensive because they would be giving up the enormous economies of risk sharing in both investment management and the payment of benefits.

Moreover it seems to go against the experience of some institutions that have found their own SAT schemes too expensive and have had to cut them (eg Warwick). All the evidence is that foregoing the economies of risk sharing in both investment and payment is extremely costly - 50% is the figure based on empirical studies.

[It is also worth considering the fact that most independent schools provide pensions to their teachers through the TPS. They know how expensive pensions are and what good value a large DB scheme like the TPS is. (BTW this represents a huge subsidy to the piviate sector in education that is almost never mentioned.)]

The alternative interpretation of their words is more chilling: that these institutions see themselves as only providing very poor off-the-shelf DC benefits. Getting out of the USS would then be an opportunity to cut costs. Yet they would still be saddled with a huge legacy bill to pay the DB pensions they are already committed to provide.

Either way, how can they see that as in their interests?

Dennis Leech : 18 Jan 2015 01:31 |  Comments (2) |  Close comments |  Report a problem