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May 31, 2015

USS assumptions out of line with other pension schemes

We know that the viability and sustainability of the universities pension scheme, the USS, depends crucially on what is believed about the unknowable future in terms of what are known as the 'technical provisions'. Members have been told by the trustee and the employers that - while the scheme may be very profitable at the moment (and increasing its portfolio of investments rapidly) - at some point in the future that is going to change and it will start to run out of money. Just when that happens - and indeed whether it is factually true that it happens at all - depends on precisely what is assumed about the key parameters like future life expectancy, inflation, salary growth, and so on.

We have been assured that the assumptions the trustee is making are conventional within the pensions industry - the USS is merely following good practice that applies to all defined benefit schemes. Members have been told not to worry too much about them because they are 'economic orthodoxy' and some have been convinced by this argument. Well, I believe we should never take anything on trust and should question everything - especially if it is something whose meaning and context are not immediately obvious to us.

It is therefore interesting to compare the USS trustee's assumptions, laid out in its consultation document and annual report, with the findings of a recent survey of pension schemes by KPMG, which reported on 270 companies with defined benefit pension schemes. This shows that some of the key USS-trustee assumptions in fact appear to be out of line with the industry norms. This seems to be the case particularly for life expectancy and mortality, salary growth and inflation.

On life expectancy, the USS trustee assumes that members who retire today at age 65 will live a further 23.7 years for males (25.6 for females). This seems very high in comparison: the survey median for males is 22.5 years (no figure for females). For those currently aged 45 the assumption is that they will live for a futher 25.5 years after retiring at 65 (males; 27.6 years for females) which compares with a survey median of 24.2.

The USS trustee not only assumes USS members to have high life expectancy but in addition that it will continue to improve at a much higher rate than for other workers, which seems surprising. The USS-trustee assumption is that life expectancy will improve at a rate of 1.5% per annum whereas the KPMG survey median is 1.25%. The survey found that 72%* of companies assumed a rate of improvement less than 1.5%. Perhaps we would expect other groups of workers to catch up with relatively long-lived university staff long term. This assumption of a very high rate of improvement in an already very large life expectancy has a significant effect on the viability of the scheme.

On salary growth, the USS trustee's assumption is again out of line with the industry norm. The KPMG survey median assumption is for salaries to grow at RPI (Retail Price Index) plus 0.5% per year. Only 12% of companies assume a rate above RPI+1%, which is what the USS trustee assumes. There is no explanation as to why this very high rate of salary growth is being assumed. Its effect is very large and it appears a very arbitrary assumption which makes the pension scheme seem very expensive.

On inflation, the USS figure is again out of line with the rest of the pensions industry. The USS trustee assumes RPI inflation will continue at 3.6% per annum while the KPMG median is 3.4% (and only 24% of schemes are assuming more than 3.5%). This seems surprising that there should be so much disagreement about inflation.

On all three it seems the USS trustee is making assumptions about the future trends in these figures that have the effect of making it more likely that the scheme will be seen as unsustainable because they have a very large effect on the calculation of the deficit.

Members might be justified in asking why it is necessary to be so much more conservative than the rest of the pensions industry, when it is known that many schemes are already very prudent.


*Thanks to Susan Cooper for pointing out the error in this figure in the earlier version posted.

May 21, 2015

Socially Responsible Investment: Church of England fund does well

The USS trustee has recently said, in a letter to a member, that the scheme's paramount concern is to "manage the fund in a manner that delivers the best possible returns for its beneficiaries consistent with appropriate diversification and prudence". This is good logic but it does not always follow that an investment fund will perform less well if it bases its selection of investments on ethical principles.

The latest report about the Church of England Investment Fund shows it is possible to be ethical and make a good return

April 25, 2015

Misleading picture of USS pension changes in UUK 'heat map'

Universities UK (representing employers) have just (on 20 April) published comparisons of the pensions members can expect under the USS employers' proposals and under existing rules. This so-called 'heat map' is meant to show the impact of the proposed changes to benefits for members of both the final salary and CRB sections of the USS scheme, modelled according to income and to the number of years before normal retirement age. It has been circulated to members (via employers) as new information in the middle of the consultation period.

Surprisingly, it suggests that almost all members, of both the final salary and the career revalued benefits sections, will get better pensions if they agree to the changes! Only those on very high salaries and close to retirement will lose out. This is a totally unexpected story in view of the dire warnings we have been given up to now about the need to address a large and growing deficit.

The figures are actually very misleading and disingenuous because they use over-optimistic assumptions and selective evidence.

Final Salary Section

The comparisons for members of the final salary section are extremely disingenuous. They are for future accrual only. But the main thing that members are worried about is the treatment of past accrual - that is, what their years of service up until the change over will be worth. But that has been completely ignored. Under the proposals past service will give a pension based only on salary in 2016 - rather than at retirement as expected. If salaries are expected to rise by RPI to retirement while inflation adjustment of the 2016 pension is by CPI - which is what the document assumes - this is going to be quite a big difference for most people in the middle of their career.

What members need is a comparison of the whole pension they can expect to receive that takes account of the number of years they have already contributed.

Also the calculation of the defined contribution pension (for salaries above £55,000) is wildly optimistic - see below.

And of course contributions rise from 7.5% to 8%, an increase in costs not mentioned in the comparisons.

CRB Section

The comparison for the CRB section is not surprising given the increase in the accrual rate from 1/80 per year to 1/75 below the salary cap at £55000. That guarantees higher pensions for all but the highest paid. But this ignores the big increase in contributions for this group from 6.5 to 8 percent of salary. It would give a more honest picture to model both changes together.

Also the calculation of the defined contribution pension (for salaries above £55,000) is wildly optimistic - see below.

The new defined contribution section for salaries over £55k

Tha assumptions underpinning the calculations in respect of the new defined contribution pensions (DC) element seem to be very dodgy. The growth rates assumed seem to be wildly optimistic. Apparenltly (according to the 'heat map' document) they have been agreed by both sides - UUK representing employers and the UCU representing members.

There are two issues: assumed growth rates of the DC fund and annuity rates for converting the DC 'pot' into pension - both are higher than seems reasonable or sensible.

For their predictions UUK assume a range of three growth rates: 4.5%, 5.5%, 6.5%. These are very healthy rates of growth and much better than the rates usually used currently in the pension industry for such comparisons: -0.5%, 2.5% and 5%.

Why have these rates been used? It looks like pension misselling on a grand scale. And why have the UCU negotiators apparently (according to UUK) agreed to them? This is surely not in members' interests.

Then there are annuity rates used to convert the pension 'pots' - on the DC element for salaries over £55k - into pensions.

The 'heat map' document assumes the following rates of conversion of DC pot to annuity:

"Joint life annuity rate (long term market conditions) 23.0 (CPI increases, 5 year guarantee)"
"Single life annuity rate (long term market conditions) 21.5 (CPI increases, 5 year guarantee)"

These rates of conversion of DC pot to annuity are more generous than what the USS modeller assumes. They also seem to be better than what one can purchase on the open market.

DC pensions are risky

What this document fails to mention is that the main objection to DC pensions is they transfer all the risk from employers to members. A DC pensions does not deliver a predictable pension on retirement but an uncertain 'pot' of money depending on investment returns in the stock market and so on, which a member is then meant to live on for the rest of their life. A DC pension is not really a pension in the dictionary sense of the word - which is an income for life - but is really a kind of subsidised saving plan to which both the employer and employee contribute.If there is some kind of financial crisis theen members can lose a substantial part of their pension. (For example, what would happen to a DC pension pot if Greece leaves the Euro?)

For most members the DC component is quite small at the moment because it accrues only on salary above £55k. But the expectation is that it will grow in the future especially if - as many expect - we are told there are further funding problems with the defined benefits CRB at the next revaluation in three years' time.

The spectre of future funding shortfalls

The main threat to the DB pension scheme is from funding. If that is deemed to be inadequate at the next valuation then the rules are likely to change yet again and the DC section will expand or replace DB altogether. Many of us (including some of the UCU negotiators) believe the methodolgy used to value pension schemes and work out funding adequacy levels is deeply flawed and does not provide a good guide when gilt interest rates are as low as they are now. This is bad economic thinking by some pension trustees and actuaries and is leading to socially harmful results.

April 01, 2015

Meeting between academic pensions experts and USS CEO

Following their letter to the USS trustee, signed by many of the country's leading academic experts on actuarial science, my colleagues Professors Jane Hutton Saul Jacka of the Statistics Department were invited to meet the USS chief executive, Bill Galvin.

Jane has now posted the following account of the meeting on her website.

Meeting with Bill Galvin, CEO of USS.
Saul Jacka and I were invited by Bill Galvin, CEO of USS, to meet him 'in a spirit of openness and transparency'. The meeting took place in London on Friday 27 March 2015. Jeff Rowney, the senior internal (USS) actuary, Ali Tayyebi, the scheme actuary from Mercers and Brendan Mulkern, Chief Policy and External Affairs Officer for USS were also present. Although Bill Galvin initially made his excuses, he stayed for almost an hour.

Ali Tayyebi made it clear that a major driver for the single estimate of the deficit which has been made public was the UUK's insistence that the employers' contribution could not go above 18%, as they could not afford more. However, UUK also insisted that the salary forecast should be CPI + 2%, (RPI + 1%, or they might be minded to accept RPI+0.7%), substantially above the historical position, even when the unprofessional discarding of the last three years actual salary position is used. So the UUK position is incoherent: they say they cannot afford to pay for pensions, but they can afford to assume a rate of pay increases which is know to be well in excess of what is actually paid. I reminded Ali Tayyebi what the statistical definition of bias is; the evidence is that the assumption on salaries gives a large over-estimate of the liabilities. There are other inconsistencies, and circular arguments, rehearsed again by the actuaries.

Ali Tayyebi also stated that describing uncertainty was a fundamental part of his advice. He had provided numerous different estimates of the deficit, under all the assumptions which we and Imperial College suggested, and many more, to the USS Trustee and the UUK. The USS Trustee has had open discussions with UUK. Bill Galvin said that, to his knowledge, nothing had been withheld which people have asked for. I find this strange, as both institutions (Warwick, Imperial College) and individuals have requested sight of a range of valuations.

Bill Galvin said the range of estimates of the deficit or surplus of USS will be released after the consultation. It seems to us that the USS Trustee and the UUK are withholding important information from members. We do not see how the USS Trustee can claim to be acting for the benefit of members and standing up to employers (two of their statutory duties) whilst failing to provide a range of estimates until after the consultation. In my opinion, I should not trust the USS Trustee to be open, transparent, or willing to respect beneficiaries of the USS.

I cannot find the 'openness and transparency' which was offered. Our replies to the consultation must request sight of the full set of estimates provided by Ali Tayyebi for Mercer.

Jane Hutton"

It is important to realise that it is not really the actuaries who should be engaging in these discussion since their role is to carry out formal analyses on the assumptions that are given to them by the trustee. The same actuary might give a range of answers if asked to consider a range of different assumptions. Also different actuaries might very well give different conclusions if asked to consider a wider range of methods rather than just the conventional one (as has been demonstrated by the First Actuarial report).

So it would have been better perhaps if the meeting had been with some of the trustees. It is they who are taking the decisions (no doubt with advice from Bill Galvin). And they (other than those appointed by the UCU) are paid very handsomely for it.

March 30, 2015

Very misleading statement by the USS trustee

"When I use a word,” Humpty Dumpty said in rather a scornful tone, “it means just what I choose it to mean— neither more nor less.” Lewis Caroll

"Words are a wise man's counters, they do but reckon by them; but they are the money of fools." Thomas Hobbes

The UUK consultation document Funding background from the trustee is highly misleading to say the least. It contains statements that appear superficially to have a straightforward meaning in ordinary language but are in fact technical in that they require special assumptions for them to be true. Also some statements are downright false. It also has to be said that the trustee's approach to funding raises the question as to whether the trustee is fulfilling its fiduciary duty to always act in the best interests of members. Here are some of my comments.

Valuation and Funding Methodology

The document says:

Since 2011, the deficit has increased significantly and, based on the current benefit structure (ie without taking any account of the proposed changes), the trustee anticipated that it would report a deficit of approximately £12 billion for the March 2014

There has not actually been a valuation as yet, by the way. That cannot be done until the changes to the scheme have been agreed. So there is an important element of circular reasoning here, which is rather awkward: the £12 billion deficit depends on members (via the trustee) agreeing to it.

Importantly there is selective use of evidence: the £12 billion figure assumes some changes are implemented but not others. It assumes valuing the liabilities using 'gilts plus' rather than 'best estimate minus' (discussed at length in the First Actuarial report); also 'de-risking': switching from long-term growth investments to lower-return (but less volatile) government bonds. At the same time benefits are assumed unchanged. Both sets of assumptions point in one direction making the deficit bigger and bigger. This is highly tendentious and quite biased reasoning.

Then it says:

... the most significant factor is the change to the assumption which the trustee is making for future investment returns – and the effect of a lower assumption reflecting the changed economic environment – which has added around £7.6 billion to the amount needed to pay pensions."

This does not mean what it appears to say if it is read as ordinary English. The reader might think it alludes to the financial crisis from 2008 on. But investments have recovered since then and the USS investment managers have done well. No. What the trustee means here is how the future pensions promises are valued - a highly technical matter. The USS has to find a figure to stand for a theoretical sum of money in today's terms that would be enough to pay them (assuming it lent securely to the government at low interest rates). Government interest rates - gilts - are not investment returns determined by the market but fixed by the government for reasons of macro economic policy. The term 'future investment returns' has to be understood in this very specific technical sense and is not referring to actual future investment returns that will be earned on the fund's investment portfolio.

This is the nub of the issue. The USS has a large and volatile deficit due to this valuation of liabilities - not poor investment returns. The USS trustee is using extremely low gilt rates for this calculation and not actual investment returns and calling this "the assumption ... for future investment returns".

... it expects those overall returns will be lower given the challenging future economic environment. These assumptions are ultimately judgements which all trustees must make about future anticipated investment returns. These assumptions are reflected in the valuations of scheme liabilities, and in the increased deficits of many defined benefit pension schemes."

What it means by "challenging future economic environment" is that it believes gilt rates will remain low for the indefinite future. The trustee is basing its policy on a myth that currently very low interest rates reflect the "economic environment" notwithstanding that it is being deliberately manipulated by the Bank of England as a matter of policy ("quantitative easing").

The pensions promises that need to be paid have little to do with this "economic environment". Pensions that are to be paid in the future are the same whether interest rates go up or down although they change the valuation of the liabilities a lot. That is why the valuation is inherently so volatile (hence not very meaningful).

The main reason the deficit is so large is that the liabilities valuation increases every time interest rates go down. If interest rates go low enough (and some inflation-adjusted gilt rates are already virtually zero and some actually negative) the liabilities will become infinite. The valuation methodology is fundamentally flawed because it actually breaks down when the discount rate is zero. It is mathematically equivalent to trying to divide by zero.

Life expectancy

The document contains a misleading statement about the pressures due to rising longevity:

Another factor contributing to this increase is the projected improvements to members' life expectancy. The trustee has reported that the changes to the projected life expectancy assumptions between 2011 and 2014 have added almost £1 billion to the amount needed to pay the pensions promised."

This statement appears to imply that there is factual evidence that life expectancy is increasing faster than before. In fact the evidence from the Office of National Statistics tells us that this is not so. But the trustee has decided to increase it nevertheless on the grounds that a survey of other pension schemes conducted by the pension regulator has shown that a majority are assuming a higher rate of improvement in longevity than is evidentially indicated.

So the approach of the USS trustee is to follow the herd. After all, whatever might happen to the USS, nobody could reasonably blame the trustee. They are only following John Maynard Keynes' dictum: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

The de-risking plan versus an ongoing pension scheme: planning to fail?

The document then goes on to say:

Additionally the trustee has carried out some work to update its understanding of the potential financial strength of the sector ... concluded that the scheme's reliance on the sector is considerable and should not grow over time.

The trustee has therefore proposed ... to gradually reduce the amount of investment risk in the scheme - over a 20-year period - in order to maintain the overall levels of risk, therefore reliance, on the sponsoring employers."

This is extraordinary. It means shifting investments from return-generating equities (ie financing investment in real productive capacity by companies thereby helping economic growth) into lending to the government by buying bonds. This is estimated to increase the deficit by £4.4 billion (part of the £12 mentioned above) which is the value of investment income foregone. This decision is to increase the deficit deliberately as a matter of policy and its wisdom is highly debatable to say the least.

The fundamental, overarching risk facing any pension scheme is that there will not be enough money to pay the pensions when they fall due. This new 'de-risking' policy does not necessarily reduce the risk of that happening. Indeed it seems if anything it might increase it. By giving up £4.4 billion of investment wealth it could be seen as almost planning to fail.

The trustee is focussing only on investment risk and ignoring investment return. Yet both are equally important to addressing the fundamental hazard of running out of money. The two need to be looked at together. It could well be that increasing investment in equities and long-term return-bearing assets will improve the chances of the scheme meeting its promises. Many actuaries argue against this kind of de-risking on precisely these grounds. (For example.)

There is also the fact that - as a general principle - this approach is harmful to the economy by leading to resources being diverted out of productive investment.

Is the trustee acting in the fiduciary interest of members?

This policy by the USS trustee is not evidence-based. The thinking behind it seems to be untested financial theory intended to be applied to private companies rather than universities.

Given that they are so controversial it is highly questionable whether these decisions are in the best interests of the scheme. It is certainly not the case that there is solid evidence behind them. The question therefore arises as to whether the trustee is genuinely fulfilling its legally required fiduciary duty. Has the UCU, as the representative of members, considered this? As far as I can see there has been no discussion of the possibiity of a legal challenge on these grounds.

Are universites acting in their own best interests as universities?

The policy seems to be based on the idea that the employer covenant with the universities only has a limited period. This seems an extraordinary idea for pre-92 universities with established reputations, a unique role in society and no reason to think they should not continue. Presumably as with so much else in this dispute it derives from the new idea that universities are businesses just like any other in the private sector and therefore must copy as many of their management modalities as possible. The recent introduction of rigorous line management, with targets defined as metrics, firing academics if they faill to meet short term targets, paying vice chancellors CEO salaries, and so on, are all evidence of the zeal with which universities are embracing what they image to be how businesses behave. Applying the same logic to pensions is more of the same. This is a grave mistake because universites by their very nature are public institutions.

One wonders if the university managements have really thought deeply enough about where they are going before responding to the surveys conducted by the USS and UUK.

February 23, 2015

Pension regulations' unintended economic consequences

Every private defined benefit pension scheme (including final salary schemes) is expected to be funded at all times. That means having enough assets to cover the liabilities there and then if need be. The idea is that if something awful happens to the sponsoring employer the scheme can be wound up in an orderly fashion. It is solvent and all the pensions can be paid from the money raised by selling the assets - notionally at least.

If there is a deficit its trustees have to put in place a recovery plan requiring extra contributions by members and employers.

This regulatory regime is partly enshrined in the law, partly the convention that now places a large emphasis on avoiding all sources of risk wherever one can be identified. This protects the Pension Protection Fund from claims but it has unfortunate wider economic consequences. It affects both long term economic growth and short term cycles.

The system of regulation focuses entirely on short term risk and volatility. Pension schemes traditionally used to invest for the long term to get the best returns. Now they are advised to avoid the short term volatility inevitable in such investments. This leads to a short-termist mentality that is harmful to economic growth.

Yet 'short-termism' has long been recognised as one of the main problems with the UK economy. Governments have tried to address it by various initiatives, most recently by the Kay Review of UK Equity Markets and Long Term Decision Making. Pension funds have a key role to play in supplying long term capital but they are being given incentives not to fulfil it for example to 'de-risk' their investment portfolios by switching from equities to government bonds.

The second unintended macro-economic effect of the funding regime is that funds are in deficit and have to make extra payments during a recession. Currently (February 2015) the combined deficit of all DB schemes stands at over £300 billion. This is treated as a gap that has to be filled as soon as practicable by a recovery plan to increase savings into the scheme. These payments come out of company cash and wages and so are a subtraction from effective demand. This is a substantial sum: the latest figure for deficit reduction payments is £25.6 billion to reduce deficits for the 2014/15 year.

Thus the regulatory regime is a pro-cyclical factor that makes recessions worse.

February 16, 2015

Why the UCU will find it hard to get any credit from the USS deal

What worries me is that what has been agreed is not a settlement and will not be the end of the matter. And it is hard to see how UCU can other than lose reputation from future developments.

First, the next step is that there will be a consultation of all USS members. All members of USS (not only UCU members) will be asked to respond to the proposals. What advice is the union going to give them? That they should protest against this shambles or support it? Our negotiators are currently sending out conflicting messages: that this was the best that could be achieved by negotiation so should be reluctantly supported and that it is unavoidable because it is based on 'economic orthodoxy' to which there is no realistic alternative. So there will be a focus on the UCU's role in the coming months.

Second, this is not a deal that will reflect well on the UCU in the long run. We hear that our negotiators 'contested the methodology' used to value the scheme. I am sure they did that. But having lost the argument the issue has not magically gone away. This is not some arcane dispute in the seminar room: it is of fundamental practical importance. It is about whether the USS pension scheme is ongoing or to be wound up. By accepting the employers' proposals we have agreed to the implementation of the methodology premised on closure of the scheme.

This methodology was debunked by the First Actual report. It showed that the employers were making assumptions that were economic nonsense. For example the assumption was that the share of GDP going to wages and salaries will increase indefinitely while that going to company dividends will decrease. Much as we might wish this were the case it flies in the face of all the evidence. And so on. All the assumptions made by the employers - and agreed by our negotiators - have been unfavourable to the solvency of the USS.

And the methodology appears to be increasing the volatility of valuations according to recent joint statement by the employers agreed with UCU: the March 2014 deficit (agreed by our negotiators to be £13 billion rather then the earlier figure of £7.6bn because we have accepted the so-called derisking strategy) could have increased by December to £20 billion. The EPF 'potential joint statement' says "At the time of writing, the deficit is now estimated to have risen to more than £20 billion because of adverse market conditions". (And this figure has been repeated in meetings by our negotiators with a straight face - so much for them not accepting the 'contested methodology') This is volatility on a scale unimaginable in the pensions world before this new methodology was introduced.

This means that the figures for the valuation of the scheme are becoming pretty meaningless - they can change hugely in a matter of months due to otherwise unspecified 'market conditions'. Yet these figures are what is driving the scheme. As I have blogged (, the methodology involves doublethink. It is supposed to reduce risk but is in fact extremely volatile (ie risky).

January 26, 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.

January 24, 2015

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.)

January 22, 2015

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):

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:

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.

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