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May 08, 2016

Misleading Times article about pension deficits

An article in last Saturday's Times, 'Universities' pension scheme could face their most rigorous examination' is an object lesson in the poor standard of reporting on pensions. Its author, Philip Aldrick, is the paper's Economics Editor, yet he displays a poor understanding of the underlying issues he is reporting which leads him to mislead the reader.

He is telling us about the large deficit that is being forecast to emerge from the next valuation of the USS, the private pension scheme that covers staff of the older universities, what are known as the pre-92 universities. The newer institutions, mainly the former polytechnics, are covered by the teachers' pension scheme, guaranteed by the taxpayer. But the USS is private so it comes under the same regulations as company pension schemes, such as the BHS.

But there the comparison ends. Questions are being asked in parliament about where the BHS pensioners' money has gone: there are some fairly simple and obvious question marks surrounding the role of the former owner of BHS, Sir Philip Green.

The USS deficit is not like that in that it is not clear where the deficiency is or how it has arisen. We cannot blame anyone for taking too much money out. We are told that at the last valuation in 2014 there was a deficit of £5.3 billion and that a recovery plan was agreed involving cuts to benefits and increases in contributions which were designed to fill the gap. Yet only a year later the deficit had become £8.2 billion. And it is estimated that by the next valuation in 2017 it will have ballooned to £11 billion.

These changes have taken place with nothing substantial changing in the actual scheme itself: there has been no Robert Maxwell raiding the pensions pots of his employees, no university finance officers indulging in creative accounting, no sudden mass retirement of thousands of senior professors on high final-salary-linked pensions, no sharp drop in recruitment. On the contrary changes in pension scheme deficits on the scale reported would only normally be expected to occur over perhaps a decade or longer, not a period of months. And they would be explained in terms of tangible factors such as increased longevity. But forecast longevity does not increase in big sudden jumps on the scale needed to explain these deficits.

No. These big swings in the deficit are almost entirely artificial. They are due to the regulation rules which have an inbuilt bias towards finding a deficit. This is is a problem that affects all defined benefit schemes: USS is merely the largest and therefore the effects are greater.

Many of the pension deficits stem from a major mistake by the government in basing regulation on what is called ‘modern finance theory’ or ‘financial economics’. Pension schemes have to be valued in terms of assets and liabilities, which are categories of capital, when what actually matters is whether the flow of income is enough to pay the benefits into the future. Capital values and income flows are two completely different things. It does not matter what the prices of the scheme’s investments in shares are on a particular valuation date; what we want to know is how much income those shares are likely to bring while they are held in the portfolio.

Theory teaches us that the capital value of an asset is the discounted present value of the expected net income received by its owner. That theory is the basis of valuation required by the pensions regulator. But we should not listen to that theory because it does not hold in practice. In reality share prices are highly volatile, far more so than the economics supposed to underly them. The asset valuations are far more volatile than the dividend and other income as a result of natural speculation in the stock market and other reasons like sentiment, 'irrational exuberance', and so on. There is massive evidence on this. There is a wealth of literature showing that excess volatility exists and that it is large; some studies have found it to be an order of magnitude greater than the volatility attributable to underlying economic events.

Yet the legislation on valuation of pension scheme assets requires it to be done in line with finance theory: by pricing to market and taking the ensuing volatility as risk and therefore something important to be managed. If anyone points out that there is excess volatility in the real world, it is dismissed as a merely a 'puzzle'.

The liabilities, too, have to be estimated in a way that makes it possible to compare a figure for them with the assets. (This is where the 'complicated mathematics' of the article comes in: Mr Aldrick reveals he is not well-up on pensions economics when he sneers at this.) The liabilities figure is an even stranger concept than the assets. And this is where most misunderstanding comes from. Most journalists do not understand how artificial and divorced from reality the liabilities figure is.

Under the rules the trustees of a scheme have to work out a hypothetical capital sum that - if it were invested in a certain way - would produce the assumed future benefits. The regulations actually allow for quite a lot of discretion in how this is done but most actuaries have got the idea from finance theory that investing in gilts is risk free. The problem with this is that gilt rates are very low at present so this means liabilities are very high. And as gilt rates change by a small amount the liabilities change massively by billions. (It is not a risk-free rate if it is constantly changing.) Yet the real liabilities are the benefits that have to be paid in the future and have not changed, they are just the same. Once again it is theory in the face of evidence: real pension schemes do not invest in gilts but in assets that will give a high return, in a prudently diversified portfolio.

The third major factor is the employer covenant. When USS was set up it was backed by the government. Any deficits could be made up by changes to the grant. The UGC (later HEFC) had a seat on the Board. So institutions did not have to worry about risk of the scheme failing. But the government (Willetts I assume) withdrew in 2011 and the scheme, as the article says, is a last-man-standing scheme. This seems to be exercising the minds of some of the employers worried about taking on the liabilities for institutions that fail in the new competitive environment where we are being under-cut by cheap new entrants. So the valuation - I believe - currently assumes only a twenty year covenant: to be on the safe side universities are assumed not to contribute beyond that. How likely is it that institutional members of the USS - the pre-92 universities mainly - will go bust.

Members are having to contribute more and more to the scheme, and benefits are being cut, in order to manage a lot of synthetic risk in the form of market volatility which is not the same as actual risk. On top of that they are having to pay to manage the risk of institutional bankruptcy.

Mr Aldrick finishes with an extraordinary comment: "The big hope is that interest rates rise which, through complicated mathematics, will reduce the liabilities. If that is the plan, however, it would make Sir Philip look as clean as a whistle. Universities, we'd like to think, measure themselves by a higher standard."

This statement suggests he does not appear to get it. He does not seem to understand that the reason that the liabilities figure is so large is mainly due to low interest rates but instead seems to believe the deficit is real and that the effect of a rise in interest rates 'through complicated mathematics' is somehow an extraneous technicality that might be as morally dubious as the shenanigans at BHS. The fact that interest rates are low is the reason the deficit appears so large.

June 05, 2015

USS attacks 'mark to market' accounting rules

The USS has criticised the government-imposed accounting rules for pension schemes. Kathryn Graham, USS’s head of strategy coordination, has said the current, so-called 'mark-to-market', rules prevent funds like the USS from investing in long-term infrastructure projects. This both limits pension schemes' investment opportunities and also harms the wider economy by discouraging much needed long-term investment.

She argues that pension funds in other countries such as Canada and Australia, that use different accounting rules that allow for smoothing, give them an advantage so that they are invested in much more long-term infrastructure.

This is of course an effect of the 'contested methodology' that the UCU has complained about. 'Mark-to-market' accounting is the major reason behind the so-called deficit and the justification for the closure of the final salary scheme and introduction of the hybrid scheme.

Graham made her remarks at an investment conference and was supported by other pension schemes. The coal industry scheme's representative said that "mark-to-market was forcing pension funds to buy UK Gilts, instead of other assets, unnecessarily" which, as members who have been following the recent debate about its future will know, is precisely what is happening to USS.

There is a clear implication that what is needed is for the rules and the 2005 legislation to be looked at again as not fit for purpose. The appointment Ros Altmann as the new minister could be an opportunity to do that. Her approach to pensions is measured and pragmatic, whereas her predecessor, Steve Webb, also a pensions expert, was an Orange Book Liberal, who seemed to have an unquestioning faith in the omniptence of markets. Ros Altmann has written about the USS saying that the deficit is overblown. On the other hand, Steve Webb has defended the mark-to-market methdology maintaining that pension scheme deficits it throws up are 'real'.

It is time the rules and methodology were looked at again before all DB pension schemes have been closed down as a result of ill-though-out legislation and regulation, and not least for the sake of combatting the short-termism of British investment.

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.

March 17, 2015

USS issue is fundamentally an intellectual dispute

The USS dispute is primarily an intellectual issue. During the consultation period - when members can have their say about its future - it needs to be addressed as such by the university community.

We know that the scheme is very profitable. It currently makes an annual surplus of over £1 billion after paying the pensions of retired members. There are good grounds for believing that it will probably remain in surplus for at least 20 years. See the First Actuarial report that was commissioned by the UCU. Unfortunately the USS trustees have not carried out this analysis (or if they have they are keeping it secret) and have yet to answer the questions that First Actuarial put to them which would enable us to see the true situation.

Instead they tell us there is a deficit that is not only large but getting bigger (and increasingly volatile). But the methodology they use is highly questionable, being based on untested economic beliefs from the neoliberal faith. It assumes it is possible to assess the health of a pension scheme solely by looking at the market value of its assets (its investments) and estimated liabilities (an imputed figure to represent the pensions already promised) at a moment in time, without needing to worry about the cash flows that are actually needed to pay the pensions promises.

A lot of assumptions are required for this methodology, many of them highly debatable - they are held as articles of faith by the practitioners. The main idea is that 'the market' knows more than any human ever can: specifically it can forecast the future - ergo there is no need for actuaries to bother trying to model the future income and pensions: asset prices contain all information about future investment returns and after some more assumptions are swallowed a valuation for liabilities is calculated as well. These figures are presented without any estimates of error and the difference is called 'the deficit'.

Although these criticisms have been made by academic experts, economists, statisticians, financial mathematicians, actuarial scientists, philosophers and others (both as individual academics and through their institutions, notably LSE, Warwick and Imperial) as well as UCU negotiators, the UUK and the USS trustees will not discuss them. They behave as if their approach is a kind of orthodoxy to which there can be no alternative and refuse to engage in open intellectual debate. They present their opinion as objective fact.

So they have told us that the deficit as of March 2014 is estimated at over £12 billion, but has increased to £20 billion by January 2015 due to unspecified 'market conditions'. In the past, before this mark-to-market methodology was adopted, actuaries used to calculate pension scheme variations over periods of decades reflecting demographic and economic trends. If there was a funding problem it would show up over many years and could be dealt with soberly and responsibly. Yet here we have a massive two-thirds increase in the deficit in a matter of a few months. That should surely show us all that the method is not fit for purpose.

The methodology: requiring all pension schemes to be funded, in the technical sense of assets being always at least equal to liabilities, in order to protect the pension protection fund - was actually made law by the Pensions Act 2005 and associated regulations. Like much Blair-era legislaton it has had dire unforeseen consequences that has led to many workers in the private sector losing their pensions as schemes have closed.

The problem is that the liabilities calculation is not reliable. When government bond rates (gilts) go lower - as they are now under the government's so called quantitative-easing policy the liabilities figure becomes larger and more unstable. That is what is happening - but it has little if anything to do with the actual future pension requirements. Some gilt rates are even so low they are below inflation, hence negative in real terms: when that happens the method would seem to fail.

The fact that so many university managements are unthinkingly following the USS management and going along with this is a real intellectual failure on the part of British universities. They are not doing their job of independent enquiry leading to their taking a view of the true situation - and moreover on a matter that applies to their own material interests where they should have a strong incentive to get it right. It is not the role of universities to simply follow convention, even if some of the negotiators have claimed it to be 'economic orthodoxy'.

The trustees' role is to ensure there will be enough funds to meet the pension payments when they fall due. They means - fundamentally - looking at income and expenditure going forward into the long distant future. That means taking a broad overview - and not relying on the belief that the market provides superior information.

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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