pension statement

They plop through the letterbox about once a year. Pension statements. They tell you what your units in the various funds you are invested in were worth at some recent date (if you have a defined contribution (DC) pension – I am not talking about defined benefit (DB) pensions today as there are far fewer consequences of not making any decisions with these). They also tell you the estimated yearly pension at your Normal Retirement Date, based on the Statutory Money Purchase Illustration (SMPI) assumptions about what will happen over the intervening years, some of which are set out in the statement. However, for many it is even more scary than the bank statements they leave unopened for six months or their insurance renewals. Why is that?

Well it seems that pensions tick all the boxes for emotional “fear factors” that make some potential threats feel scarier than others:

  • Human-made risks scare us more than natural ones. The basic reasoning is perhaps that natural things have been around for longer and therefore “stood the test of time”. That piece of paper with your pensions details on it is as man-made a thing as things come. And the more that pension providers seek to make them look slick and professional, with brightly coloured diagrams and soundbites extracted from longer bits of text, the more new and untrustworthy they can seem. Ingenious ways of hedging your investment risk within a pension fund which cannot be easily explained are also likely to make it feel more “unnatural” than a more direct investment.
  • Imposed risks scare us more than those we take voluntarily. So one of the consequences of auto-enrolment may have been to make pensions appear as less of a voluntary process. Also the more restrictions that are placed on the investments you hold, the less control you will feel you have because:
    • Some “expert” is needed to explain the restrictions to you;
    • The restrictions almost inevitably mean that you need to behave in a different way to how you would have done otherwise (otherwise the restriction would not have been necessary). This might mean you have to put more money into it than you had intended, or in a different place to where you would have chosen or have to wait longer before you can take it out again.
  • Risks to children scare us more. Newspapers and online articles are full of stories about how much worse off our children are likely to be as a result of threats to our pensions system: whether this is the retreat of defined benefit pensions or the reform of the state pension or the collapse of capitalism.
  • We subconsciously weigh possible harms against potential benefits. This is the one to which pensions are particularly vulnerable. The harms are immediately obvious: money that we could be spending now on things which are important to us now are instead being funnelled away into a fund to which we have no immediate access. The benefits are uncertain, particularly now most of us are in DC arrangements, even within the current set of rules governing how pension schemes operate. But on top of this uncertainty is yet another layer of uncertainty concerning how those rules might change before we get our hands on our cash. We feel powerless and at the mercy of forces we don’t understand.

So what is to be done? I think that pension providers could address many of these fears by doing two things:

  • Keep it simple. Only introduce complexity when the benefits are obvious enough to be explained simply. More complex financial instruments may be appropriate for corporate pensions (although often they are not). They are almost never appropriate for retail pensions. Make sure every fund you offer has an easily accessible factsheet which covers what it invests in, what it is trying to do and how much it will cost. At the end of each year you should be told how much interest (why do we use different words for fund growth depending on where it is invested?) you have earned on your fund and how much you have been charged for having your money in that fund. Just like you would on your bank account. Some funds do this very well already.
  • Keep restrictions to the absolute minimum and let everyone know about them in advance. If someone is not going to be able to take advantage of some particular aspect of the pension freedoms now available, don’t wait until they try and do so. Tell them now. Few, if any, funds currently offer this.

Unfortunately there is probably not much that can be done about future pensions uncertainty. The future of the global economy is very uncertain and the UK’s economic future equally so. There is no political consensus over economic policy and the rules by which pensions are governed in the future seem likely to change in unpredictable ways over the next 30 years. But the simpler the products are, the easier they will be to regulate and the less likely they are to be affected in unforeseen ways by future changes.

I have deliberately avoided the question of pensions guidance or advice. This is because I do not think that people fear pensions advice itself, they fear paying for advice that they don’t understand and then making bad decisions as a result. This is a debilitating fear which is often discussed as if it suddenly struck as an individual approached retirement. In reality it has grown year by year as people feel powerless to affect what happens to the money everyone tells them they have been paid but which they have never seen other than in this annual pensions statement when it lands on the mat.

Take the fear out of that and it would change the pensions environment completely.

S&P sovereign credit ratings

The Treasury is consulting on the tax relief that should be available in future for pension schemes and their members. The principles for any reform that it has set out are:

  • it should be simple and transparent;
  • it should allow individuals to take personal responsibility;
  • it should build on the success of automatic enrolment; and
  • it should be sustainable.

Simplicity, transparency, personal responsibility and sustainability mean different things to different people, which means that the precise meaning of these principles will depend on the politics of the people proposing them. However the words themselves are difficult to argue with, which is presumably why they have been chosen.

It has then set out 8 questions that it would like answered in response to its consultation. The consultation ends on 30 September. I have set out my responses below. I hope that they will sufficiently incense one or two more people into making their views heard, before the chance disappears.

1. To what extent does the complexity of the current system undermine the incentive for individuals to save into a pension?

On this question I think I agree with Henry Tapper at the Pension PlayPen. He says the following:

In summary, millions of pounds of tax relief is wasted by the Treasury helping wealthy people avoid tax…Incentives are available to those on low earnings who pay no tax, but this message is not getting through, we need a system that resonates with all workers, not just those with the means to take tax advice.

I then think I agree with the following:

The incentive should be linked to the payment of contributions and not be dependent on the tax or NI status of the contributor – if people are in – they get incentivised.

That would certainly make the incentive to the pension scheme member clearer and potentially easier to understand. The other simplification I would support would be the merging of income tax and national insurance contributions – many of the sources I have referenced below are trying to solve problems caused by the different ways these two taxes are collected. This simplification would be an essential part of any pension reforms in my view.

2. Do respondents believe that a simpler system is likely to result in greater engagement with pension saving? If so, how could the system be simplified to strengthen the incentive for individuals to save into a pension?

This is the invitation to support TEE (ie taxed-taxed-exempt, the same tax treatment as for ISAs). I have up until now been persuaded by Andrew Dilnot and Paul Johnson’s paper from over 20 years ago that this was not a good idea. This pointed out that the current EET system:

  • Avoids problems with working out what level of contributions are attributable to individuals in a DB system
  • Does not discourage consumption in the future relative to consumption now

I have changed my mind. The first point has already been addressed in order to assess people against the annual allowance, although this may need to be further refined. The second point is more interesting. As Paul Mason has pointed out in Postcapitalism, the OECD 2010 report on policy challenges, coupled with S&P’s report from the same year on the global economic impacts of ageing populations point to the scenario pensions actuaries tend to refer to when challenged on the safety of Government bonds, ie if they fail then the least of your problems will be your pension scheme. The projections from S&P (see bar chart above) are that 60% of government bonds across all countries will have a credit rating below what is currently called investment grade – in other words they will be junk bonds. In this scenario private defined benefit schemes become meaningless and the returns from defined contribution schemes very uncertain indeed. A taxation system which seeks to extract tax on the way in rather than on the way out then looks increasingly sensible.

I think that both the popularity of ISAs and the consistently high take up of the tax free cash option by pensioners, however poor the conversion terms are in terms of pension given up, suggest that tax exemptions on the way out rather than on the way in would be massively popular.
3 Would an alternative system allow individuals to take greater personal responsibility for saving an adequate amount for retirement, particularly in the context of the shift to defined contribution pensions?

Based on my comments above, I think the whole idea of personal responsibility for saving adding up to more than a hill of beans for people currently in their 20s may be illusory. People do take responsibility for things they can have some control over. Pension savings in the late twenty-first century are unlikely to be in that category.
4 Would an alternative system allow individuals to plan better for how they use their savings in retirement?

As I have said I favour a TEE system like ISAs. I think some form of incentive will be required to replace tax exemption, such as “for every two pounds you put in a pension, the Government will put in one” with tight upper limits. The previous pensions minister Steve Webb appears to broadly support this idea. Exemption from tax on the way out (including abolition of the tax charges for exceeding the Lifetime Allowance) would also aid planning.
5 Should the government consider differential treatment for defined benefit and defined contribution pensions? If so, how should each be treated?

I think this is inevitable due to the fact that defined contribution (DC) schemes receive cash whereas defined benefit (DB) schemes accrue promises with often a fairly indirect link to the contributions paid in a given year. In my view taxation will need to be based on the current Annual Allowance methodology, perhaps refined as suggested by David Robbins and Dave Roberts at Towers Watson. The problem with just taxing contributions in DB is that you end up taxing deficit contributions which would effectively amount to retrospective taxation.

A further option discussed in Robbins and Roberts is making all contributions into DB schemes into employee contributions. I would go further and apply this to both DC and DB schemes – a sort of “reverse salary sacrifice” which could be encouraged by making the incentives on contributions only available on employee contributions, which would then be paid out of net pay. Any remaining accrual contributions made by employers in a DB scheme would be taxed by an adjustment to the following year’s tax code.
6 What administrative barriers exist to reforming the system of pensions tax, particularly in the context of automatic enrolment? How could these best be overcome?

I think everything points to the need for the retirement of DB for all but the very largest schemes. It would be better to do this gradually starting soon through an accelerated Pension Protection Fund (PPF) process rather than having it forced upon us in a hurry later in the century when PPF deficits may well be considerably higher than the current £292.1 billion.
7 How should employer pension contributions be treated under any reform of pensions tax relief?

As I have said, I think they should be converted into employee contributions based on higher employee salaries. This would make it clearer to people how much was being invested on their behalf into pension schemes.
8 How can the government make sure that any reform of pensions tax relief is sustainable for the future.

They can’t, and any change now will almost certainly be revisited several times over the next 50 years. However, systems where people feel they can see what is going on and which are tax free at the end are currently very popular and I would expect them to remain so for the foreseeable future. That takes care of political sustainability in the short term. What about longer-term economic sustainability? Faced by an uncertain and turbulent next 50 years where I have argued that personal responsibility (rather than communal responsibility) for pensions will seem increasingly irrelevant, I think what I have proposed will allow us to transition to a system which can be sustained to a greater degree.

We are entering what may prove to be a traumatic time for the world economy if Postcapitalism is even half right. Pensions taxation seems a good place to try and start to move our financial institutions in a more sustainable direction.

Nick Foster is a former pensions actuary who now lectures at the University of Leicester

Go on pick a card

Defined ambition has failed.

  • This was mainly because, tasked with suggesting a less onerous alternative to defined benefit (DB) schemes that gave more protection than defined contribution (DC) schemes, the pensions industry (including actuaries) did not get behind the least bad option, but instead presented a spectrum of options
  • The public and employers were unimpressed
  • And employers had enough on their plate anyway dealing with auto-enrolment
  • So they have now all (or nearly all) enrolled their employees into DC
  • And the reason they are in DC now is the same reason they were in DB before: because they were offered so many choices they lost sight of the fact that there was a choice.

DA options

The time to significantly influence corporate pension provision would appear to have passed until people realise how hard it is to make sufficient provision via a DC scheme. That may not be until the money actually runs out as the finance industry has a proven track record in keeping people in schemes (eg the early personal pensions and later endowment mortgages) long after they retain the capacity to do them any good.

In the meantime, people with DC pensions and madly transferring DB members now have freedom and choice. I predict that this too will fail.

  • This will mainly be because, tasked with providing cost-effective advice to people to empower them to make good decisions about their financial future, the pensions industry do not get their act together and just present a spectrum of options
  • The public will be unimpressed
  • And employers, who might have been persuaded to increase employee education and engagement in pensions, will have enough on their plate anyway dealing with auto-enrolment
  • So now most of them will be managing their own retirement with not enough money, vulnerable to pensions scammers and paying far more tax than they need to
  • And the reason they will not be in an annuity now is the same reason they were in one before: because they were offered so many choices (see the Pension Wise website, inexplicably still in an unfinished Beta state) they lost sight of the fact there was a choice.

Pension_Wise_Logo

The time to significantly influence individual pension provision appears to be rapidly running out.

How does this story end, I wonder?

shutterstock_84989578

The Institute and Faculty of Actuaries (IFoA) is introducing a new mandatory Actuarial Profession Standard (APS) in relation to review of actuarial work. The existing requirements in the APS applying to scheme actuaries will be withdrawn.

APS X2 Review of Actuarial Work will come into force on 1 July 2015 and is accompanied by a detailed, practical Guide. One of its key requirements is that actuaries, for any piece of work they wish to have reviewed, will need to consider the need for that review to be independently carried out, ie by someone not otherwise involved in the work in question.

I should declare straight away that I have a conflict of interest about this new standard, having set up a business because I felt scheme actuaries should have access to peer review services from an experienced scheme actuary outside their organisations. I am delighted that an idea which seemed a little odd to some when I first started offering these services in 2013 should now be regarded as sufficiently mainstream by the IFoA to prompt a revision of peer review guidelines.

Under APS X2, review processes are defined as either work review or independent peer review. Whereas work review is a general term covering all forms of review processes, the term independent peer review can only be applied to review processes involving reviewers not otherwise involved in the piece of work under review.

There are many reasons why you might want to have your work independently reviewed, for example:

  • Work reviewed within a firm might be influenced by the respective positions of the actuary and his/her reviewer within the management structure of the organisation;
  • Even if the work is reviewed by a colleague completely objectively, it might not be seen to have been;
  • There is a risk of group think in any organisation. Review from outside can significantly reduce this risk;
  • An independent reviewer may have a different range of experiences to draw on from those within your organisation. This can be particularly useful when reviewing work where there are potential conflicts of interest or concerns over how best to communicate a piece of work.

If this sounds of interest and you think it might be time to take a look outside for some of your peer review needs, my details can be found by following the link.

 

The announcement by the Office of Qualifications and Examinations Regulation (Ofqual), the UK schools examination regulator, of the new grade structure for GCSEs is explained on their website by their Chief Regulator Glenys Stacey as follows:

For many people, the move away from traditional grades, A, B,C and so on, may be hard to understand. But it is important. The new qualifications will be significantly different and we need to signal this clearly. It will be fairer to all students that users of the qualification will be able to see immediately whether they did the new or a previous version of the GCSE. The new scale will also allow better discrimination between the higher performing students.

This is a big claim, which is not supported by any evidence I have seen. As Dylan Wiliam pointed out as long ago as 2001, the available data suggest that a student receives the grade that their achievement would merit only around 65% of the time. This is very close to the proportion of the time a random variable (which I think is how an examination mark needs to be treated) with a Normal Distribution falls within one standard deviation either side of its expected value. For mathematics, grade boundaries in 2014 were about 15% apart (80% A*, 65% A, 50% B, etc).

Therefore the narrowing of the grade boundaries the new system ushers in, now helpfully illustrated by Ofqual, will merely introduce more randomness to the grading process amongst higher performing students.

Ofqual

If the distribution of marks really is normal, a replacement of a 15% grade width by one closer to 10% would be expected to reduce that 65% accuracy to closer to 50%, ie you will be as likely to get the wrong grade as the right grade. This does not look like progress to me. Ofqual are, however, undaunted:

We realise introducing the new GCSEs alongside other changes will be challenging for schools, teachers and students. But the prize – qualifications that are better to teach, better to study, better assessed and more respected – will be worth it.

I remain to be convinced.

I ask this question because:

  • I have just read The Spirit Level by Richard Wilkinson and Kate Pickett, and am convinced by their arguments and evidence that inequality lies at the root of most of the social problems we have in the UK; and
  • As a scheme actuary, I persuaded myself that I was facilitating a common good, namely the provision of good pensions to people who might not otherwise have them to as high a level and for as long as possible given the economic conditions of the sponsors. The introduction of the Pension Protection Fund reduced the importance of the scheme actuary role, by mitigating the impact of sponsors not meeting their obligations, but still left a job I felt was worth doing. However, it now seems to me that, if pensions are not tackling inequality or even exacerbating it, they might be doing more harm than good.

First of all, I strongly recommend the Equality Trust website, which has a number of graphs showing the links between inequality and various social ills. One example, showing the relationship between inequality and mental illness, is set out below.

Equality Trust graph

So what is the evidence on inequality and pensions? Certainly inequality, as measured by the Gini coefficient, in this case after a reduction for housing costs, has increased markedly in the UK since the 1960s.

Gini over time

While the proportion of private pension provision since 1997 as a percentage of the workforce has fallen (courtesy of the Office for National Statistics).

ONS workplace pensions

But is there much of a correlation between them? Well there is a weak negative correlation between the Gini coefficient and the percentage in workplace pensions as a whole.

Gini v workplace pensions

And a rather stronger one when we just look at defined benefit (DB) pension scheme membership.

Gini v DB scatter

Neither of these are particularly strong correlations. Any impact by workplace pensions on inequality is likely to be limited of course, because they are in general structured (via final salary formulae in the case of DB, and employer and employee contributions as a percentage of salary in the case of defined contribution (DC)) to preserve relative incomes in retirement, even if not absolute differentials. However, moving now to the OECD statistics website, we can look at the retirement age community as a whole and compare their relative inequality with that of the working age population.

Turning to the working age population first, we can see below that the UK is a very unequal society compared to a range of rich countries, although less so than the US.

Gini working age

data extracted on 15 Aug 2014 15:52 UTC (GMT) from OECD.Stat

On the other hand, we get a very different picture if we consider the UK’s over 65 population, where the level of inequality is well below that of the US, and broadly comparable with the other major EU states.

Gini retirement age

data extracted on 15 Aug 2014 15:52 UTC (GMT) from OECD.Stat

Clearly this is not primarily down to private pension provision, but the more redistributive state pension and other benefits. However, at least the weak correlations we saw previously suggest that private pensions have not made inequality any worse and possibly slightly mitigated against it.

I think we can do better than this: after all we had inequality levels equivalent to current Norwegian levels back in the early 60s (which is why I included them in the international comparisons above). So the news that pensions tax relief is likely to be provided at a 30% rate for all after the election rather than reflecting the current tax bands is not, in my view, the cause for gnashing of teeth as the Telegraph and others believe but actually a good thing. After all, the Pensions Policy Institute have shown that 2/3rds of all tax relief is going to those earning over £45,000 pa.

One of the clear conclusions of the research carried out in The Spirit Level and elsewhere is that reducing inequality in society benefits every group in it, including those who are redistributed away from. Pension provision has its part to play in this.

And 30% tax relief does not seem like too high a price to me.

Trust me. I'M AN ACTUARY!

Trust me. I’M AN ACTUARY!

I commented on the Pensions Regulator’s new code of funding in a recent post. The reason I am returning to it so soon is that a good friend of mine has pointed out a rather important, but subtle, aspect of the new code which I had missed. It goes to the heart of what we should expect from a professional in any field.

Experts and the Problem of P2C2Es

In 1990, while still in hiding from would-be assassins keen to implement Ayatollah Khomeini’s fatwa, Salman Rushdie wrote a book for his son called Haroun and the Sea of Stories. This introduced the idea of P2C2Es or Processes Too Complicated To Explain. These were how awkward things, like the fact that the Earth had a second moon which held the source of all the world’s stories, were kept hidden from ordinary people. All the people who worked on P2C2Es were employed at P2C2E House in Gup City under a Grand Comptroller. When I read it to my son a few years later I enjoyed the story of very clever people conspiring against the general public as a fairy tale.

Since 2008, it has become increasingly clear that this is no fairy tale. Whether you are looking for the cheapest quote for insuring your life, house or your car; a medical opinion about your health; an investment that meets your needs: it is a P2C2E.

Malcolm Gladwell and others make the case that expert failure is what we should really fear, when important things rely on experts not making mistakes doing things that most people do not understand. The inability to challenge expert opinion has cost us all a lot of money in the last few years. We should stay clear of P2C2Es whenever we can in my view. Professionals should present evidence and the intuitions gained from their experience, but leave the decisions to people with skin in the game.

Other professionals disagree with this. There is, from time to time, a push to get rid of juries in cases where the evidence is thought too complicated (eg fraud) or too dangerous to make public in even a limited way (eg terrorism). Some of these succeed, others don’t. There are also frequent political arguments about what we should have a referendum on, from Scottish independence (got one if you’re Scottish) to membership of the EU (one is promised) to recalling your MP mid-term (so far no luck on this one).

There is a similar divergence of opinion amongst actuaries. Since the Pensions Regulator’s first code of practice for funding was launched, in 2006, the scheme actuary’s role has been clearly set out as one of adviser to the scheme trustees and not, other than in the rare cases it was cemented in the scheme rules, a decision maker. However there are actuaries who look back wistfully to the days when they effectively set the funding target for pension schemes and all parties deferred to their expertise. I am not one of them.

Because this was really no good at all if you were a trustee expected to take responsibility for a process you were never really let in on. The arrival at a contribution rate or a funding deficit for a scheme funding on a basis presented to them as a fait accompli was to many trustees a P2C2E. We risk returning to those days with the new code of funding.

What this has to do with pensions

Compare the wording of the new Code of Practice for pension scheme funding with the previous one:

2006 code

The actuary is not passing an opinion on the trustees’ choice of method and assumptions.

2014 code

Trustees should have good reasons if they decide not to follow the actuary’s advice. They should recognise that if they instruct their actuary to certify the technical provisions and/or schedule of contributions using an approach which the actuary considers would be a failure to comply with Part 3, the actuary would have to report that certification to the regulator as the regulator considers such certification to be materially significant.

Where Part 3 refers to the funding regulations for actuarial valuations. Previously actuaries who were unable to provide the required certification of the calculation of the technical provisions or of the adequacy of the schedule of contributions had to report the matter to the regulator only if a proper process had not been followed or the recovery plan didn’t add up to the deficit. It was thought that going any further would involve passing an opinion on the trustees’ choice of method and assumptions.

Will the new code make schemes better funded? In some cases perhaps, but at the cost of moving scheme trustees into a more passive role where they do not feel the same level of responsibility for the final outcome. It is the difference between roads where cars are driven by people concerned with road safety and the ones we have where drivers are primarily concerned with not setting off speed cameras. The general level of safety is reduced in both cases, with the further danger that this passivity will trickle into other areas of trustee responsibility. And the risk to the schemes of the group think of scheme actuaries (a relatively small group of professionals who tend to all cluster around the same schedule of continuing professional development (CPD) events) is massively increased.

Ha-Joon Chang famously said never trust an economist. Is it any less dangerous to trust an actuary under these circumstances?

 

 

 

The response to the consultation on the Budget pension proposals has much to welcome in it. The Government appears to have listened to the arguments that their concerns about the impact on financial markets of the reforms bordered on paranoia, and have agreed to continue allowing private sector defined benefit schemes and funded public sector schemes to process transfers. They have committed to continuing to consult on the idea of extending the new freedoms to defined benefit schemes themselves, which would avoid the need for a lot of expensive fee-generating transfers into defined contribution arrangements.

And yet. The section on the guaranteed guidance suggests that, despite the opinions expressed in the consultation, the Government is still primarily focused on guidance “at the point of retirement” despite the probability that this is likely to become just one of the criticial retirement phases following these reforms. And the reform of pensions legislation seems overly concentrated on facilitating innovations in annuities rather than allowing the level legislative playing field between different forms of pension provision that would be required to prevent the death of defined ambition.

But the real problem I have with the consultation response concerns the minimum pension age. A point i have made before. Currently 55, the Government has decided to increase this to 57 by 2028. I think this is a mistake. Why promote freedom in the form you take your benefits but not when you take your benefits?

And the need for this freedom is evident. The latest Office of National Statistics (ONS) release on healthy life expectancy at birth by local authority suggests that, in many areas, this may condemn people to work until they are sick.

Here is the graph for males in local authorities where the healthy life expectancy (HLE) is less than the state pension age (SPA):

HLE males

And the equivalent graph for females:

HLE females

For each local authority area you need the red line to be above the minimum pension age to be 95% sure the average member of its population is able to retire, even if only partially, in good health. For the males, Blackburn, Blackpool, Islington and Tower Hamlets already have red lines below a minimum pension age of 55. Increase this to 57 and the number of red lines below multiplies alarmingly. And this is just an average – many will have life expectancies well below this.

Of course we assume life expectancy will increase between now and 2028, but healthy life expectancy? One of the problems is that it has not been measured for very long, and there have been disagreements about how it should be measured. As the King’s Fund shows, in 2005 a change to the methodology caused healthy life expectancy to plunge by 3 years, suggesting a rather optimistic approach previously. The ONS methodology is set out here.

It seems clear to me that there is sufficient doubt around how long people around the UK are expected to remain in good health for the Government to pause before raising the minimum pension age. After all we already know how those in ill health are likely to be treated if they try to claim they can’t work.

ATOS

A flower for every person that died within 6 weeks of ATOS finding them fit for work

At times it all sounds like the joke about the visitor to Hell being shown by their PR department how the bad press had been much exaggerated. There were concerts on Wednesday afternoons and coffee mornings on Fridays, the manure was only ankle deep in many places and the eternal flames were optional. However, on accepting his place for eternal damnation, another senior devil he had never seen before walked in to announce “Ok, tea break’s over. Back on your heads!”

It would seem that tea break is over.

Another month, another consultation. This time it’s the Pension Protection Fund’s (PPF) turn. I last wrote about their plans five months ago. Since those dark days things seem to have moved on a bit: there is now a proposed model and a timetable for implementation.

And there is much to cheer here. One of the main criticisms consistently levelled at the current system was that it was hard for employers to understand how to improve their score, without handing over money to Dun & Bradstreet (D&B) for reports and fees to advisers to interpret them. Here, at last, is a model which is not owned by the credit agency running it, something I have long argued for. This means that the scores and data underlying them can be monitored by companies much more easily, and in more detail, by a free web-based portal.

Unfortunately the PPF are risking undermining this transparency for large companies by considering a credit rating override, where the insolvency risk would be determined by the company’s credit rating score instead. In my view this idea should be resisted.

Other successes are the moves to stop ABCs from getting too much credit for their complex structures, and the use of past data to review the treatment of Type A contingent assets (although they have chickened out of removing these altogether) and the last man standing levy reduction.

In all there were nine success criteria which were used to make the decision on the model used, but the one given the greatest weighting was “predictiveness”. According to the Oxford English Dictionary this word does not exist, but I take it to mean “degree to which insolvency risk assessed predicts the number of actual insolvencies for a given score”. Of course, it is nothing of the kind that has been assessed. They have taken the last eight years of data and compared the proportion at each score level with the percentage of insolvencies expected (they say “predicted”), and wrapped up the differences in an eye-catching diagram using the Gini coefficient (this is usually used to talk about inequality, when you are looking to minimise it, but here they are trying to allocate levies where the risk lies and therefore trying to maximise the distance from an even distribution).

PPF levy GiniAll a high Gini score means in this context is that the selected model fits well with the actual insolvencies over the last eight years. The danger is that the model has been over-fitted to eight years’ data, a rather untypical period for the economy in many ways and possibly not very indicative for what lies ahead until 2030 (when the levy is supposed to end). Fortunately they are proposing to continue monitoring how well the “predictiveness” works in future.

The other area of the consultation where I take issue is the PPF’s opposition to having a transition period. Their impact assessment shows that 10% of schemes are expected to see an increase of over £50,000 in their levy as a result of these changes, with 200 of them seeing an increase of over £200,000. It therefore seems odd that they should oppose a transition period to allow companies to better cope with the long term move to a fairer allocation of levies. The main argument they give for this is that it would be a cross subsidy. But so is the restriction on the increase in levy by moving down a band to 60%, which I can see much less justification for and which results in bands 2 and 3 underpaying for their insolvency risk and bands 5 and 6 overpaying for it.

But overall a broad welcome, as I will be telling them. Let’s see what survives the consultation (it ends at 5pm on 9 July).

My consultation responses are as follows:

Chapter 2

1. Do you agree that we should seek to maintain stability in the overall methodology for the levy, only making changes where there is evidence to support them?

Yes.

Chapter 3

2. Do you consider that the definition of the variables in the scorecards is sufficiently precise to provide for consistent treatment?

Yes.

3. Do you agree that it is appropriate to re-evaluate the model to ensure that it remains predictive?

Yes.

4. Do you have comments on the design of the “core model” developed by Experian?

Very pleased that the PPF have decided to move away from a proprietary model, where large parts of its operation are kept secret through commercial confidentiality arguments.

5. Do you agree with the success criteria set out by the Industry Steering Group and that the PPF-specific model developed by Experian is a better match with them than Commercial Delphi?

Yes.

6. Do you agree that it is appropriate to use the separate scorecard developed by Experian not-for-profit entities, even though this requires an extension of the data set used to generate the scorecard?

Yes.

7. Do you have comments on the approach to the rating and proposed identification of not-for profit entities, developed by Experian?

No.

8. Are there other public sources of data that Experian should consider extending coverage to?

No.

9. Do you agree with the proposed data hierarchy?

Yes.

Chapter 4

10. Do you favour a credit rating over-ride?

No. This would undermine the gain in transparency offered by the PPF-specific model.

Chapter 5

11. Do you agree with our proposed aims for setting levy rates?

I am concerned about the cross subsidy implicit in the 60% limit on levy differences between adjacent bands.

12. Do you agree it is appropriate to divide the entities with the best insolvency probabilities in to a number of bands, to ensure that the cliff-edges between subsequent bands are limited, or do you favour a broad top band?

Cliff edges are unavoidable with this model. I think there is a strong argument for having slightly fewer slightly bigger ones. This would remove many of the small band movements at the top end, which are relatively unproductive for risk management.

13. Do you agree with the proposed 10 levy bands and rates?

Not completely. Bands 2 and 3 appear to be underpaying for their insolvency risk, and bands 5 and 6 appear to be overpaying.

14. Do you agree that for 2015/16 levy year insolvency probabilities are averaged from 31 October 2014 to 31 March 2015?

Yes.

Chapter 7

15. Do you support transitional protection for those most affected by the move to the new methodology, recovered through the scheme-based levy?

Yes.

Chapter 9

16. Do you agree that the appropriate route to reflecting ABC’s in the levy is to value them based on the lower of the value of the underlying asset (on employer insolvency) after stressing or the net present value of future cashflows?

Yes. I do not accept that ABCs’ primary objective is to reduce risk. The changes proposed appear to ensure that they do not get overly favourable treatment in terms of levy reduction.

17. Do you agree that a credit should only be allowed where the underlying assets for the ABC is UK property? Do you have any comments on the example voluntary form/required confirmations?

Yes.

18. Do you support the proposal to make the certification of contingent assets more transparent, through requiring certification of a fixed amount which the guarantor could pay if called upon?

Yes.

19. Do you have any comments on the proposed revised wording for trustee certification for Type A contingent assets?

The revised wording seems appropriate.

20. Do you agree with our proposals to adjust guarantor scores to reflect the value of the guarantee they are potentially liable for? Do you favour the adjustment being achieved by a factor being applied to the guarantor’s Pension Protection Score or by an adjustment of the guarantor’s levy band?

This looks like a very complicated approach designed to put off sufficient schemes from using Type A contingent assets so that there will not be a very large squeal when they are removed altogether.

21. What other measures do you suggest to ensure that, where a scheme certifies information about a contingent asset to the PPF, any resulting levy reduction is proportionate to the actual reduction in risk?

I think the proposals are complicated enough.

22. Do you agree with the proposed form of confirmation when Last Man Standing scheme structure is selected on Exchange?

Yes.

23. Do you agree with the revised scheme structure factor calculation proposed for associated last man standing schemes?

Yes.

I have been reading Ha-Joon Chang’s excellent book Economics: The User’s Guide after listening to him summarising its thrust at this year’s Hay-on-Wye Festival of Literature and the Arts. It is very disarming to meet an economist who immediately tells you never to trust an economist, and I will probably return to his thoughts on the limitations of expert judgement in a future article.

But today I want to focus on his summary of the major schools of thought in economics, and what the implications might be for actuaries. Chang’s approach is that he does not completely subscribe to any particular school but does not reject any either. He bemoans what he sees as the total domination of all economic discussion currently (and therefore also all political discussion about running the economy) by neoclassical economists. I think actuarial discussion may suffer from a similar problem.

So what is neoclassical economics? Well it has become almost invisible to us due to its omnipresence, in the way fish don’t see the water they swim in, but its assumptions may surprise you. It assumes that all economic decisions are at an individual level, with each individual seeking to maximise what is known as their utility (ie things and experiences they value). The idea is that we self-interested individuals will collectively make decisions which, within the competitive markets we have set up, result in a socially better outcome than trying to plan everything. This approach has become a very conservative outlook (ie interested in preserving the status quo) in Chang’s view ever since it was further developed to include the Pareto principle in the early 20th century, which says that no change in economic organisation should take place unless no one is made worse off. This limits the scope for redistribution within a society, which can lead to the levels of inequality we see now in parts of the developed world which many are becoming increasingly concerned about, Thomas Piketty included.

Arguments between neoclassical economists in Chang’s view tend to be restricted to ones about how well the market actually works. The market failure argument says that there is a role to play for governments in using taxes and regulations (negative externalities) or in funding particular things like research (positive externalities) to mitigate the impacts of markets, particularly in areas where market prices do not fully reflect the social cost of particular activities (eg pollution on the environment). Another criticism made of neoclassical economics is that it does not allow properly for the fact that buyers and sellers do not have the same level of information available to them in many markets, and therefore the price struck is often not the one which would lead to the best outcome for society as a whole. So the more “left wing” neoclassicalism requires more market regulation to protect consumers and the environment they live in.

The more “right wing” neoclassical response to this is that people actually do know what they are doing, and even build in the likelihood that they are being conned due to asymmetric information in the decisions they make. The government should therefore reduce regulation and generally get out of the way of wealth-creating business. This form of neoclassicalism views the risk of government failure as much greater than that of market failure, ie even if we have market failure, the costs of government mistakes will inevitably be much greater.

And if you draw a line between those two forms of neoclassicalism, somewhere along that line you will find all of the main UK political parties and pretty much all economic discussion within the financial services industry.

And, on the whole, it tends to circumscribe the role that actuaries play in the UK.

One of the major drawbacks of neoclassical theory is that is assumes risks can be fully quantified if we only have a comprehensive enough model. Actuaries are predominantly hierarchists, who believe that they can manage the inequalities which flow from neoclassical theory via collectivist approaches, like insurance policies and pension schemes, and protect individuals and indeed whole financial systems from risk. Since Nicholas Nassim Taleb and others made so much money from realising that this was not the case in 2008, this has probably been neoclassicalism’s most obvious flaw, and the one which has given rise to the most discussion (although possibly not so much change to practice) amongst actuaries.

But there are others. Neoclassicalism assumes that individuals are selfish and rational, both of which have been persuasively called into question by the work of Kahneman and others, who have shown that we are only rational within bounds and make most of our decisions through “heuristics” or rules of thumb. Actuaries have tried to reflect these views, some of which were originally developed by Herbert Simon in the 40s and 50s, particularly in the way that information is communicated (eg the recent publication from the Defined Ambition working group), but have very much stayed at the microeconomic level (very much, according to Chang, like much of the Behaviouralist School themselves) rather than exploring the implications of this theory at a macroeconomic level.

Neoclassical theory is also much more focused on consumption than production, with its endless focus on markets of consumers. One alternative approach is that proposed by the Neo-Schumpeterian School, which rightly points out that, in many markets, technological innovation is considerably more important than price competition for economic development. The life-cycle of the iphone, from innovation to temporary market monopoly to the creation of a totally new market in android phones is a case in point. Actuaries have done relatively little work with technology firms.

Another school of economic thought which is much more focused on production is the Developmentalist Tradition, which believes governments can improve outcomes considerably by intervening in how economies operate: from promoting industries which are particularly well-linked to other industries; to the protection of industries which develop the productive capability of the economy, particularly infant industries which might get smothered at birth by the more established players in the market. This tradition clearly believes that the risk of government failure is less than the potential benefits of intervention. The failure of productivity to pick up in the UK since 2008 has been described as a “puzzle” by the Bank of England and other financial commentators. Perhaps some clues might lie outside a neoclassical viewpoint.

The Institutionalists have looked at market transaction costs themselves, pointing out that these extend way beyond the costs of production, and could theoretically encompass all the costs of running the economic system within which the transactions take place, from the courts to the police to the educational and political institutions. They have suggested that this may be why so much economic activity does not take place in markets at all, but within firms. I think actuaries have started to engage with failures in pricing mechanisms recently, particularly where these have environmental consequences such as in the case of carbon pollution and the implications for the long term valuations of fossil fuel reserves on stock markets.

The Keynesians I have written about before. They are probably the most opposed to the current austerity policies, pointing out how, if a whole economy stops spending and starts saving when in debt, as an individual would, the economy will stay in recession longer and recovery (and therefore the possibility of significant deficit reduction) will be slower. The coalition government in the UK have neatly proved this point since 2010.

I could go on, about the Classical or Marxist Schools which have been largely discredited by historical developments over the last 200 years, but which still have useful analysis of aspects of economics, or the spontaneous order of the markets believed in by the Austrian School. However my point is that I think Chang is right to highlight that there is a wider range of economic ideas out there. Actuaries need to engage with them all.