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.

Group of pins

Two women were fighting on my train the other morning. It was a packed train, with people standing the length of the carriage, so I didn’t see it so much as hear it. The first woman felt she had been pushed by the other one and complained very loudly and with much swearing. The second woman made some comment about the first woman’s mother and it escalated from there, getting louder and louder. Neither was prepared to let the other have the last word and, seeing the impact the mother comment had had, the second woman used it again. At which point the first woman hit her. The other passengers had been sitting and standing grim-faced up until this point, but now one or two intervened. One, who had the bearing of a lay preacher, attempted to assume sufficient authority to stop the argument. He was ignored. Another one stood and put the second woman in his seat and stood between them.

The second woman continued to make comments, but as much to herself as to the first woman. She kept stamping her feet in frustration. She was clearly in unbearable discomfort, but not from any physical pain. Finally she called the police and, as we pulled into New Street Station, started to give a physical description of her assailant. “Everyone on the train saw it” she said several times, while the passengers around her stared in any direction but hers.

I don’t know what happened next in the lives of these two women, although an announcement was made a couple of days later on the same service that police were working their way through the train for witness statements about the incident. They never appeared in my carriage, and I am not sure what I would have said if they had. And I don’t know what your reaction to my story is – whether that the other passengers, including me, should have acted differently or some commentary on the behaviour of the two women. I am, however, reasonably confident that you will have a reaction, perhaps quite a strong one, despite my limitations as a narrator. The reason I am confident about this is that I found myself, involuntarily, completely absorbed in the dispute, upset when one of the women expressed upset, constructing back stories for each of them, questioning their strategic wisdom at various points and, by the time we arrived at New Street Station and I dispersed with all the other witnesses, emotionally drained. And a look at the faces around the carriage suggested to me that most of my fellow passengers reacted similarly.

Why am I telling you this? Because it is a clear example of our domesticated brains in action. The almost physical pain this argument caused me and most of my fellow passengers is the reason we can travel from Sutton Coldfield to Birmingham every day with rarely an incident. It is often referred to these days, in pejorative terms, as Group Think. The shared assumptions and behaviours which allow us to live alongside each other in peace. I then get on a second train each day from Birmingham to Leicester, which I tell everyone is a great train to work on. But this is only because I can trust the 80 or so other passengers not to start an argument. The police could not cope if everyone behaved like the two women in my story. When the police do make an appeal for witnesses, they do so secure in the knowledge that nothing they say or do will encourage more than a handful to come forward, so strong is our group instinct to stay out of each other’s lives if we can. It is not indifference but survival. You need very strong structures to counteract the very strong instinct for Group Think.

However the reason Group Think is used pejoratively is that we have had vivid demonstrations of its power to make large groups of people behave stupidly. For example, herding behaviour in financial markets often causing the very problems people are trying to protect themselves from by going with the crowd. Or regulatory regimes which seem to encourage monocultures to develop, whether in finance, health, education, politics or academia, based on shared assumptions rather than encouraging diversity, because monocultures are easier to regulate. Many professions, including the actuarial profession, have introduced specific professional guidance to encourage whistle-blowing where appropriate, ie standing up to the policies and practices of their own organisations in most cases, which often means doing battle with Group Think. How successful such initiatives prove to be remains to be seen.

Encouraging challenges to Group Think is hard. It normally means going out of your way to allow views to be expressed you don’t agree with. It makes getting your own way harder to achieve. It can seem to us like the opposite of strong leadership and decisiveness when we seek out opinions that will make decision-making more complex. But we have made our society so complex and organisationaly fragile that this is what we are going to need to do more of in the future to stop it all from crashing down around us.

I wanted to share this lovely account of Vonnegut’s story shapes because it is one very powerful way to categorise different outcomes and, as such, potentially a very interesting way of illustrating them and their implications. I feel sure I will be returning to this theme soon.

Kurt Vonnegut - The Shapes of Stories

From Visually.

 

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

From time to time I get asked about my banner header showing successive Office of Budget Responsibility (OBR) forecasts for GDP growth against actual GDP growth and, in particular, what has happened since. The OBR produces its forecasts twice a year, in March and December, and the latest one is here. However I have resisted updating my banner to date for a number of reasons:

  • The statement that economic forecasts are wildly inaccurate has become a truism that, in my view, no longer needs additional evidence in support; and
  • To be completely honest, once actual GDP growth started to increase (as was inevitable eventually, and particularly once the Government’s austerity boot’s grip on the economy’s neck started to weaken), the graph no longer looked quite as amusing.

However, I have recently started to question the first of these assumptions so here is an updated graph:

OBR update 2014

Notice how the point at which growth peaks and starts to fall is moving closer with each new forecast. This is as much a part of their models as putting back the upward path a quarter or two with each successive forecast was while that path was still actually falling. Be assured that the OBR will not forecast the next fall before it actually happens.

What concerns me is the forecast consensus which is starting to build around 2014-2018 of GDP growth between 2% and 3% pa (currently narrowing as a forecast to 2.5% – 2.8% pa). This is despite the OBR themselves making no more than a claim of 20% probability of growth staying in this range, as the following fan chart shows:

OBR fan chart

However I don’t see this fan chart turning up in many news reports and therefore my concern is of an election campaign fought under the illusion of a relatively benign economic future. I think it is likely to be anything but, particularly as the Government is likely to stick the boot back in post election whoever wins.

There seems to be no chance of stopping the OBR and others publishing their forecasts, too many people seem to value the power of the story-telling however implausible the plot, so the only course available seems to be to rubbish them as often as we can. That way it may just be possible, despite all the noise about predictions of economic recoveries and collapses we cannot possibly foretell being used to try and claim our political support more generally, to keep in mind that we know zero. And make better decisions as a result.

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?

 

 

 

I have written about false positives before, as have many others, but the media stories keep on coming. The latest reports, by the BBC most notably but also carried by the New Scientist and a number of other sources, display such an unfortunate ignorance of the issue of false positives that they risk raising false fears in the minds of sufferers of mild cognitive impairment and their families.

The BBC article makes a number of statements:

1. British scientists have made a “major step forward” in developing a blood test to predict the onset of Alzheimer’s disease.

2. Research in more than 1,000 people has identified a set of proteins in the blood which can predict the start of the dementia with 87% accuracy.

Neither of these statements are true. What the new test can do is guess right about patients with mild cognitive impairment (MCI) going on to develop Alzheimer’s disease (AD) within a year in 87% of cases. What it cannot do is predict whether someone with MCI will develop AD with 87% accuracy. The research article is here.

It all comes down to the likelihood of someone with MCI developing AD. It does not help that there is no general agreement of a definition for either term. The research reported on used the Petersen criterion for MCI. The likelihood of people within the population with MCI developing AD each year is again unknown, but 6 quite small studies (a total of 476 people across all the studies, with different average ages and sample sizes among the groups) carried out in North America analysed by Petersen et al in 2001 suggested that it lay between 6% and 25%, with an overall average rate of 12.5%.

So let’s assume that it is 12.5%. In a population of 1,000 people with MCI, we would expect 125 to develop AD. The test will identify 109 of them on average. Unfortunately, assuming the same accuracy rate of 87%, it will also give false positives for 13% (or 114) of the 875 not expected to develop AD in any particular year. That means that, of the 223 who test positive, less than half (49%) are actually expected to develop AD within a year. As the NHS choices website points out, in one of the few sceptical articles I could find, this is no better than tossing a coin.

If we assume the probability of moving from MCI to AD is at the higher bound of 25%, the positive predictive value (or PPV, as it is known) increases to 69%. However if we assume the lower bound of 6%, the PPV falls to 30%. In other words, if we get a positive blood test for this panel of 10 proteins, we currently do not know whether it is twice as likely to be a true positive than a false positive, or twice as likely to be false as true. Or anywhere in between.

Despite this, Dr Eric Karran, director of research at Alzheimer’s Research UK (clearly no conflict of interest there in promoting stories which promote the idea that Alzheimer’s research is highly effective) is widely reported as describing the study as a “technical tour de force”, while also acknowledging that the current accuracy levels risked telling many healthy people they were on course to develop Alzheimer’s.

In some reports it was pointed out that it was unlikely that the test would be used in isolation if it eventually made its way into clinics. A positive result could be backed up by brain scans or testing spinal fluid for signs of Alzheimer’s, they said. However if the test is no more predictive than a coin toss that is hardly encouraging.

There was more from Dr Karran: “This gives a better way to identify people who will progress to Alzheimer’s disease, people who can be entered into clinical trials earlier, I think that will increase the potential of a positive drug effect and thereby I think we will get to a therapy, which will be an absolute breakthrough if we can get there.”

This is simply untrue. Clearly it is important to support research into therapies for Alzheimer’s disease, but in raising funds for this the ends do not justify any means. Additional funding gained through false claims for any particular discovery will come at the expense of funding in other equally important areas. Like agreeing a definition of MCI and AD for instance, or better data on the transition probabilities from MCI to AD at different ages, without which a lot of the more laboratory-based research will be a waste of time as it will be unclear how best to apply it.

So let’s be careful how we report these things. People’s hopes and fears are at stake.

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.

The Pensions Regulator has finally released its response to its consultation on regulating defined benefit pension schemes along with the simultaneous release of the final new code on funding defined benefits, its latest annual funding statement and two new documents: the defined benefit regulatory strategy and the defined benefit funding, regulatory and enforcement policy. It’s a bit of a mixed bag.

I set out a critique of the draft proposals back in January. These boiled down to two main criticisms:

  • That the new system proposed was effectively a return to the one-size-fits all approach of the Minimum Funding Requirement, which had done so much to undermine responsible scheme funding by employers; and
  • That the focus on governance, reverse stress testing, covenant advice, etc, effectively smuggled in from EIOPA’s latest IORP Directive, was likely to be a problem for small schemes.

BFO RIP

So what has the Regulator’s response been to these criticisms? Well, on the one-size-fits-all approach which was proposed as the Balance Funding Objective (BFO), the response is comical:

  • They have changed the name of their funding objective. The BFO is now called the Funding Risk Indicator (FRI). It is otherwise unchanged. This is reminiscent of the Lenny Henry sketch at the time that Windscale was renamed as Sellafield: “In future, radiation will be referred to as magic moonbeams”.
  • They are going to keep all their risk indicators secret. I have set out below their response in full on this point.

We believe that there may be potentially significant benefits to be gained in using the FRI and publishing more detail on our risk indicators in terms of providing clarity around standards, especially for small schemes, driving consistency and providing a useful framework for evaluating impact. However, after careful consideration of the risks and benefits highlighted in consultation responses, we have concluded that we should develop further our approach to risk assessment over the next year, including our risk indicators, to make sure it is sufficiently robust to support our intended uses beyond using it, alongside our other risk indicators, to prioritise our engagement. We have decided, for the time being, not to publish in detail where we set our risk indicators (beyond a high level description) in the funding policy document or in the annual funding statement.

So how will this work? Will the Regulator display charts like this one each year?

TPR graphWill they then berate the schemes and their advisers who were so bad at guessing where their secret line was? Because be in no doubt, with the speed of the revolving door operating between the Regulator and the industry it regulates, these indicators will get out and then gradually get disseminated through the pensions industry, from the biggest consultancies (who can easily fund having their consultants on secondment to Brighton) downwards, just as the Regulator’s previous “secret” link between assessment of covenant strength and “expected” discount rate assumptions did.

And what about the problem with small schemes? This is, in my view, considerably better handled by the Regulator. However, it does all comes down to its idea of proportionality.

Proportionality

The response to the consultation states:

Many respondents were concerned that proportionality did not follow through consistently in the consultation code or it was not explained clearly how it could be applied in practice. In particular, some thought our expectations around the extent of the analysis required to assess the covenant seemed disproportionate. The concern was that it would be difficult and costly for small schemes to apply the code’s principles.

I was one of those respondents. It continues:

We have reviewed the drafting to ensure that proportionality is properly referenced and emphasised throughout. We are looking to develop additional guidance to support the final code and will consider whether the proportionality principle can be explained further through illustrative examples.

On covenant assessment, we had already made clear (under the ‘Working with advisers’ section) that trustees may chose not to commission independent covenant advice as long as they can satisfy
themselves that they are sufficiently equipped, independent and experienced to undertake the work to the appropriate standard. In the section on ‘Employer covenant considerations’, we have emphasised the need for a proportionate approach (for instance, in-depth analysis may not be necessary if the scheme is relatively small or there has been no material change in the covenant since the last review). We also stress that assessment should focus on the knowledge gaps and where value can be added. Finally, we have made clear that the scope of any covenant review will depend on the circumstances of the scheme and it is, therefore, not always necessary for trustees to consider all the factors listed in the code.

In addition the Regulator has dropped the size of employer and strength of covenant as factors for trustees to consider in deciding on what is proportionate for their schemes, realising, rightly in my view, that the absolute size of employer and strength of covenant are much less important than the relative size of employer to scheme and risks to the scheme from failures of covenant which are already mentioned.

This all seems sensible. I do, however, think they will struggle to go further in setting out what proportionality means, since the problem of defining it has bedevilled the Solvency 2 project from the beginning and has still not been fully resolved. The IORP Directive is no clearer in this respect. What the Regulator could do is make a clear distinction between schemes with less than 100 members and the rest in terms of their responsibilities under the Code, reflecting the fact that the IORP Directive does not apply to these schemes.

Small schemes and risk-based prioritisation

But perhaps they have. Concerns were raised in the consultation about considering the size of the scheme in deciding whether to subject that scheme to greater scrutiny. It was argued that smaller schemes tended to be less well administered and advised (presumably by advisers and administrators of larger schemes!), more risky than larger schemes and should receive greater regulatory scrutiny. Some also questioned the usefulness of education without what they felt was the same prospect of regulatory scrutiny. I admit that I was one of those expressing concern about a lack of scrutiny coupled with a much increased regulatory burden for small schemes before the Regulator’s latest concessions on proportionality.

In their response the Regulator defended its actions by stating that large schemes all other things being equal, are of greater concern to us as they have the greatest impact on members and risk to the system (90% of members and liabilities are concentrated in the 1,210 largest schemes). However they expect the same standards of the small schemes that they aren’t scrutinising so hard. Bearing in mind that the Regulator regulates scheme managers rather than members (and many of those small schemes have just as many trustees as the larger ones) I don’t think this is a very convincing defence, but it seems to be preferable to admitting that they are just regulating schemes that fall under the IORP Directive.

Next steps

So a big raspberry for the secret FRI and a qualified welcome for the changes on proportionality. The final code has now been laid in Parliament and is expected to come into force in the next few months, subject to the parliamentary process. So if you think that there is more than a little tweaking left to do to this legislation, you need to start lobbying now.