Magical Realism and the Pensions of Europe

23. September 2013 · Write a comment · Categories: EIOPA, Pensions, Regulation

shutterstock_154809119The Wizard of EIOPA is back. Gabriel Bernardino, the chairman of the European Insurance and Occupational Pensions Authority (EIOPA), outlined in May the powers he thought were necessary for EIOPA to enhance its role as a European Supervisory Authority for the insurance market. Insurers are currently busily opposing such calls.

On 5 September, therefore, he changed tack with a speech about pensions instead, entitled Creation of a sustainable and adequate pension system in the EU and the role of EIOPA.

“The creation of an adequate, safe and sustainable pensions system is one of the key objectives of the European Union and EIOPA is committed to contribute by all means to the development of such a system,” he boomed, despite the EU’s Constitutional Treaty not mentioning pensions anywhere among its objectives. He went on to state that EIOPA approved of assets and liabilities being valued on a market consistent basis. So far, so uncontroversial.

But then he continued. “EIOPA suggested a number of elements to reinforce the governance of IORPs: for example the performance of an own risk and solvency assessment.” What? An ORSA? You mean that thing that has led the insurance industry to spend millions on consultants, conferences and which, 5 years on from when it was first mooted, is only currently fully implementable by 24% of European insurers with all of the resources available to them? (Moody’s Analytics, in their July 2013 survey of 45 European insurers, concluded that 24% of the insurers interviewed had their processes, methodologies and models in place to fulfil Pillar 2 requirements – the key one being the ORSA).

He wasn’t finished. EIOPA proposed to require defined contributions (DC) schemes to produce a Key Information Document (KID). This would contain “information about the objectives and investment policies, performance, costs and charges, contribution arrangements, a risk/reward profile and/or the time horizon adopted for the investment policy”. So, a massive amount of additional bureaucracy around the default funds in a DC scheme by the sound of it, with no appearance of understanding that members of DC schemes can choose their own investment policies, nor a word about the hottest issue in DC provision at the moment, ie the level of charges. Surely he is KIDding?

Next he carried on a bit about the “holistic balance sheet” concept, despite it having recently been kicked into the long grass for implementation by pension schemes he clearly desperately wants to bring it back if he can, before giving his interpretation of the findings of the quantitative impact study (QIS) as part of the process to advise the European Commission on the review of the IORP Directive. This boiled down to:

  • Some pension schemes have surpluses, others have deficits.
  • Schemes can either make up deficits by paying more contributions (“It is not unusual that future sponsor support needs to cover as much as 25% of liabilities.” Said the Wizard, with the air of a man discovering a new physical law) or by reducing benefits.

I think we can all agree that however much the QIS cost it was worth the money.

Then we moved onto the Swedish part of the speech. “I would like to take this opportunity to thank the Swedish pension industry, the Swedish pension protection scheme (PRI Pensionsgaranti) and the Swedish supervisor (Finansinspektionen) for their contributions to the QIS. Sweden was the only member state with sufficient financial assets to cover the pension liabilities as well as the solvency capital requirement. Pension funds showed on average even a substantial surplus over the SCR of 13% of liabilities. Of course, an important reason for these positive outcomes is that Sweden already imposes a prudential regime that is market consistent and risk based, by using the quarterly Traffic Light stress test. In my view, this clearly illustrates that a future European regulatory regime should be market consistent in order to ensure a comparable and realistic assessment of the financial situation of pension funds; and risk based in order to provide IORPs with the right incentives for managing risks.”

What? According to the Swedish Pension Agency’s annual report on the Swedish Pension System for 2012, it consists of a pay-as-you-go scheme (the inkomstpension) and effectively an insured personal pension (the premium pension). So it clearly illustrates precisely nothing for a defined benefit occupational pension system like that of the UK with total buy out liabilities of around £1,700 billion (according to the UK Pensions Regulator’s Purple Book for 2012). However, did I mention where this speech was taking place? Sweden.

It was time for the Wizard to return to building his empire. EIOPA need more resources, more powers and now, apparently, more of a mandate. Obviously the m-word is a bit of a problem for all European institutions but it grates on the Wizard particularly. Despite the Solvency II omnibus grinding along on the hard shoulder and the first attempt at new funding targets for occupational schemes being rebuffed, he believes that now the time is right for a foray into personal pensions. He refers to occupational pensions as “the so called 2nd pillar” which confused me at first as I thought that was the risk management part of Solvency 2. However, then I realised that it was just that Eurocrats are obsessed with pillars because now he is calling personal pensions “the so called 3rd pillar”. And he wants to run them with the same efficient competence we have come to associate with the Wizard.

The Wizard wants a new sort of personal pension known as an “EU retirement savings product”. This would avoid “the traps of the short term horizon” (ie pesky scheme members deciding they need their money earlier than EIOPA decree they can have it) and “managed using robust and modern risk management tools” (does he mean things like the stochastic techniques and Value at Risk methodologies which have shown no discernible ability to manage risk in banks to date?). Finally “it should have access to a European passport allowing for cross border selling”. There has been scope for UK occupational pension schemes to become cross border schemes for some time now. Hardly any have taken up this “opportunity” so far because it came with a requirement to immediately increase the level of funding of a defined benefit scheme to buy out level. For defined contribution schemes, as we saw with the fate of stakeholder pensions, the appropriate vehicle very much depends on the form of social security system in place, the degree of means testing and when it happens and, most importantly, how it interacts with the state pension system. One size will definitely not fit all, and I expect that the Wizard’s EU retirement savings product will remain a largely theoretical entity for this reason.

However, my favourite part of the Wizard’s speech was left until last. “It is our collective responsibility to face reality,” he offered, with no hint of irony. I fear that the Wizard’s sense of reality is more a type of magical realism where people can fly, or turn into unicorns and EU officials can regulate things they don’t understand without unintended consequences.

“Please help us to move in the right direction,” he concluded. I think we should all do precisely that, by opposing what the Wizard of EIOPA proposes for pension schemes of all kinds.

Lawyers Go Negative

16. September 2013 · Write a comment · Categories: Legal, Regulation

Lawyer attack adThe Advertising Standards Authority (ASA) has decided that no action will be taken against the Law Society as a result of their Don’t Get Mugged campaign, which ran during July and August. The advert encouraged accident victims to seek legal representation from solicitors rather than rely on a third-party capture offer from an insurer. The ASA considered that it neither denigrated insurers nor was likely to distress victims of actual muggings.

What this campaign does appear to do is open the door to professionals attacking each other overtly in their advertising (what US presidential candidates call “going negative” with “attack ads”) in their desire to get more business from the public. Supermarkets have done this from time to time, but it is relatively rare elsewhere. I still remember the Dillons advert from the eighties aimed at its main competitor, Foyles, (Foyled again? Try Dillons) because of its rarity. However it looks like we may be about to see a lot more of it. Will this give rise to insurers and banks going at it with independent financial advisers even more loudly over the level of independence of the advice being received, or solicitors and licensed conveyancers escalating hostilities? Will this help informed decision making by anyone? I somehow doubt it.

It seems unlikely that solicitors will turn the same type of emotional manipulation on each other any time soon, as the Solicitors’ Regulatory Authority sets out as one of its principles that solicitors should “behave in a way that maintains the trust the public places in you and in the provision of legal services”. So that leaves the field clear for other professions to get in there. I would suggest something like this (add the name of your profession as appropriate):

shutterstock_106513214

Let the games commence!

Land mines and bank bailouts

28. August 2013 · Write a comment · Categories: Cartoons, Economics, Prediction, Regulation, Risk

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A man is sentenced to 7 years in prison for selling bomb detectors which had no hope of detecting bombs. The contrast with the fate of those who have continued to sell complex mathematical models to both large financial institutions and their regulators over 20 years, which have no hope of protecting them from massive losses at the precise point when they are required, is illuminating.

The devices made by Gary Bolton were simply boxes with handles and antennae. The “black boxes” used by banks and insurers to determine their worst loss in a 1 in 200 probability scenario (the Value at Risk or “VaR” approach) are instead filled with mathematical models primed with rather a lot of assumptions.

The prosecution said Gary Bolton sold his boxes for up to £10,000 each, claiming they could detect explosives. Towers Watson’s RiskAgility (the dominant model in the UK insurance market) by contrast is difficult to price, as it is “bespoke” for each client. However, according to Insurance ERM magazine in October 2011, for Igloo, their other financial modelling platform, “software solutions range from £50,000 to £500,000 but there is no upper limit as you can keep adding to your solution”.

Gary Bolton’s prosecutors claimed that “soldiers, police officers, customs officers and many others put their trust in a device which worked no better than random chance”. Similar things could be said about bankers during 2008 about a device which worked worse the further the financial variables being modelled strayed from the normal distribution.

As he passed sentence, Judge Richard Hone QC described the equipment as “useless” and “dross” and said Bolton had damaged the reputation of British trade abroad. By contrast, despite a brief consideration of alternatives to the VaR approach by the Basel Committee on Banking Supervision in 2012, it remains firmly in place as the statutory measure of solvency for both banks and insurers.

The court was told Bolton knew the devices – which were also alleged to be able to detect drugs, tobacco, ivory and cash – did not work, but continued to supply them to be sold to overseas businesses. In Value at Risk: Any Lessons from the Crash of Long-Term Capital Management (LTCM)? Mete Feridun of Loughborough University in Spring 2005 set out to analyse the failure of the Long Term Capital Management (LTCM) hedge fund in 1998 from a risk management perspective, aiming at deriving implications for the managers of financial institutions and for the regulating authorities. This study concluded that the LTCM’s failure could be attributed primarily to its VaR system, which failed to estimate the fund’s potential risk exposure correctly. Many other studies agreed.

“You were determined to bolster the illusion that the devices worked and you knew there was a spurious science to produce that end,” Judge Hone said to Bolton. This brings to mind the actions of Philippe Jorion, Professor of Finance at the Graduate School of Management at the University of California at Irvine, who, by the winter of 2009 was already proclaiming that “VaR itself was not the culprit, however. Rather it was the way this risk management tool was employed.” He also helpfully pointed out that LTCM were very profitable in 2005 and 2006. He and others have been muddying the waters ever since.

“They had a random detection rate. They were useless.” concluded Judge Hone. Whereas VaR had a protective effect only within what were regarded as “possible” market environments, ie something similar to what had been seen before during relatively calm market conditions. In fact, VaR became less helpful the more people adopted it, as everyone using it ended up with similar trading positions, which they then attempted to exit at the same time. This meant that buyers could not be found when they were needed and the positions of the hapless VaR customers tanked even further.

Gary Bolton’s jurors concluded that, if you sell people a box that tells them they are safe when they are not, it is morally reprehensible. I think I agree with them.

My ETV – part two

22. July 2013 · Write a comment · Categories: Actuarial, Pensions, Regulation

At the end of my previous post, I was keenly awaiting the written report on my enhanced transfer value (ETV) consultation, after feeling some concerns about the process up to that point. What arrived earlier this month came in three part harmony:

1. A Transfer Suitability Report, which summarised the conversation I had had with my adviser, and the recommendation which I had rather wrung out of him not to transfer (a red traffic light illustration next to the summary reinforced the point), and included the modeller output that suggested a 9 in 10 chance of receiving a higher income at retirement (weather symbol: sunny).

sunnyThere was nothing more for me to read on the assumptions here while I waited at the red light in the sunny weather but, instead, a new concept to anyone not working in pensions for a living which had not been mentioned in our previous conversation: critical yield. It explained that this was “the estimated investment return you would need to achieve year on year, if you were to transfer to a personal pension, in order to match the benefits provided by the Scheme at retirement”. It was calculated at 6.4%.

This was a little confusing since, when put together with the sunny 9 out of 10 assessment of my chances of receiving a higher income at retirement, it might lead you to think that there was a 90% chance of at least a 6.4% pa average investment growth over the next 10 years based on my new medium risk tolerance (which only reduced my equity allocation from 90% to 85%). But in fact 9 out of 10 was based on needing no spouse pension (they thought this reasonable as I am currently separated, but my Scheme benefits will include a spouse pension provided I have a spouse at retirement) and lower pension increases than are provided by the Scheme (these are indexed to the Retail Prices Index (RPI) rather than the Consumer Prices Index (CPI) assumed after the transfer, CPI tending to be lower). So 9 out of 10 was not replacing like with like, and the probability of achieving the critical yield over the next 10 years was more likely to be in the cloudy-with-a-chance-of-rain category.

2. Additional Information. This must contain the assumptions used, I thought. But no. It was instead an overview of how they had selected Aviva to be the pension provider, what the pension protection fund and financial services compensation scheme did and a glossary of terms. The glossary, interestingly, included lifestyling. “Lifestyling”, it said, “is an investment approach in which funds are gradually switched from more volatile asset classes, such as UK and Overseas Equities, to lower risk investments, such as Fixed Interest and Cash, in the period leading up to retirement. The aim of lifestyling is to reduce the risk of large fluctuations in your fund value as you approach your chosen retirement age. The reason for this is that, if markets were to fall significantly immediately before you retire, this would lead to significant reduction in your retirement income.” Lifestyling had not previously been mentioned as being assumed to be taking place over the next 10 years in any of my illustrations. This eagerly awaited report appeared to be raising more questions than it was answering.

3. Transfer Value Analysis Report. This gave more details about the benefits I was currently entitled to and that the projections of future income were based on CPI increases of 2% pa. And then finally, in the final appendix of the final report, there were notes on the assumptions underlying the calculation of the critical yield. Unhelpfully this included an annuity interest rate and annuity expense assumptions, but no mortality assumption. You would obviously need to know how long you were expected to live to work out how much they expected the annuity to cost. Or they could just have told me. Unfortunately, how much the annuity was expected to cost seemed to be on the list of things the member was not expected to need to know.

So, at the end of the process, I was still no wiser about the annuity rates assumed, or what high, medium and low meant in the years leading up to retirement. I didn’t think that the adviser I had knew either. And on this basis I was being asked to make an irrevocable decision about a third (more if you considered the cost of purchasing an equivalent guaranteed deferred annuity rather than the transfer values offered) of my pensions wealth.

I reflected on the times in the past when I had advised trustees to ensure as a minimum that transferring members in such exercises received independent advice, and on how inadequate that now seemed to be to support a decision in this case. As far as I could see everyone involved was doing their job in the way the regulatory regime intended them to. It was, in many ways, a model process:

  • The sponsor was making an offer to members, and paying for independent advice to those members. If the advice was not to transfer or the member decided not to take any advice, the transfer was not allowed to proceed.
  • The independent adviser had made a modeller available to members, and had carried out an assessment of each member’s attitude to investment risk. However both of these were seen as guides only, and they were prepared to be influenced in their advice by the attitudes presented to them directly by the members.
  • The Trustee Board had made it clear that it was up to the members to decide and that members should consider any information provided carefully before opting for a transfer.

However, if I had accepted the original risk assessment, and let large parts of the information provided go over my head as too technical, I could well have been both advised to transfer and left with the impression that I had a 9 out of 10 chance of being better off as a result. This would not have been a remotely accurate impression. However, even if I had avoided that particular banana skin, I would still not, at the end of this totally professional and, at first sight, thorough process, have had enough information to decide whether I agreed with the advice given. This meant that, despite everyone’s best efforts here, it would still have been possible to have been missold a transfer.

That that should still be the case after all the regulatory activity in this area suggests to me that there is a limit to what regulators can achieve when it is seen as enough for the regulated to merely follow codes of practice and guidance. To aim higher than this requires both trustees and their advisers to do more than play the referee.

And my pension is staying where it is.

 

 

My ETV – part one

17. July 2013 · Write a comment · Categories: Actuarial, Pensions, Regulation

Diamond graphA couple of weeks ago, I had a session with Beaufort Consulting. They had been selected by the Phoenix Group to provide independent financial advice to members of the Pearl Group Staff Pension Scheme who had been offered an enhanced transfer value (ETV).

The aim of an ETV is simple. The sponsors of the scheme are looking to reduce the uncertainty and cost (the ETV is normally considerably less than the cost of purchasing an annuity with an insurer to an equivalent level to the pension given up). I have been the actuary to schemes in the past where the sponsor has carried out such exercises and, beyond advising the trustees to press the sponsor for certain minimum standards (for example independent financial advice, communication of risks and making sure the security of the non-transferring members is maintained), it has been frustrating to watch members seeming to give up the security of their benefits in many cases with rather little to show for it. I was curious to experience the process from the member’s perspective.

I had been warned by the Trustee Board of the Scheme that an exercise was going to be taking place in February. Then last month I received a transfer value quotation from the Phoenix Group, indicating that not only would the current reduction to transfer values of 10% be removed, but that an enhancement of a further 10% would be added. I had six weeks to register for advice with the Beaufort Group, and a further six weeks to accept the offer before it was withdrawn. I was directed to the modelling tools on Beaufort’s website and my attention was drawn to the Code of Good Practice and the Pension Regulator’s guidance on such offers. An “important additional information” booklet, in the form of questions and answers on the overall process, was also enclosed. From Beaufort consulting I received a client agreement, a key facts document and log in details for their website (referred to as the “Member Advisory Platform” or MAP).

Whew! So I went on the website and answered the 15 questions designed to assess my risk profile. I was interested to note, despite indicating that I tended to disagree with accepting the possibility of greater losses to achieve high investment growth and rating the amount of risk I had taken in the past as medium compared to other people, that I had been categorised as having a risk rating of medium/high. The suggested asset allocation was 90% in equities and 10% in corporate bonds.

On the basis of this, a requirement to provide a 50% spouse pension and annual pension increases in line with CPI increases capped at 2.5%, and with no lump sum taken, the modeller told me that I had a 6 out of 10 chance of getting a higher income from the transfer at retirement (in 10 years’ time at age 60). Taking out the spouse pension increased this to a 9 out of 10 chance. In fact, out of the high outcome, mid outcome and low outcome shown, only the low outcome led to a lower income from the transfer. The thick black line of certainty of the Scheme benefits was placed beside the alluring diamond of possibilities from the transfer (see diagram above). None of the financial assumptions or assumed cost of buying an annuity were spelt out. I decided this would benefit from further discussion and clicked to arrange an appointment. My slot for a telephone meeting with an adviser was quickly arranged and the afternoon arrived.

The adviser was very polite and unpushy. I explained my surprise at the outcome of the risk profiler, on the basis of which he agreed to reduce my profile risk level; from medium/high to medium.

He explained that Beaufort were not incentivised to get people to transfer and that the same offer was being made to everyone more than five years from retirement.

I asked him what assumptions had been made in the modeller. This took a while to get a response to, during which time I got an interesting account of a stochastic process (this is where you let the various outcomes be chosen randomly but according to an underlying probability distribution, then run the model lots of times to show the relative likelihood of different results. Throwing dice lots of times is a very simple stochastic process). I persisted, saying that the darker area in the middle of their diamond must be based on an average level assumed for investment returns and annuity rates. The response, after a moment when I thought he was going to put the phone down on me due to some noise on the line that I couldn’t hear, was that the assumptions were standard and he thought the low one was 5% pa. I felt that he was telling me all he knew about the modeller.

We moved on to what I thought of the strength of the Phoenix Group, what my preference was on death benefits, etc, before he ran a few modeller examples to illustrate how my income following the transfer would be greater until age 81 (all stochasticism had been abandoned at this stage).

I decided to move my adviser back onto risk. I said that, as my Pearl pension was about a third of my (non-state) total pension benefits, and all my other pensions were per force defined contribution (DC – see my previous post for explanation of defined contribution and defined benefit), it seemed a good idea to diversify my risks by keeping some in defined benefit form. If equity returns over the next 10 years were like those of the last 10, I might be very glad I had.

To his credit, he accepted my argument, and said that he would not recommend I transferred. I thanked him for his time and for a helpful discussion and checked that I would be receiving a final written report, which he confirmed.

I put down the phone and reflected on what had happened. I realised I had some concerns about the process:

  • The adviser had been courteous, and had not pushed me in any particular direction, but had been unable to provide any information to assess the plausibility of the modeller at the heart of the advice.
  • I had had to introduce the idea of the risk of having all my pension benefits in DC form.

In particular, after reading a fair volume of paperwork and spending the best part of an hour on the phone, I was, as a pensions actuary, unable to recreate (even approximately) the modeller calculations from the information provided. I awaited the written report with interest.

To be continued…

Conflicts of Disinterest

25. June 2013 · Write a comment · Categories: Actuarial, Regulation

Would you rather have someone giving you advice to be independent or disinterested? The Oxford English Dictionary (OED) definitions suggest some crossover but ultimately quite distinct meanings for the two words:

Disinterested

  1. not influenced by considerations of personal advantage
  2. having or feeling no interest in something

Independent

  1. free from outside control; not subject to another’s authority
  2. not depending on another for livelihood or subsistence
  3. capable of thinking or acting for oneself; not influenced by others; impartial
  4. not connected with another or with each other; separate; not depending on something else for strength or effectiveness; free-standing

I would opt for a disinterested adviser rather than an independent one every time. After all, you don’t want an adviser who is not connected with another or with each other. Those are normally the reported attributes of someone who has just done something terrible. And requiring your adviser to be neither subject to another’s authority nor depending on another for livelihood or subsistence probably means restricting yourself to people working on their own with no clients.

In opting for disinterested as a better adjective for advisers to shoot for, I am excluding the second definition here (some will argue that this is uninterested in any case, but 20% of the usage of the word disinterested is in the uninterested sense). Although many people giving advice will find their interest in advising anyone ever again for the rest of their lives waning at times, most of them return to being interested after a few days away from it, particularly if they have just enjoyed a holiday benefiting from the freely dispensed advice of their nearest and dearest.

However the definition of disinterested only takes us so far. You could be not influenced by considerations of personal advantage and yet still not be working in someone else’s best interests.

The Actuaries’ Code states that a conflict of interests arises if a member’s duty to act in the best interests of any client conflicts with:

a) the member’s own interests (ie you would not be disinterested by the OED definition); or

b) an interest of the member’s firm; or

c) the interests of other clients (you can’t provide full-blooded no-holds-barred advice to a client if you are also advising a company who is trying to buy them, sell them, merge with them or has different interests within the same organisation).

Consideration b) of this list then introduces a requirement on actuaries to take reasonable steps to ensure that they are aware of any relevant interest, including income, of their firm. And with this awareness comes the same responsibility to deal with any conflict arising as a result. However the Code is very much aimed at individual actuaries rather than their firms.

The Law Society’s practice note on conflicts of interest takes a similar line, recognising two types of conflicts of interest: own interest conflict (which includes the lawyer’s own interests and those of the lawyer’s firm) and client conflict. However it goes further by making it clear that the note applies to individuals and to firms collectively. Conflicts of interest are also regulated by the Solicitors Regulation Authority (SRA) within an overall framework of regulation that has two elements: firm-based requirements and individual requirements. It focuses on the practices of regulated entities as well as the conduct and competence of regulated individuals. This approach allows the SRA to take regulatory action against firms or individuals, or both, in appropriate cases.

All of this is fine as far as it goes, but I wonder if a process that relies on individuals effectively acting as investigators within their own firms to dig up instances where either the spirit or letter of some code is infringed is ever going to prevent deeply embedded practices on its own. It is very difficult to call time on arrangements which are making people money, particularly when you are dependent on the people making the money for your job.

Perhaps another way to go (or an additional one, as in this case I don’t think there is a conflict involved!) would be to recognise the meaning of the Latin root of the word conflict, which is conflictus, meaning contest. Wouldn’t it be helpful to individuals trying to avoid conflicts of interest if the companies they worked for operated a conflict of disinterest? Where firms competed with each other to demonstrate how disinterested they were. Where firms felt it gave them a competitive advantage to show how the only thing they had at stake in taking on a client or a project or any other piece of work was the agreed fee.

For a firm actively engaging in a conflict of disinterest, the individuals working for it wouldn’t have to knock down several doors to raise their concerns, they would find they were regularly being asked about the status of potential conflicts of interest, in case they in turn were in conflict with the firm’s client agreements and promotional material. The markets clients worked in would be regularly scanned for intelligence on deals in the pipeline and the firm’s own client lists would be scrutinised for potential implications.

So how could such a conflict of disinterest be brought about? By campaigning for it. If this is how we want business to be done we need to ask for it. If a change in public expectations of corporate tax management practices can lead to significant changes in those practices, the same could be achieved on conflicts of interest.

Because currently they are everywhere. At one end is the chimney sweep who brought a pile of soot down onto my new carpet and then turned to me and told me not to worry as he also ran a carpet cleaning business. At the other are the ratings agencies, paid by the firms they are rating, who both give credit ratings on financial instruments and advise individual firms on how to construct those financial instruments so as to score the highest possible ratings, which ultimately contributed significantly to the market crash and subsequent economic recession we have still not recovered from.

So declare a conflict of disinterest today and let’s start a movement.

 

 

Uncertainty and its discontents

20. June 2013 · Write a comment · Categories: Economics, Prediction, Regulation

There’s certainly a great deal of uncertainty about.

In Nate Silver’s book, The Signal and the Noise, there is a chapter on climate change (which has come in for some criticism – see Michael Mann’s blog on this) which contains a diagram on uncertainty supposedly sketched for him on a cocktail napkin by Gavin Schmidt. It occurred to me that this pattern of uncertainty at different timescales was more generally applicable (it describes very well, for instance, the different types of uncertainty in any projections of future mortality rates). In particular, I think it provides a good framework for considering the current arguments about economic growth, debt and austerity. Some of these arguments look to be at cross-purposes because they are focused on different timeframes.

uncertaintyIn the short term, looking less than 10 years ahead, initial condition uncertainty dominates. This means that in the short term we do not really understand what is currently going on (all our knowledge is to some extent historical) and trends which might seem obvious in a few years are anything but now. Politics operates in this sphere (long term thinking tends to look two parliaments ahead at most, ie 10 years). However, the market traders who by their activities move the markets and market indices on which we tend to base our forecasts and our economic policies are also working in the short term, the very short term (ie less than 3 months to close off a position and be able to compare your performance with your peers), even if they are trading in long term investments.

So both the politics and economics is very short term in its focus, and this is therefore where the debate about growth and austerity tends to be waged. The Austerians (which include the UK Government) claim to believe that debt deters growth, and that cutting spending in real terms is the only possible Plan A policy option. The Keynesians believe that, in a recession, and when interest rates cannot go any lower, demand can only be revived by Government spending. This argument is now well rehearsed, and is in my view shifting towards the Keynesians, but in the meantime austerian policies (with all the economic destruction they inevitably cause) continue in the UK.

However, there are other groups seemingly supportive of the UK Government’s position in this argument for altogether different reasons. Nassim Nicholas Taleb argues that high levels of debt increase an economy’s fragility to the inevitable large devastating economic events which will happen in the future and which we cannot predict in advance. He therefore dismisses the Keynesians as fragilistas, ie people who transfer more fragility onto the rest of us by their influence on policy. These concerns are focused on the structural uncertainty which is always with us and is difficult to reduce significantly. It is therefore important to reduce (or, if possible, reverse) your fragility to it.

At the longer term end are the groups who believe that we need to restrict future economic growth voluntarily before it is done for us, catastrophically rapidly, by a planet whose limits in many areas may now be very close to being reached. They are therefore implacably opposed to any policy which aims to promote economic growth. These concerns are focused where there are many possible future scenarios (ie scenario uncertainty), some of which involve apocalyptic levels of resource depletion and land degradation.

These different groups are tackling different problems. I do not believe that those concerned with the structural fragility of the economy really believe that the people paying for the restructure should be the disabled or those on minimum wage. Similarly, there is a big difference between encouraging people to consume less and move to more sustainable lifestyles and recalibrating down what is meant by a subsistence level of existence for those already there.

We do need to worry about too big to fail. Our economy houses too many institutions which appear to be too large to regulate effectively. We do need to reduce levels of debt when economic activity has returned to more normal levels. We will need to restructure our economy entirely for it to make long-term sense in a world where long term limits to growth seem inevitable. But none of these are our immediate concern. We need to save the economy first.

Skin in the right game

11. June 2013 · Write a comment · Categories: Actuarial, Economics, Prediction, Regulation

skin in the gameIn my previous post, I looked at some of the reasons why we are so useless at making economic predictions, and some of the ideas for what might be done about it. One of the key problems, raised by Nassim Nicholas Taleb most recently in his book Antifragile, is the absence of skin in the game, ie forecasters having something to lose if their forecasts are wildly off.

But what if all forecasters had to have something to lose before they were allowed to make forecasts? What if every IMF or OBR forecast came with a bill if it was seriously adrift? What if you knew whenever you read a forecast in a newspaper or on a television screen that the person making that forecast had invested something in their belief in their own forecast?

Betting on events dates back at least to the 16th century, but prediction markets (also known as predictive markets, information markets, decision markets, idea futures, event derivatives, or virtual markets) have developed most strongly over the last 25 years or so (the University of Iowa launched its first electronic market as an experiment in 1988). Intrade, which describes itself as the world’s leading prediction market, is now a little smaller than it was following the news just before Christmas last year that it would no longer let Americans trade on its site. It had been sued by the US regulator of the commodities derivative markets for breaking a commitment not to allow trading on the constituents of those markets.

A paper on prediction markets earlier this year called Prediction Markets for Economic Forecasting by Snowberg, Wolfers and Zitzewitz suggests there are 3 main types:

·         Winner takes all. If the event you have bet on happens you win. If not, you lose your stake. Intrade is this type of prediction market: you pay a proportion of £10 a share based on the average probability of the event happening (according to the market participants) and get £10 back if it happens, nothing if it doesn’t. The Iowa Electronic Market current offerings, on congressional elections and US federal monetary policy, are also winner takes all. The price of the bet at any time should reflect the market’s view of the probability of the event happening.

·         Index. The amount paid out is unknown but tied to the variable you are betting on, eg the number of seats won by a party in a particular parliamentary election, or the value of an index at close of business on a particular date. The price of the bet at any time should reflect the market’s view of the expected value of the outcome.

·         Spread betting. Most commonly found on sports betting sites, the amount bet and the amount paid out are fixed, but the event that leads to a pay out (eg number of goals scored in a match more than x) changes until the numbers of buys and sells match (a “buy” in this example is betting the number of goals will be above x, a “sell” is betting the number of goals will be below y, a number less than x. The spread, on which the betting site makes its money, is the difference between x and y. This could equally be applied to the values of an index at a particular date (eg Spreadex offer just such bets on several major share indices as well as currency exchange rates). Depending on the relationship between the pay out and the bet, the value of the spread points at any time should reflect the market’s view of a particular point in the probability distribution of the event, eg if the pay out is twice the bet, this would be the median (ie a 50% chance of the outcome being higher or lower).

As we saw in my previous post, currently economic predictions are largely blown off course by either:

  • Over-confidence in the information used to make them; or
  • The difficulty in standing out against a market which is making everyone a lot of money (buying has limited downside, selling limited upside); or (another possibility I haven’t mentioned before)
  • Bias in individual “expert” judgements, eg those with reputations at stake may want to keep their assumptions somewhere in the middle of the pack rather than standing out most of the time as this is less risky (hence the obsession with “benchmarking” assumptions in the actuarial world for instance).

Prediction markets can help with all of these problems:

  • Having to bet on your opinion should cause you to weigh the evidence backing it more carefully. Also, once a market is established and attracting a lot of bets, the range of evidence on which opinions are being based should expand. Prediction markets also appear to be quite difficult to manipulate or arbitrage.
  • Prediction markets can respond very rapidly to changes in the information available. As an example, within 25 minutes of Donald Rumsfeld’s former chief of staff tweeting about the death of Osama Bin Laden, the market view of the probability of this event on a prediction market rose from 7% to 99%.
  • Betting can take place anonymously. So, although the betting site knows who you are, no one else does, and the data from the voting therefore gets out into the public domain without any individual being accused of talking down a market or risking their reputation.

For these reasons, amongst others, forecast accuracy for established prediction markets might be expected to outperform that of professional forecasters. The paper of Wolfers et al suggests that this is the case.

There are still problems. The markets need to be popular to be much use for predictions, so the questions need to be interesting enough for mass participation. Secondly, a market could theoretically be undermined (although not necessarily to the detriment of its predictive ability) by traders with inside information. However, there are quite a few safeguards in place against this type of activity. Intrade, for instance, requires a photo ID and two proofs of address before it registers anyone to trade on their site. And Spreadex are regulated by the Financial Conduct Authority. A third problem is referred to as the “longshot bias”, which is observed on all types of betting markets. People tend to over-bet on events with long odds against them and under-bet on events which are fairly likely (which explains the narrowing of the odds as the starting gun approached on that horse you bet on just because of its name in the Grand National a couple of months ago). This is a problem of the winner takes all type of market, seemingly related to behavioural factors around the difference between how we view winning and losing, and it is difficult to see how it could be avoided completely. Care may need to be taken therefore when interpreting prediction markets on events which are seen as having fairly low probabilities.

But overall, prediction markets would seem to offer a way of significantly improving economic predictions, so why not make them compulsory for people who want to make such forecasts? By putting a cost on such predictions (a minimum bet could be set based on the size of the organisation making it), it would remove the casual forecasting we currently see too much of, and encourage people to review their beliefs rather more carefully. It would also ensure that the markets were popular enough to be effective. It may be that economic forecasting will always be far from perfect, but this seems a good place to start if we want, in Nate Silver’s words, to be “less and less and less wrong”.

A tax on economists? Not at all. But it might mean that we all have skin in the right game.

The Wizard of EIOPA

04. June 2013 · Write a comment · Categories: Actuarial, EIOPA, Pensions, Regulation

My post on 24 April suggested that the threat posed by EIOPA’s proposals for occupational pension schemes (or IORPs, as they call them) went well beyond increases to funding targets, specifically setting out tougher regulation on:

  • Governance requirements;
  • Fit and proper requirements of pension scheme trustees;
  • Risk management requirements; and
  • The establishment of own risk solvency assessments.

“Solvency II” type funding targets have now been postponed, but the other threats remain. So what is the true nature of this threat?

It is easy to portray “Europe” as some massive irresistible force which can only be opposed by an increasingly immovable UKIP-type object. However, occasionally the curtain gets whipped away to reveal, Wizard of Oz style, a few technocrats frantically pulling the levers up and down to maintain the illusion of unquestionable authority.

Gabriel Bernardino, the Wizard of EIOPA, certainly appears to be feeling the strain of maintaining this illusion. Last week he suggested that EIOPA needed more power and more money, some of which needed to come from levies on “the industry”, ie individual pension schemes.

Coincidentally, the Pensions Regulator has also issued a report on occupational pension scheme governance in the UK. There are 128 tables in its accompanying technical report but, picking out one or two statistics on each of the four of EIOPA’s focus areas I have highlighted, it suggests that meeting the tougher regulations on governance and risk management is likely to cause UK pension schemes considerable problems.

For instance, the 70% of small and over 50% (I’m assuming this, the Regulator’s summary of DB/Hybrid medium schemes’ responses only total to 90%) of medium schemes which have trustee meetings less frequently than once a quarter are unlikely to be seen by EIOPA as adequately providing “continuous operational governance”. As EIOPA’s advice recognises (the italics are mine): “many IORPs do not have truly continuous operational governance (e.g. IORP governing bodies that meet monthly or less frequently), so their operational characteristics fundamentally differ from insurance entities”. And the 3% or so of medium-sized schemes who admit to never having had a trustee meeting at all would I assume be seen as not providing operational governance at all.

a1

Next up, if the requirements to establish that trustees are fit and proper persons to govern pension schemes were a worry, the revelation that 57% of small schemes and 41% of medium schemes have no training plan in place for its trustees will not help matters.

b1

Meanwhile, it comes as a bit of a shock to those of us who thought that the Pensions Act 2004 did away with actuaries and other advisors acting as judge, jury and executioner of policy decisions for the pension schemes they represented, that 26% of small, 17% of medium and 18% of large schemes generally let their advisors take the lead on making decisions. Again this is not going to help trustees establish that they are fit and proper to govern their schemes.

d3

It might be hoped that trustees could have a reasonable stab at meeting the risk management requirements of their schemes. However, a stubbornly persistent 13-15% of small and medium schemes (both defined benefit and defined contribution) who have at the very least some form of risk register review it less than once a year.

e4

Finally, there are those who believe that the kicking of a new capital requirement for defined benefit pension schemes into the long European grass, if not the Eurasian Steppe, will just lead to the beefing up of the proposal of a pension scheme own risk solvency assessment along the same lines as insurers are currently developing, ie expecting each pension scheme to develop its own solvency target (which may introduce something equivalent to the holistic balance sheet by the back door) and a reasonably plausible account of how they expect to get there. The nearest thing we have to this in the UK at the moment is for those schemes who are developing a ‘flight path’ to buy out or ‘self-sufficiency’ (itself a concept which may not survive the Wizard of EIOPA). Over half of small and medium schemes have no such plan.

i3

So much to be concerned about here, and none of it without cost. The Wizard may feel he needs help to wiggle levers to maintain an illusion of European managerial competence, but few people the other side of the curtain believe in this any longer. And, with the loss of this illusion, EIOPA’s ability to bully schemes into measures not previously thought necessary in the UK despite nearly 20 years of increasing domestic regulatory hyperactivity in this area recedes. If Bernardino can get the Pensions Regulator to implement all of this and get it to pay EIOPA for the privilege of being more intrusively regulated into the bargain, he will be a wizard indeed.

 

DA = CB

23. May 2013 · Write a comment · Categories: Actuarial, Defined Ambition, Economics, Pensions, Regulation

Steve Webb, the pensions minister, thinks we only have 12 months to save DB but that, in its current form, it might be like trying to apply electrodes to a corpse. Unfortunately his prescription – Defined Ambition (DA) – is still very much undefined and therefore, as yet, unambitious.

Pension active membership

Number of members of private sector occupational pension schemes: by membership type and benefit structure, 2004-11

Source: Office of National Statistics

The graph above shows how dramatic the decline of DB active membership (ie members still accruing benefits in defined benefit schemes which provide a pension defined in advance, where the balance of funding is committed to by the employer in nearly all cases) has been in recent years. It also shows, contrary to some reports, that there has been no advance in DC active membership (ie defined contribution schemes where only the contributions are defined in advance and final benefits are at the mercy of financial markets and annuity rates). It just hasn’t fallen much. In fact, if all of the DC active members had instead been offered DB active membership, the number of DB active members would still have fallen.

So it is a crisis and it appears to be those who are opting for no pension scheme at all who are really growing in number. The auto-enrolment programme starting to be rolled out across the country will have an impact, after all if you keep asking the question and don’t take no for an answer you will attract customers – just ask the banks who were selling PPI cover.

But I wonder if the crowd avoiding pensions of any sort up until now might perhaps have more wisdom than those trying to pile them into schemes whether they want to or not. Because DC has to date been a very poor offer for most, with very low levels of contributions. The latest survey by the ONS of households between 2008 and 2010 where the primary earners are between 50 and 64 revealed that median pension savings in DB schemes were equivalent to around six times those in DC schemes. And the minimum contributions under auto-enrolment of 8% of qualifying earnings from all sources with all risks staying with the member is unlikely to change this massive inequality quickly if at all.

If you have very little money, and the pension option means that your pension contributions are likely to be bounced around by the markets for a few decades before dribbling out in whatever exchange the insurance companies are prepared to give you, is it irrational to think that you might want to keep some access to your savings along the way? The following graph suggests most people don’t think so.

Decile savings

Breakdown of aggregate saving, where household head is aged 50 to 64: by deciles and components, 2008/10

Source: Office of National Statistics

This graph suggests that people do save for a pension where they can, but if there is not much to go round, they also want some more liquid savings. The problem is not that they are not saving for a pension, it is that they have no assets at all.

So what is to be done? Clearly campaigning for a living wage needs to continue and be intensified, and reductions to benefits are going to make the problem worse. But fiddling around with marginally different forms of DC arrangements for decades will also be disastrous. Think not just a few naked pensioners on the beach as we had before the Pension Protection Fund (PPF) came in for DB members. Think armies of them with a genuine grievance against a society that did this to them. And what will have been done to them is to suggest that by paying 4% of their salary into a pension scheme, they have somehow safeguarded their future. Good employers are not going to want to be associated with scenes (or schemes) like this.

DC contributions need to be much higher while they remain so risky, which is why DB schemes target asset levels much higher than their best estimate of the cost in most cases, but clearly DB levels are too high for nearly all employers. There is not much time, as Steve Webb says, so let’s stop messing around and pick an alternative.

I vote for cash balance (CB). There are many different sorts but the feature they all have in common is a defined cash sum available at retirement which members can then take in a combination of lump sum, annuity and drawdown (ie keeping the sum in the scheme and drawing income from it as needed). It means that the bumping around by the markets is taken on the chin by your employer not you, but only until retirement (the type of risk employers are used to managing in their businesses anyway), and the risk of you living longer (reflected in lower annuity rates) when you get to retirement is your problem. It seems reasonable to me. Whoever thought that an employer should be concerned with how long you are going to live (unless they were the mafia)? Good employers could also offer a broking service for annuity purchase to avoid the problem of pensioners not shopping around adequately.

There are a few of these in existence already, although only 8,000 members in total benefit from them so far. In the case of Morrisons, the guarantee is 16% of salary a year, uprated in line with CPI. This is one of the current minimum levels to be accepted as an auto-enrolment plan. Alternatively you could drop to 8% a year, but uprate it by CPI plus 3.5% pa. Either would be a huge improvement for someone with limited means to relying on what 8% of earnings pa might amount to in 40 years’ time, and unable to take the risk that the answer is not much.

But the first step is to establish CB as what is meant by DA and that will need Government support to work. I propose:

  • CB to be promoted as one of the main options for an auto-enrolment scheme, equivalent to the 8% minimum but without total risk transfer to the employee.
  •  Develop a colour coding scheme for a combination of benefit level and risk transfer, with DC at minimum auto-enrolment at the red end, minimum CB at amber running through green to the equivalent of a public sector DB scheme or better as (NHS) blue.
  • Sort out the PPF position on CB. They currently treat them as full DB schemes. Scale down PPF levies to reflect the lower level of risk that they present to the PPF.
  • Simplify the pensions legislation around CB to reflect the fact that the scheme’s responsibility for managing risk ends at retirement.

And we really need to start now!

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