Risk – Page 4 – We Know Zero

Actuaries and Economics

20. June 2014 · Write a comment · Categories: Actuarial, Antifragility, Defined Ambition, Economics, Pensions, Regulation, Risk

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.

A proportionate response?

12. June 2014 · Write a comment · Categories: Actuarial, EIOPA, Pensions, Regulation, Risk

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?

Will 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.

Freedom and choice – a response to the Treasury pensions consultation

05. June 2014 · Write a comment · Categories: Defined Ambition, Legal, Pensions, Regulation, Risk

The consultation on the proposals for pensions announced in the Budget, and contained in yesterday’s Queen’s Speech, ends on 11 June. I have set out my response below. I hope that it will sufficiently incense one or two more people into making their views heard, before the chance disappears.

A.1
The government welcomes views on its proposed approach to reforming the pensions tax framework.

1 Should a statutory override be put in place to ensure that pension scheme rules do not prevent individuals from taking advantage of increased flexibility?

Yes. Otherwise you are just writing cheques to pensions lawyers.

2 How could the government design the new system such that it enables innovation in the retirement income market?

Reform preservation rules, the TPR code on funding, HMRC rules and the PPF levy framework so as not to penalise different arrangements across the defined ambition spectrum. Remove the annual allowance, controlling the level of tax relief offered through the lifetime allowance only (I got this the wrong way round in my first draft – the annual allowance assumes regular incomes, many people now have incomes which bounce up and down alarmingly from year to year. It is also ridiculously cumbersome to administer).

3 Do you agree that the age at which private pension wealth can be accessed should rise alongside the State Pension age?

No. There is already an issue around healthy life expectancy and the state pension age in some regions of the UK.

4 Should the change in the minimum pension age be applied to all pension schemes which qualify for tax relief?

Yes. The arrangements need simplification.

5 Should the minimum pension age be increased further, for example so that it is five years below State Pension age?

No (see answer to 3).

A.2
The government welcomes views on its proposed approach to supporting consumers in making retirement choices.

6 Is the prescription of standards enough to ensure the impartiality of guidance delivered by the pension provider? Should pension providers be required to outsource delivery of independent guidance to a trusted third party?

There needs to be more clarity about the charges which can be levied for guidance or if it is to be remunerated in some other way.

7 Should there be any difference between the requirements to offer guidance placed on contract-based pension providers and trust-based pension schemes?

No. In most cases the scheme members have not chosen to receive lower levels of service.

8 What more can be done to ensure that guidance is available at key decision points during retirement?

I think there needs to be a right (but not requirement) to it for everyone at 50, 60, 70 and 80 as a minimum, at an agreed national nominal charge. I imagine that the £20 million available to develop resources for this will need to be increased significantly to make an impact on the quality of guidance materials provided.

A.3
The government would welcome views on the options outlined in point 5.15, including their likely complexity, and the burdens they might place on scheme sponsors and HMRC.

9 Should the government continue to allow private sector defined benefit to defined contribution transfers and if so, in which circumstances?

Yes. In all circumstances.

10 How should the government assess the risks associated with allowing private sector defined benefit schemes to transfer to defined contribution under the proposed tax system?

The reasons the Government have advanced for the changes to DC are equally compelling when applied to DB:

1. There is a lack of choice for people at retirement, which has become more of an urgent concern now that auto enrolment is boosting DC membership. This is even more the case for DB members who are already numerous (although getting less so daily), as their only choices are how much cash to take up to the 25% tax free limit and (up to a point) when to retire.
2. Current regulations deter innovation. This is, of course, why defined ambition as an idea has been so slow to get off the ground.
3. Restrictions on cash commutation imply a lack of trust of members to be able to decide how they spend their savings.
4. The concern that the annuity market has not maximised income for scheme members. This is mirrored by the high cost of de-risking via bulk annuities, which is the ultimate “flight path” for most DB pension schemes, and which many argue has resulted in a big drag on the growth of UK PLC.

All that would be required to extend the proposed freedoms would be to allow DB members to commute as much of their benefits at retirement, whether for cash or income drawdown, as they wanted, with the rest taken as pension as now. This could be applied to private and public sector schemes and would, I believe, at a stroke head off the rush to transfer.

Even if the Government does manage to stop people pouring out of the exits before April next year, this has to be bad policy. To provide more freedom and choice to one group of pensioners and at the same time to remove a longstanding freedom (and one available at the point members joined the schemes) from the other groups is clearly unfair. What is worse, with an election looming, it is likely to be unpopular.

A.4
The government would welcome views on any potential impact of the government’s proposals on investment and financial markets.

For private DB schemes, the Government says the decision is “finely balanced”. I think their fears are exaggerated and rather contradict the earlier declaration of trust in pensioners to make appropriate decisions about their retirement – after all appropriate investment in support of regular income in retirement (which would presumably be recommended by the “guaranteed guidance” to be offered to DC members) should not differ markedly from the equivalent investments in DB schemes. Whether DB schemes invest on a longer-term basis than individuals is, as the Kay Review made clear, uncertain.
The level of the Government’s concern about financial markets rather makes it look as if individuals can be trusted to look after themselves, with a slightly bigger safety net and a bit of advice, but financial markets cannot. This cannot be right.

Investment consultants and value

15. May 2014 · Write a comment · Categories: Birmingham, Pensions, Regulation, Risk

I was introduced to a great piece of research by Tim Jenkinson, Howard Jones and Jose Vicente Martinez this week (Tim was speaking at the Workplace Pensions Live event in Birmingham). It looked at the performance of US active equity products recommended by investment consultants (a large sample covering 90% of the investment consulting market worldwide) compared to those not recommended by them over the period 1999-2011.

What they found was that:

Investment consultants’ recommendations seem less heavily influenced by return-chasing strategies than by more intangible personal assessments, eg of the capabilities of fund managers, the consistency of their philosophies and the usefulness of their reports (any of those explanations for recommendations sound familiar?);
People tend to follow the recommendations they are given; and
There is no evidence that investment consultants’ recommendations add value to plan sponsors.

The underperformance of recommended funds compared to unrecommended was 1% pa on average when all funds were given an equal weighting, falling to an underperformance of 0.26% pa when weighted by the size of fund recommended. This suggests that when investment consultants move away from recommending larger funds they are doing even worse.

There may be other reasons for using an investment consultant other than higher returns of course. People may appreciate “a narrative that provides comfort” (similar to the placebo effect in financial advice I previously discussed here) and which gives them ready-made explanations for their own stakeholders. However, bearing in mind the consistent underperformance, why do they follow the recommendations they are given?

One reason may be that the recommendations provide cover for decisions made. Another may be regulatory pressures, eg the Pensions Regulator in the UK requires pension scheme trustees to take professional investment advice (a requirement Tim Jenkinson believes is unhelpful) and it may be viewed as odd to then ignore it.

But the report concludes that a more likely reason is that people are generally unaware of how little value is being added. Certainly studies like this one that set the problem out in such stark terms are fairly thin on the ground. The investment consultants’ world is a very concentrated one (of the $25 trillion funds under management: $4.4 trillion are managed by Aon Hewitt, $4 trillion by Mercer and $2.1 trillion by Towers Watson) and the necessary information can be difficult to get hold of.

Another reason that the underperformance may be less obvious is the impact of the recommendation itself. As John Allen Paulos explains in his classic A Mathematician Plays the Market, for an over or underperforming stock you both need the performance itself and for someone to pick it. If you always pick what the investment consultant recommends the second condition is automatically met. Sometimes that will be the lucky stock and sometimes it won’t, but you will always choose it when it is, whereas a random choice of stocks will choose it in its lucky weeks less frequently.

What all this tells us is that you cannot assume that the additional complexity investment consultants’ appear to be biased towards is adding any value to your pension scheme or business. Tim Jenkinson suggests there should be a presumption of passive investment unless a very persuasive argument for active management can be advanced. And at the small end, as he says: “if you’re not big, be simple”.

The misbehaviour of mistakes

25. April 2014 · Write a comment · Categories: Cartoons, Risk

The Comedy of Errors
– with apologies to William Shakespeare in the week of his 450th birthday

There are two ways that mistakes can happen when you are carrying out an experiment to test a hypothesis. Experiments usually have two possible outcomes: accepting a “null” hypothesis, which means concluding that the experiment does not challenge its truth, and rejecting a null hypothesis, which means concluding that the experiment does provide sufficient evidence to do so.

Type 1 errors, otherwise known as “false positives” are when you think there is evidence for rejecting the null hypothesis (eg deciding there actually is something wrong with a smear test) when there isn’t. Type 2 errors, otherwise known as “false negatives”, are when you accept the null hypothesis but you really shouldn’t (eg telling someone they are all clear when they are not).

Saddam Hussain once famously said “I would rather kill my friends in error, than allow my enemies to live”. This suggests that he was really very much more concerned about Type 2 errors than Type 1 errors.

He is not alone in this.

A recent widely reported academic paper published in Nature claimed to have a test that “predicted phenoconversion to either amnestic mild cognitive impairment or Alzheimer’s disease within a 2–3 year timeframe with over 90% accuracy”.

The latest statistics from the Alzheimer’s Society suggest that around 1 in 14 or 7% of over 65s will develop Alzheimer’s. Probably not all of these people will contract the disease within 3 years, but let’s assume for the sake of argument that they will. Even so this means that, out of 1,000 people over 65, 930 people will not get Alzheimer’s within 3 years.

Applying the 90% accuracy rate allows us to detect 63 out of 70 people who actually will get Alzheimer’s. There will be 7 cases not picked up where people go on to develop Alzheimer’s. However the bigger problem, the Type 1 error that Saddam Hussain was not so bothered about, is that 10% of the people who do not and will not get Alzheimer’s will be told that they will. That is 93 people scared unnecessarily.

So 63 + 93 = 156 people will test positive, of which only 63 (ie 40%) will develop Alzheimer’s within three years. The “over 90%” accuracy rate becomes only a 40% accuracy rate amongst all the people testing positive.

In statistical tests more generally, if the likelihood of a false positive is less than 5%, the evidence that the hypothesis is true is commonly described as “statistically significant”. In 2005 John Ioannidis, an epidemiologist from Stanford University, published a paper arguing that most published research findings are probably false. This was because of three things often not highlighted in the reporting of research: the statistical power of the study (ie the probability of not making a type 2 error or false negative), how unlikely the hypothesis is being tested and the bias in favour of testing new hypotheses over replicating previous results.

As an example, if we test 1,000 hypotheses of which 100 are actually true but with a 5% test of significance, a study with power of 0.8 will find 80 of them, missing 20 because of false negatives. Of the 900 hypotheses that are wrong, up to 5% – ie, 45 of them – could be accepted as right because of the permissible level of type 1 errors or false positives. So you have 80 + 45 = 125 positive results, of which 36% are incorrect. If the statistical power is closer to the level which some research findings have suggested of around 0.4, you would have 40 + 45 = 85 positive results, of which 53% would be incorrect, supporting Professor Ioannidis’ claim even before you get onto the other problems he mentions.

We would have got much more reliable results if we had just focused on the negative in these examples. With a power of 0.8, we would get 20 false negatives and 855 true negatives, ie 2% of the negative results are incorrect. With a power of 0.4, we would get 60 false negatives and 855 true negatives, ie still less than 7% of the negative results are incorrect. Unfortunately negative results account for just 10-30% of published scientific literature, depending on the discipline. This bias may be growing. A study of 4,600 papers from across the sciences conducted by Daniele Fanelli of the University of Edinburgh found that the proportion of positive results increased by over 22% between 1990 and 2007.

So, if you are looking to the scientific literature to support an argument you want to advance, be careful. It may not be as positive as it seems.

The Nature of Risk and Pensions

11. March 2014 · Write a comment · Categories: Actuarial, Defined Ambition, Pensions, Risk

I found this diagram recently in a paper by John Adams from 1999 entitled Risk, Freedom and Responsibility. It attempts to summarise different people’s attitude to risk-taking based on their views about the kind of world they live in, represented by a ball sitting in very different types of landscape. It explains a great deal about pensions.

Much is often made about our seemingly inexorable shift away from collective solutions to problems to individualised ones, aided on the one hand by technology like tablets, smart phones and other devices which make it easier for us to create our own environments and cut ourselves off from each other, and on the other by a loss of trust in many of the traditional collective organisations, such as banks and governments, which have previously been used by us to pool our risks and protect the most vulnerable.

If this is true, then it would be represented in the diagram by a shift in world view from right to left.

Others focus on the triumph of the American business model or ABM as the dominant school of political and economic thought in the globalised world of today, just as socialism was in previous times. This model leads to a belief in low taxation, small government, minimal market regulation and the reliance of self-interested materialism of individuals within these markets to deliver what we need. Despite its name, it is not a description of how American business actually works, but just one of what Adams would call the “myths about nature” which often determine our thinking about risk and much else besides.

If the triumph of the ABM is true, then it would be represented in the diagram by a shift in world view from bottom to top.

Adams points out that most people exhibit several of these world views and move between them, sometimes very quickly, but I think that it is easy to see where the stereotypical figures from the UK pensions landscape might sit. For instance, many owners of SMEs are calculated risk-takers who believe that things tend to turn out okay on the whole. That is how they became business owners in the first place. So, in the diagram above, taking a few risks with the football is not going to lose it, but there might be a reasonable amount of bouncing around: ie they are individualists.

In the top right hand corner are the hierarchists. They do not believe that the environment in which they operate is fundamentally benign but they do think that it can be managed. This is why their landscape resembles a series of speed bumps: the football cannot be allowed too much freedom or the consequences might be serious and it is possible to deny the football that freedom. This is the world view of a large number of civil servants and actuaries, which is why the public sector is still running defined benefit pension schemes and the private sector (with the smaller schemes overwhelmingly sponsored by individualists) has largely retreated from them. The larger companies, which tend to harbour their fair share of hierarchists, have been the slowest to abandon such schemes.

In the bottom right hand corner are the egalitarians: people who believe that giving the football anything more than a light tap is likely to lose it forever. Nature is unforgiving and cannot be controlled, but the less we do to destabilise the environment, the longer she is likely to let us live. The resource and environment group of actuaries, with their focus on limits to growth and the implications of this, are likely to contain a number of egalitarians in their ranks.

And where are the pension scheme members? Well, even 15 years ago Adams reckoned on at least 40% of the population being fatalists. This is the perfectly flat landscape representing the idea that it does not remotely matter what you do with the ball, the end result will be the same. Adams cites a survey carried out in 1998 on young adults in England in which, when they were asked to imagine that they could only have one of two rights – the right to vote in an election, or the right to obtain a driving licence, 72% chose the driving licence. I think it is probable that this proportion would be higher now.

So we have pension schemes largely inhabited by fatalists and run either by individualists, in the case of smaller schemes, or by hierarchists in the case of larger and/or public sector schemes. The reason they have had to be auto-enrolled into schemes they did not choose to join themselves is because they do not fundamentally believe that it will make any difference, which makes the cost of it at any price too high.

However they are not comfortable being fatalists. The Pension Regulator’s survey of defined contribution (DC) pension scheme members in 2012 revealed that the three things they wanted most of all were:

Someone making clear to them how much they needed to save;
Being able to talk to someone to understand their pensions better; and
Clear communication from their employer and their pension provider.

All of which would make them less fatalistic and feel more in control. Whether you feel this would move them upwards into the individualist camp or diagonally across to the hierarchical camp (or even over to the egalitarian position) probably depends on your politics, but none of these positions are fixed. The recent floods have shaken many business people’s faith in things basically turning out okay in the end, and the credit crunch certainly moved many people out of hierarchist into either egalitarian or individualist territory.

What it suggests to me is that the way we organise pension scheme membership may be fundamentally flawed. Talking to members about their risk appetite or tolerance to risk is starting from an individualist perspective: that the world is a benign place, nothing too extreme is likely to happen and the only choice for you to make is how you want to invest your money. But it makes no sense if, assuming you can be coaxed away from the fatalist position, you turn out to be an egalitarian or a hierarchist. And this position probably makes no sense to the sponsor of the scheme.

When asked, sponsors of smaller schemes are very clear that they do not support the idea of collective schemes. They want to run their own schemes otherwise a large part of the benefits of the arrangements to them are lost. However, if auto enrolment is to deliver the changed relationship between the public and pensions everyone hopes for, I think prospective members are going to need choices about more than investment strategy. If members want to pool risk I think they should be able to, and collective schemes alongside firms’ own DC arrangements, perhaps with joint membership, may be the way to achieve this.

Individualists, hierarchists, fatalists and egalitarians. As Adams points out “the clamorous debate is characterised not by irrationality, but by plural rationalities.” It is a debate which has a long way to go yet.

When it comes to annuities, most of us are enhanced. We just don’t know it yet

27. February 2014 · Write a comment · Categories: Cartoons, Demographics, Pensions, Risk

In all the talk about annuities and the poor value they currently offer, nearly all of it has been based on standard annuity rates, ie where there is nothing sufficiently medically wrong with you to affect your life expectancy. However this is almost certainly not the rate you should be looking at.

Go to any of the annuity provider or broker websites, sometimes buried away a little, and you will find a link explaining what they can offer in the way of “enhanced” or “impaired lives” annuities. Legal & General’s web page on this looks like the kind of warning notice you find on the wall of your doctor’s surgery waiting room, with headings like Smoking, Type 2 Diabetes and High Blood Pressure. But in the upside-down world of buying annuities these become good things to do or have.

Just Retirement give some handy illustrations of what various conditions could mean for your income: up 20% for minor conditions like obesity and hypertension, up 30% for “moderate” ones like being a heart attack survivor with a bypass and 40% for serious medical conditions like stage 2 bowel cancer one year in. However, you don’t need to get anywhere near the frankly frightening conditions in the moderate and serious boxes to make a big difference to the income you can receive. annuitydiscount.co.uk provide a very long list of medications (covering every letter in the alphabet except J and Y) which could lead to an impaired life annuity if disclosed to the annuity provider.

As the BBC article from 2012 posted by the Better Retirement Group on enhanced annuities says: “At its simplest an annuity is a bet with the insurance company about how long you will live.”

So on that basis, it makes sense to stack the odds in your favour as much as you can. Which makes the 2007 article in the New England Journal of Medicine entitled, rather dully, Incidental Findings on Brain MRI in the General Population, such an interesting read.

They studied 2,000 people (mean age 63.3 years, range 45.7 to 96.7) from the population-based Rotterdam Study in whom high-resolution, structural brain MRI scans had been carried out. Asymptomatic brain infarcts (more commonly known as strokes) were present in 145 people (7.2%). Among other findings, aneurysms (1.8%) were the most frequent. Benign brain tumors also turned up reasonably often (1.6%). The most extreme case was someone with a large, chronic subdural haematoma, who was subsequently found to have had a minor head trauma 4 weeks before the MRI scan. Some of the scans are shown below.

brain scans But the really amazing thing is this: only 2 of the 2,000 people scanned (the subdural haemotoma mentioned above and another who had a 12 mm aneurysm of the medial cerebral artery) had any idea that there was anything wrong with them!

Another huge area of undiagnosed disease (and on the annuity.co.uk list for enhanced annuities) is prostate cancer. According to a systematic review of prostate cancer biopsy schemes by the University of York in 2005, where they quoted from the NHS Centre for Reviews and Dissemination publication on screening for prostate cancer, Effectiveness Matters:

Post mortem studies show that 30% of men over 50, who had no symptoms of prostate cancer whilst alive, had histological evidence of prostate cancer at the time of death. This percentage rises to 60-70% in men over 80 years of age. In other words, most men with prostate cancer die with, rather than from, the disease.

The main reason these studies have been carried out is to determine whether screening for prostate cancer, which kills 3.8% of men with the disease, has saved many lives. The Prostate Specific Antigen (PSA) test that is commonly used to detect prostate cancer in the absence of symptoms is not only prone to false positives and negatives (ie telling you you have it when you don’t and don’t have it when you do – something all screening suffers from to some extent), but can lead to you being offered treatment which may well be worse than the disease. This is discussed further in the excellent The Norm Chronicles, by Michael Blastland and David Spiegelhalter, which questions whether, overall, screening is particularly effective in saving lives.

Effective in preventing death? Perhaps not. But effective in increasing retirement income? Almost certainly.

The latest Association of British Insurers (ABI) facts and figures on the UK annuity market suggest that enhanced annuities have grown in popularity, to 24% in 2012 from 2% in 2003. There is scope to make further large increases in these figures if more people can be persuaded to have themselves screened for some of the most common undiagnosed conditions before they retire.

So don’t necessarily accept a standard annuity rate. And consider getting yourself tested first.

Camps, acronyms and other small stuff

08. February 2014 · Write a comment · Categories: Actuarial, Defined Ambition, Pensions, Regulation, Risk

The Defined Ambition consultation ended on 19 December but the lobbying has continued. Camps have now formed around the various options.

Steve Webb, the Pensions Minister, and Alan Rubinstein, Chief Executive of the Pension Protection Fund, have been enthusiastic supporters of something called the pension income builder, which increases the guaranteed pension accrued each year with part of the annual contribution, with the remaining contributions invested in a collective defined contribution (DC) arrangement.

The Collective DC more generally, where returns are smoothed between members in an attempt to reduce the volatility of returns on individual DC, has also had some very vocal proponents. Considering it was originally ruled out as an option by the Department of Work and Pensions (DWP), has had 10 objections to it raised by the Association of British Insurers (ABI) and has been accused of not reducing risk so much as moving it around between members by Lord Hutton, this is a little bit of a surprise.

Lord Hutton, former Secretary of State for Work and Pensions and chair of the Commission on Public Service Pensions Commission, is dismissive of the whole defined ambition idea. Recently he said that the Government should stop “banging on” about defined ambition and let the pensions industry focus on applying defined benefit (DB) investment strategies to DC schemes. He is a particular fan of the Liability Driven Investment (LDI) approach, common in DB schemes protecting their funding position, being applied more consistently to DC. Hutton has recently joined Redington, an investment consultancy, so I imagine we can expect to hear a lot more from him on this subject.

Much has been made of the Dutch system, which has a “second pillar” of large industry-wide pension schemes. This has suffered from the same economic pressures which have dogged the UK system since the turn of the century, but has arguably retreated from straight final salary benefits – first to career average retirement earnings (CARE), then to risk sharing via variable contributions for employers balanced by variable benefits for employees, and currently renegotiating again in the wake of the 2008 crash – in a more orderly manner. I tend to feel that the main reason the Dutch system is better than ours is the same reason that their flood defence system is better: they put a lot more money into it. Nine times as much in the case of flood defences, and contributions into their second pillar average 20% of salary compared to the current average into DC schemes in the UK of under 8%. They also make you buy an annuity, make you join and don’t let you opt out. Despite this it remains remarkably popular with the public.

As you can see, there are a lot of acronyms flying around, and relatively little discussion with the people who these schemes are likely to end up getting foisted on. The Association of Consulting Actuaries (ACA) carried out a survey of smaller firms which revealed that what they wanted was:

Members to receive more from their savings;
Increased transparency and trust in the companies who provided pensions;
No collective schemes; and
More tax concessions.

This last point is unlikely to be conceded, with the Institute of Fiscal Studies joining the increasing clamour this week to limit the generous tax exemptions to employers and members with occupational pension arrangements.

But has anyone asked members of pension schemes? Very few, as far as I can see. The most notable being the Pension Regulator’s survey of DC pension members in 2012. When those still actively contributing to these schemes were asked which of a long list of things would encourage them to take more interest in their pension, the three things they wanted overwhelmingly most of all were:

Someone making clear to them how much they needed to save;
Being able to talk to someone to understand their pensions better; and
Clear communication from their employer and their pension provider.

Notice how concerns about guaranteed benefits did not feature here. When asked, 85% had some understanding that their pension income was not guaranteed, and even more (94%) had an understanding that contribution levels were a key factor in determining that income. While 78% thought their company or personal pension would be one of their main sources of income in retirement (the next highest was the state pension with 22%), only 24% were confident that their current level of contributions was going to provide an adequate income. So they know they have a problem.

What they are asking for is a step change in financial education so that they can begin to tackle that problem. So could it be that all of the groups we have heard from above are trying to solve the wrong thing entirely?

As far as the regulatory environment is concerned, I think the document Defining Ambition produced by the National Association of Pension Funds (NAPF) before the consultation probably summarised the situation best. Joanne Segars stopped short of supporting any particular solution and instead laid out some of the main options and where they sat on the scale of risk (which I have reproduced above) to the member.

Segars suggested that we shouldn’t “sweat the small stuff”, and should instead concentrate on providing a flexible continuum of regulation to cover the whole scale of risk, otherwise any new approaches would be snuffed out by HMRC’s and TPR’s lack of flexibility and overly complex approach before they even got going, much as cash balance schemes have been over the last 20 years. I felt that this was just fence-sitting at the time, but have since realised that she was right. We have all been “banging on” for too long about things about which prospective members simply don’t care.

Assuming a relaxation of the regulations which doesn’t yet exist, we actuaries have piled enthusiastically into debating slight differences between our different pet schemes, standing toe to toe and swapping model results like punches, while seemingly forgetting all about the member.

Suddenly the most important contribution in Defining Ambitions seems clear to me: that of Morrisons’ HR Director about how they introduced a three year financial education and advice programme (called Save Your Dough) throughout their workforce ahead of their auto-enrolment date. They realised that they needed to help their employees understand their finances first before they would understand that they could make a difference to their long-term finances by saving into a pension. They involved Alvin Hall to add some celebrity glitter to the process, but also involved their main union USDAW. And they used a lot of different communication tools, from booklets to podcasts to online modellers to short films and video diaries in addition to the more traditional information sources and face to face sessions. They trusted that they had good people who would make reasonable decisions given sufficient accessible information.

I am sure there are other examples of such good practice out there, but we have not encouraged them with our endless debates about DC plus v CDC v DB minus and everything in between. The small stuff has been sweated quite enough. Let’s help firms talk to their members better instead.

It’s like deja-vu all over again

28. January 2014 · Write a comment · Categories: Actuarial, Pensions, Regulation, Risk

The Pensions Regulator has a consultation on the go. In fact they have two: regulating defined benefit pension schemes and regulating public service pension schemes. Both started in December and are due to wind up in February. The defined benefit pension schemes one alone runs to over 160 pages across the four documents published. All at the busiest time of the year for most pensions actuaries, caught between the 31 December 2013 accounting disclosures and the looming deadlines for submitting the 31 December 2012 scheme funding assessments. Could it be that they are rather hoping to limit the feedback they get?

Because the changes that are being proposed to the funding regime known as scheme specific funding which has run for 8 years are dramatic. Under the pretext of only making changes to allow the introduction of the Regulator’s new objective to “minimise any adverse impact on the sustainable growth of an employer” (see my previous post on this), they have effectively announced the death of scheme specific funding and proposed a system which looks very much like the Minimum Funding Requirement (or MFR – the previous discredited funding regulations) mark two to me, although the Regulator insists that it will be completely different this time.

The main problem with the MFR was that it was a one-size-fits-all approach (although it did vary in strength depending on how far on average members had to go until benefits were paid – known as the duration of the scheme), which encouraged an inappropriate level of contributions for many schemes (the minimum funding requirement effectively became a maximum funding requirement in many cases).

Fast forward to now, and the new proposed funding approach based around something called the Balanced Funding Outcome (BFO). This calculates a required level of assets for each scheme on an “objective liability measure, independent of the scheme’s funding assumptions”. The actual assets will be compared with the required amount and a recommended level of contributions to get up to the required level will then be calculated by the Regulator. The contributions the scheme trustees have agreed with the scheme’s employer will then be assessed to see if they measure up. Where MFR varied by duration, BFO will vary by duration and covenant (how likely the employer is to stick around to pay the last pensioner). So, as you can see, completely different!

At the end of Appendix G of the 50 page draft funding policy, we finally find the problem that I think the Pensions Regulator really wants to solve:

Look at all those dots. They’re all over the place. There is currently absolutely no correlation between the deficit reduction contributions (DRCs) employers are paying and the funding level in their schemes. The Regulator is determined to change that, by giving trustees and employers sight of their preferred contribution number during their negotiations. The contribution number won’t be compulsory of course, but if you use it then the Regulator will leave you alone. It is almost as if they have never heard of Daniel Kahneman or behavioural economics.

What will happen? Well who knows but here’s a guess. Schemes to the bottom left of the chart above (ie low assets and contributions) are already being subjected to extra scrutiny and generally have employers in such a poor financial state that there is very little they can do about it. But those in the top right will effectively have been given permission to swoop down to the blue line with a whoop of “Pensions Regulator’s new objective”. It will be like the 90s all over again when pension schemes took contribution holidays because they were measuring their funding in an unrealistic way. It will be seen as financially stupid to be in the top right of the Regulator’s graph. Group think will be in charge once more. But, to use another quote from Yogi Berra, the baseball icon, “If you don’t know where you are going, you might wind up someplace else”.

If we agree to this we will be making the pensions system more fragile. The model used by the Regulator will not anticipate the next defaulting economy or other Black Swan that throws currency and financial markets into meltdown (no one was suggesting Argentina would default a month ago) and reduces everyone’s level of funding, so when that happens everyone will be in trouble rather than just the proportion of schemes in difficulties we have now. The overall funding risk of defined benefit pension schemes will be inflated so much that the system may not easily recover.

It gets worse. There is a lot in this consultation about governance, and also references to asset liability modelling, due diligence, reverse stress testing, scenario testing and covenant advice. These are all things which are likely to be a problem for small schemes, which I pointed out previously when they were proposed by EIOPA (because, let’s be clear, it is compliance with prospective EU legislation which has driven many of these proposals). But guess which group are going to see an almost total reduction in the scrutiny they get from the Regulator under the new regime? That’s right: small schemes.

There is still time to register your opposition to reliving the last 15 years of defined benefit pensions all over again: the consultation runs until 7 February.

When the levy breaks

13. January 2014 · Write a comment · Categories: Actuarial, Pensions, Regulation, Risk

For those people who are not pensions geeks, let me start by explaining what the Pension Protection Fund (PPF) is. Brought in by the Pensions Act 2004 in response to several examples of people getting to retirement and finding little or no funds left in their defined benefit (DB) pension schemes to pay them benefits, it is a quasi autonomous non-governmental (allegedly) organisation (QUANGO) charged with accepting pension schemes who have lost their sponsors and don’t have enough money to buy at least PPF level benefits from an insurance company. It is, as the PPF themselves appear to have acknowledged with several references to the schemes not yet in their clutches as the “insured” in a talk I attended last week, a statutory insurance scheme for defined benefit occupational pension schemes, paid for by statutory levies on those insured. As a scheme actuary I have always been very glad that it exists.

The number of insured schemes has dwindled since it was named the 7800 index in 2007 (with not quite 7,800 members at the time) to the 6,300 left standing today. As you can imagine, the ever smaller number of schemes whose levies are keeping the PPF ship afloat are very nervous about how that cost is going to vary in the future. They have seen how volatile the funding of their own schemes is, and seemingly always in the worst case direction, and worry that, when their numbers get small enough, funding the variations in PPF deficits could become overwhelming. Particularly as the current Government says whenever it is asked (although no one completely believes it) they will never ever bail out the PPF.

So there has been keen interest in the PPF explanations of how those levies are going to change next year.

PPF levies are in two parts. The scheme-based levy, which is a flat rate levy based on the liability of a scheme, and the normally-much-bigger-as-it-has-to-raise-around-90%-of-the-total-and-some-schemes-don’t-pay-it-if-they-are-well-funded-enough risk-based levy. The risk-based levy depends on how well funded you are, how risky your investment strategy is and the risk your sponsor will become insolvent over the next 12 months.

It is this last one, the insolvency risk, which is about to change. Dun and Bradstreet have lost the contract to work out these insolvency probabilities after eight years in favour of Experian. However, unfortunately and for reasons not divulged, the PPF has struggled to finalise exactly what they want Experian to do.

The choices are fairly fundamental:

The model used. This will either be something called commercial Delphi (similar to the approach D&B currently use) or a more PPF-specific version which takes account of how different companies which run DB schemes are from companies which don’t. The PPF-specific version looks like it was originally the front runner but has taken longer to develop than expected.

The number of risk levels. Currently there are 10, ie there are 10 different probabilities of insolvency you can have based on the average risk of the bucket you have landed in. One possibility still being considered at this late stage is not grouping schemes at all and basing the probability on what falls out of the as yet to be announced risk model directly. This could result in considerable uncertainty about the eventual levy. Even currently, being in bucket 10 means a levy 22 times bigger than being in bucket 1.

So reason for nervousness amongst the 6,300 perhaps? The delay will mean that it won’t be known by 1 April (an appropriate date perhaps) when data starts to be collected for the first levies under the new system next year. Insolvency risk is supposed to be based on the average insolvency probability over the 12 months to the following March, but the PPF will either have to average over a smaller number of months now or go back and adjust the “failure scores” (as the scale numbers which allocate you to a bucket are endearingly called) to the new system at a later date. Again, the decision has yet to be made.

All of this suggests an organisation where making models is much easier than making decisions. And that is in no one’s interest.

Perhaps surprisingly in the audience I was in, the greatest concern expressed was about the fact that the model the PPF uses to assess the overall risk to their future funding (and therefore used to set the total levy they are trying to collect each year) was different from either the current D&B approach, or either of the two possible future approaches, to setting failure scores, ie the levies they pay are not really based on the risk they pose to the PPF at all.

There are obviously reasons why this should be the case. Many of the risk factors to the PPF’s funding as a whole would be hard to attribute, and therefore charge, to individual sponsors. For instance the PPF’s Long-Term Risk Model runs 1,000 different economic scenarios (leading to 500,000 different scenarios in total) to assess the amount of levy required to ensure at least an 80% chance of the PPF meeting its funding objective of no longer needing levies by 2030. Plus it plays to sponsors’ basic sense of fairness that things like their credit history and items in their accounts (although perhaps not including, as now, the number of directors) should affect where they stand on the insolvency scale, rather than things that would impact more on PPF funding, like the robustness of their scheme deficit recovery plans for instance.

It is rather like the no claims discount system for car insurance. This has been shown to be an inefficient method for reallocating premiums to where the risk lies in the car driving population, and this fact has been a standard exam question staple for actuarial students for many years. However it is widely seen as fair by that car driving population and would therefore be commercial madness for any insurer to abandon.

So there we have it. The new PPF levy system. Late. Not allocating levies in accordance with risk. And coming to a pension scheme near you soon.

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