Skin in the wrong game

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

The main reason I set up this website was to draw more attention to the fact that we are fairly useless at making economic predictions. The graph I use as a logo is just one of many comparisons of economic projections with reality which could be shown to demonstrate just how useless. The problem is that there is then a bit of a void when we are looking for ways to support economic decision making. Nassim Nicholas Taleb and Nate Silver are, in different ways, exploring ways to fill this void.

Taleb, in his book Antifragile, links the fragility of the economic system, amongst other things, to an absence of “skin in the game”, ie something to lose if things do not go to plan. Something is fragile if it is vulnerable to volatility, robust if it is relatively unaffected by it, and antifragile if it profits from volatility. If decision makers gain an upside when things go right, but are effectively bailed out from the downside when they don’t by others who then suffer the downside instead, they will have no real incentive to be sufficiently careful about the decisions they take. This makes the chance of a downside for everyone else consequently greater. Taleb refers to people in this position, championing risky strategies (or, more often, strategies where the risks are not really known) without facing the risks personally, as “fragilistas”. He suggests instead a system of “nonpredictive decision making under uncertainty” on the basis that “it is far easier to figure out if something is fragile than to predict the occurrence of an event that may harm it”.

Silver, in his book The Signal and the Noise, suggests the main reason why economic predictions are routinely so awful, even when the forecasters are trying to be accurate rather than making a splash, is that the events forecasters are considering are often out of sample, ie the historical data they are considering to make their forecasts do not include the circumstances currently being faced, but that the forecasters are confident enough to make predictions despite this. This explains, for instance, the failure in the US to predict the housing crash (there had never been such a boom before), the failure of the ratings agencies to understand how risky mortgage-backed securities were (they were in new more complex forms) and the failure to predict that the housing market would take the rest of the economy down with it (much more trading betting on house price rises that did not materialise than had ever been seen before).

Silver cites the economist Terence Odean of the University of California at Berkeley, whose paper Do Investors Trade Too Much shows that equity traders trade excessively in the sense that their returns are, on average, reduced through trading (due to transaction costs), and suggests that this is partly due to overconfidence in the constant stream of information in the media drawing their attention from one possible model to another. This effect can be modelled to show that markets behave irrationally in the presence of overconfident decision making, even when decision-makers are otherwise completely rational.

However, when we are looking at the calls made by traders there are other forces at work that make things even worse. Silver’s book advances the theory that it is not so much an absence of skin in the game that leads traders to continue betting on rising markets when bubbles have started to develop, but skin in the wrong game (at least from the point of view of the rest of us fragile people). He gives the example of a trader looking a year ahead to make a call on whether the market will crash or not. If he buys and the market rises everyone is happy. If he buys and the market crashes, he will be in the same boat as everyone else and will probably keep his job if not his bonus. If he sells and the market crashes he will be seen as a genius, but the tangible rewards of this beyond his current position might not be life changing. However, if he sells and the market rises he may never work in the industry again.

For a trader who wants to keep his job and remain popular with his colleagues, selling therefore has limited upside and unlimited downside, to analyse it in a Talebian way. Buying on the other hand has potentially unlimited upside while the music is playing and limited downside when it stops. So these traders do have skin in the game, which keeps them buying even when they can see the iceberg approaching, and does not particularly reward accuracy in forecasting. It’s just a different game to the one the rest of us are playing.

For these amongst many other reasons, economic forecasting (Silver differentiates forecasting – meaning planning under conditions of uncertainty – from predicting – meaning calling the future correctly) is unlikely ever to be very accurate. But whereas Taleb believes that planning for the future must be nonpredictive to avoid making suckers of us all, Silver believes there may be some scope for improvement. This brings us to the idea of prediction markets and their ability to introduce some of the right skin in the right game, which I will discuss in my next post.

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!

Getting excited about economics

16. May 2013 · Write a comment · Categories: Economics

The people in power have no real belief that Plan A will work but refuse to even consider there might be a Plan B. They occupy themselves and the surrounding elite class bubble in which they operate with trivial concerns played out as if they were life and death ones, and the rest of the population are pacified with horse tranquilisers muscle relaxant.

Sound familiar? There is also inevitably a banker involved and someone who cannot stop herself from making dire predictions which her fellow travellers cannot prevent themselves from taking seriously.

Pedro Almodovar has come in for a fair amount of criticism for the perceived shallowness of his latest film Los Amantes Pasajeros (presented as “I’m So Excited” in English due to the prominence of the Pointer Sisters’ song in the film, but more literally translated as the on board or passing lovers). However what came to mind most strongly for me when watching it was Bismarck’s famous comparison between the making of laws and sausages (ie not a pretty sight). And indeed quite a few sausages are “made” during this film, under the influence of a “Valencia cocktail” with added mescaline, as all efforts are concentrated on sleepwalking to the planned emergency landing at an as yet unavailable airport in as pleasantly mindless a way as possible.

An economic policy in which only a tiny minority have any idea what is going on and only a tiny minority of that tiny minority feel able to influence what is going on in the cockpit is a shallow one. Perhaps we all need to get a bit more excited.

The Clocks and the Wind

12. May 2013 · Write a comment · Categories: Birmingham, Economics, Prediction

There has been much discussion over the past few months over whether high levels of debt cause low growth (the “austerian” camp, eg Britain, Canada and Germany within the G7) or whether instead low growth causes high levels of debt to accumulate (the “Keynesian” camp, to which Japan appears to be providing leadership currently). There has been relatively little discussion about the possibility that neither is the case.

We are compulsive pattern spotters. That explains to a large extent our dominance as a species, and completely explains the dominant position that mathematics and its applications holds in our culture.

I was reminded most stirringly of this a few years ago, on a lunch break. The Ikon Gallery in Birmingham was hosting an exhibition by Japanese sound artist Yukio Fujimoto called The Tower of Time. However, instead of siting it at their gallery space in Brindley Place, it had instead been staged at Perrott’s Folly, just around the corner from my office at the time.

Yukio Fujimoto. The Tower of Time
Installation view – Perrott’s Folly, Birmingham, UK 2009  Photo: Stuart Whipps

Perrott’s Folly was built in 1758 by John Perrott. It is a building 94 feet high, with one room on each of its six octagonal floors, and no obvious purpose (hence “folly”). It may have been somewhere to spy on his wife from, while she was alive or dead, or it may have been a gambling den for him and his mates. Or it may have been something else entirely. I think we are unlikely to ever know for sure.

After a brief introduction on the ground floor, I climbed the stairs to the first floor to find one little black square alarm clock with a red second hand ticking in the middle of the wooden floor. The next floor had ten such clocks, in a row. The next 100, in a square, the fifth floor had 1,000.

A curious thing happened to me as I moved up the tower. The clocks’ mechanisms appeared to alter with altitude. I put it that way as an example of an obviously false causality, ie that the height above sea level in some way affected how the clocks worked (and before I get complaints, I mean effects that could be detected within a matter of a few tens of feet and with no measuring equipment other than my eyes and ears). Because what I saw did change. I looked at one clock and I could see that the battery was powering the gear mechanism that kept the second hand, minute hand and hour hand in their required relative motion. I looked at ten clocks in a row and I could see the same, although I also noticed the second hands were not all at the same point along the row and that there was an order in which each piece of red plastic reached the top before beginning the next circuit. I found myself having to watch the clocks for several minutes to see the pattern confirmed. But was this “pattern” anything which had any meaning, or was it just a way for my brain to store the images it was collecting in an easily fileable format?

When I moved to 100 clocks, the relevance of the gear mechanism became secondary. I could “see” lines of second hands moving together in the way that lines of plants in a cornfield move with the breeze. This, combined with the swooshing of 100 clocks (as the ticking of each individual clock combined to make a different noise – this change in sound was I believe the artist’s main reason for constructing the installation in the first place), made me need to check several times that one of the strange pointed windows in the tower had not been opened and let in a stray breeze. At 1,000 clocks it was just pure cornfield, the individual clocks now as hard to imagine as it had been to imagine anything else four floors below.

I can “see” that the “wind” is blowing a pattern through the second hands of the clocks and yet I “know” that this is not happening. Now transfer that wind I can see to a situation where I do not readily have a theory for what is happening to individual elements within a system. Suddenly what anyone with eyes can see becomes so much more powerful than what we might know. Returning to the austerity debate for instance, perhaps the individual growth clocks have no relationship with the patterns of debt I can see being blown through them. Perhaps if I just arranged the clocks differently I would see the wind blowing from a different direction. Perhaps the clocks and the wind have nothing to do with each other outside my head, despite the “evidence” of my eyes.

Why does it matter? Because if we cannot prevent ourselves from seeing patterns and then extending them via models where we have to make some things depend on other things, even in the face of weak and conflicting evidence, then we need to know this about ourselves. Because if giving a person the wrong map is worse than not giving him one at all, our natural instinct to construct these maps is likely to keep getting us into trouble.

The Threat of a Good Example

09. May 2013 · Write a comment · Categories: Actuarial, Economics, Pensions, Regulation

The interests of the UK’s private sector defined benefit (DB) pension scheme members, and the security of their vested benefits (ie the ones they are entitled to keep), were weakened this week. The Pensions Regulator, slow to act in many cases, bureaucratic and inconsistent in others, did at least have a coherent set of objectives which allowed it to focus on reducing the fragility of the pensions system overall. However this is not an example of how the Government wants its regulators to behave it seems. The announcement in the Budget in March that the Regulator is to get an additional statutory objective to encourage “sustainable growth” amongst scheme sponsors, following sustained lobbying from the National Association of Pension Funds and the Confederation of British Industry, led to a swift consultation on, and acceptance of, the proposals. It also appears to have led to an equally swift exit for the Regulator’s chief executive Bill Galvin (he leaves next month) who had had dared to reject calls for such an objective, pointing out reasonably that the existing arrangements required the Regulator and trustees to balance the interests of business, the pension scheme and the Pension Protection Fund.

So here it is, the Pensions Regulator’s first statement on DB pension schemes since the new objective was announced. The Regulator looks to have been very mindful of the not-yet-quite-existing objective in framing this statement and, although the precise wording of the objective is not expected until later in the year, has obviously already decided which way the wind is blowing. The key word that jumps out at you on a first skim is “flexibility”, which seems to be the new code for weakening regulation now that “light touch” has been discredited. This contrasts with last year’s statement, when the use of the word was accompanied by a warning that “we will consider whether the flexibility in the funding framework has been used appropriately”, ie emphasising the limits of flexibility rather than its possibilities.

There are also a number of areas where the position taken by the Regulator on funding appears to have noticeably weakened since 12 months ago. Here, in my view, are some of the main ones (italics are mine):

Section

Pension scheme funding in the current environment – April 2012

Section

Defined benefit annual funding statement – May 2013

17

In the regulator’s view, investment outperformance should be measured relative to the kind of near-risk free return that would be assumed were the scheme to adopt a substantially hedged investment strategy.

7

Trustees can use the flexibility available in setting the discount rates for technical provisions…to adopt an approach that best suits the individual characteristics of their scheme and employer.

19, 14

The regulator views any increase in the asset outperformance assumed in the discount rate to reflect perceived market conditions as an increase in the reliance on the employer’s covenant. Therefore, we will expect trustees to have examined the additional risk implications for members and be convinced that the employer could realistically support any higher level of contributions required if the actual investment return falls short of that assumed.

…Where appropriate the use of actual post valuation experience is acceptable.

 

8

The assumptions made for the relative returns of different asset classes may rise or fall from preceding valuations reflecting changes in market conditions and the outlook for future returns. Trustees should ensure that they document their reasons for change and have due consideration to any increase in risk this might bring.

2

As a starting point, we expect the current level of de­ficit repair contributions to be maintained in real terms, unless there is a demonstrable change in the employer’s ability to meet them.

 

12

Where there are significant affordability issues trustees may need to consider whether it is appropriate to agree lower contributions and this may also include a longer recovery plan. Trustees should ensure that they document the reasons for any change and indicated that they have had due consideration of the risks.

Finally, under the heading what you can expect from us, the Regulator also mentions that it has discarded any triggers it had for subjecting schemes to further scrutiny “on individual items such as technical provisions”.

Unfortunately the combined impact of the changes in emphasis, specific wording and the ditching of the triggers would appear to directly conflict with two of the Pensions Regulator’s definitely-still-existing objectives, namely:

  • to protect the benefits under occupational pension schemes of, or in respect of, members of such schemes; and
  • to reduce the risk of situations arising which may lead to compensation being payable from the Pension Protection Fund.

The House of Lords Select Committee on Regulators in 2007 concluded that:

  • Independent regulators’ statutory remits should be comprised of limited, clearly set out duties and that the statutes should give a clear steer to the regulators on how those duties should be prioritised.
  • Government should be careful not to offload political policy issues onto unelected regulators.

We will have to wait and see exactly where this new objective is to be pitched, but, on the evidence of this funding statement from the Regulator, there must now be considerable doubt that either of the select committee principles will be met.

Set any organisation conflicting objectives and no clear way of prioritising between them and the chances are they won’t achieve any of them. The Pensions Regulator has already started to run this risk.

Needles and Pins 3 May 2013

03. May 2013 · Write a comment · Categories: Cartoons, Prediction

 

Spreadsheets and the Under Toad

29. April 2013 · Write a comment · Categories: Actuarial, Economics

In The World According to Garp, John Irving describes how Garp’s son mishears the word “undertow” as a source of danger at the seaside as a child, and spends the rest of his life in fear of the “Under Toad”.  This word now appears in dictionaries as referring to a general fear and anxiety about the unknown and mortality. It sounds like a word almost designed for actuaries, and never more so than when dealing with spreadsheets.

Spreadsheets are of course currently in the news because Thomas Herndon, a graduate student at the University of Massachusetts, was set an exercise to choose an economics paper and replicate its results. He chose Growth in a Time of Debt, a paper by Professors Reinhart and Rogoff, which had been cited by George Osborne more than any other in defence of his policy of austerity.

He couldn’t replicate any of it, and when the professors sent him the spreadsheet they had used, the reasons why became apparent. Only 15 of the 20 countries with high public debt in the analysis had been included in the calculation of average GDP growth. The As to Ds had been missed off. The paper had not been peer reviewed.

This particular error, when combined with other criticisms Herndon and his professors had of the methodology used in the paper, provided considerable challenge to the original conclusions of the analysis and was therefore widely reported due to its implications for UK economic policy in particular. However errors of this kind in Excel spreadsheets are very common.

The European Spreadsheet Risks Interest Group, or EuSpRIG (“yewsprig”) for short, is an organisation sponsored by a group of heavy spreadsheet users which runs conferences and forums designed to pool users’ experiences and suggest best practice in spreadsheet use. EuSpRIG are therefore connoisseurs of the spreadsheet error. They helpfully include a list of spreadsheet horror stories on their website, including the GDP growth one.

Perhaps the most significant spreadsheet foul up on their list is described in the Report of JP Morgan’s Management Task Force regarding billions of losses in 2012 in its chief investment office, which cited a number of spreadsheet errors. However, my personal favourite is the one involving the London 2012 organising committee (Locog) confirming in January 2012 that an error in its ticketing process had led to four synchronised swimming sessions being oversold by 10,000 tickets. Locog said the error occurred when a member of staff made a single keystroke mistake and entered “20,000” into a spreadsheet rather than the correct figure of 10,000 remaining tickets.

It is tempting to think that our technological advancement and exponentially increasing computer power have made some kind of computational HD within our grasp, with every wart and blemish of the object of investigation now detectable by our ever more sophisticated tools. But EuSpRIG estimate that over 90% of spreadsheets contain errors. Most of these will never be found, but lurk beneath the surface threatening the accuracy of any calculations carried out by the spreadsheets concerned. In other words, the Under Toad.

Carveth Read once said (although only famously when it got attributed to Keynes): “It is better to be vaguely right than exactly wrong.” However, when most spreadsheets contain Under Toads, it is clear that a lot of the supposed precision with which information is provided to us is illusory. That exponential increase in computer power has made even the very measurement of precision in the more complicated spreadsheets virtually unknowable. We may never be more than vaguely right, but often have no real idea how wrong we are.

So we check, to ensure that the numbers coming out of the spreadsheets and other models we use are within a tolerable distance of what we would expect. Some of us use pen and paper. The GDP growth Under Toad might for instance happen when a formula which adds up a column in one worksheet is copied to another worksheet where the columns have a different number of rows in them, and the formula is not adjusted. I have certainly done that before now, and only found it when I checked it against a number of other sources. For this reason, I am always a bit nervous about model results being checked by spreadsheet. It doesn’t seem sufficiently unlikely to me that the two could be acceptably close to each other but, perhaps due to entirely different errors, many miles from the truth.

There is a generation of actuaries, of which I am one, that experience almost physical pain when we see students carrying out even the simplest calculations using spreadsheets, knowing that each new one on the block is almost certainly adding to the unknown unknowns of the Under Toad. I know there are just as many mistakes in my biro scrawls, but I also know it will be a lot easier to find them later.

A GDP increase of 0.3% on Thursday was greeted with relief at a triple dip averted, when a fall of just 0.1% would have been met with anguish. Tiny movements in the FTSE 100 are described as “up” and “down”, as if the direction were more important than the amount and when “broadly unchanged” would be a more informative description.

We are obsessed with tiny movements which contain no information and which, thanks to the Under Toad, we cannot meaningfully calculate. This obsession distracts us from seeing the bigger picture, the fuzzy connections that only become apparent when we look up from our HD sharp tiny piece of detail. And our spreadsheets won’t help us with that.

Relax Luther, it’s much worse than you think

24. April 2013 · Write a comment · Categories: Actuarial, EIOPA

On 9 April, the European Insurance and Occupational Pensions Authority (EIOPA) published the preliminary findings of the quantitative impact study on its proposed changes to the Institutions for Occupational Retirement Provision Directive (or IORP II as some have started to call it). That sentence might not mean much to many people. But once you understand that EIOPA is the pensions regulator for the whole EU and that IORP is the European word for pension scheme you will probably be expecting bad news. And you would be right.

The study showed that the combined deficits of the 6,432 defined benefit pension schemes in the UK as at 31 December 2011 would have increased from £300bn (the UK Pensions Regulator’s calculated figure) to £450bn (based on methodology designed to bring pension funding more in line with insurance company reserving).

The National Association of Pension Funds warned that this move would put a “huge burden” on remaining UK defined benefit pension schemes and the businesses that run them.  Steve Webb warned that “The EU’s latest figures show the extremely high cost its plans would place on UK defined benefit pension schemes.”

Others were less positive about the proposed changes.

However, I am reminded every time this story is reanimated by the latest stage in the unending dance of death of the European insurance and pensions legislative process, of the line Tom Cruise uses in Mission Impossible to calm objections to his scheme to break into CIA Headquarters. It really is much worse than you think.

IORP II was set in motion with 3 main aims:

  • to make cross border schemes more widely used (which are avoided by most UK employers as they require an immediate increase in funding level in most cases);
  • to create a level playing field between pensions and insurance; and
  • to make sure that this level playing field includes a common supervisory system at EU level which is risk-based.

Which all adds up to a lot more than just a new funding requirement.

Therefore, quite apart from any proposals on extra funding, in over 500 pages of advice to the European Commission last year, EIOPA recommended:

  • The same governance requirements for pension schemes as for insurers. Getting governance and the documentation of it right has and continues to be a challenge for insurers with all of the resources available to them. Can trustees of pension schemes realistically be expected to do the same?
  • Fit and proper requirements for pension scheme trustees equivalent to the requirements of boards of insurance companies. The implication is that the current trustee toolkit might not cut it any more. Might this mean the end of the non-professional trustee?
  • Similar risk management requirements for pension schemes to those of insurers. This would include the possibility of pension schemes needing to set up contingency funds for “operational risks”, eg errors made in administering the scheme that might lead to losses, for the first time.
  • The requirement to conduct an Own Risk and Solvency Assessment (ORSA) for pension schemes. Again, these are very demanding exercises for insurance companies who have whole departments devoted to conducting them.

I could go on. Unfortunately the one thing that is certain is that EIOPA will go on. They have demonstrated through the tortuous nature of the process to date that their tolerance of bureaucracy is almost unlimited. There is a principle of proportionality referred to in the recommendations, which is supposed to mean that no organisation has requirements foisted on it totally out of proportion to the risks it poses to the financial system, but this has yet to be properly tested.

My fear therefore is that what we might have assumed would be regarded as unreasonable requirements of groups of mainly volunteer trustees trying to look after member benefits in their pension schemes will be viewed by the European institutions who will vote on these recommendations as nothing of the sort.

Hopes over Experience

19. April 2013 · Write a comment · Categories: Economics, Prediction

“IMF slashes UK growth forecast”. Does this sound familiar? It should. Every 9 or 10 months the headline seems to return to the newspapers in an almost identical form. September 2011, July 2012 and now “IMF slashes” is back this month. This occurs every time the IMF’s world economic output report (full reports every April, updates every October) happens to adjust down one of its predictions for UK growth.The latest is entitled Hopes, Realities, and Risks and is notable for its Oxford comma.

According to Stephanie Flanders, the BBC Economics Editor, the IMF rarely gives direct advice on the back of these reports, preferring to give discreet prompts. However this time the report says about the UK: “Greater near-term flexibility in the path of fiscal adjustment should be considered in the light of lacklustre private demand.”

Olivier Blanchard, the IMF’s chief economist, even singled out the UK in response to a question while launching the latest report: “There are a few countries where there is enough fiscal space to go further – one example is the UK. In the face of weak demand it is really time to consider an adjustment to the initial fiscal consolidation plans.”

So there you are, we are all doomed unless we change policy. You would imagine that an institution would have a fairly solid track record of understanding countries’ economies and making reasonably accurate predictions on the back of this expert knowledge for it to feel able to lecture us all quite so authoritatively. Unfortunately, they don’t.

As you can see, compared to the stacks of predictions the IMF have given us over the last 4 years on growth in world output alone, the actual growth figures are unfortunately fairly clearly outliers. The one thing we can take from the latest report with any confidence is that the current projections for 2013, 2014 and 2018 will not only be wrong, but probably by miles.

So it would be very difficult to justify a change in economic policy on the basis of a world economic output report. Which is a pity, because I agree that many of us will be doomed to a life of fewer opportunities and less economic independence if the current contractionary policies continue, scrabbling around for our share of a crumbling welfare state while the few of us already immunised from society by money feel very little pain at all. For a proper description of why austerity is a very bad idea, read Paul Krugman’s End This Depression Now or read his blog. Read the account of the Great Capitol Hill Baby Sitting Co-op crisis on page 26, which originally appeared in a 1977 article by Joan and Richard Sweeney. The means for ending the double dip, soon to be triple dip and probably ultimately corrugated recession are in our hands and have been known about for decades. Your spending is my income, and my spending is your income, so we need to stop contracting our economy.

And we also need to stop reading IMF reports.

 

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