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!

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.

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.

Actuaries and Science Fiction

18. April 2013 · Write a comment · Categories: Actuarial, Prediction, Science Fiction

Brian Aldiss told me a story the other week (at the Birmingham Science Fiction Group, where he is an honorary president) about Margaret Thatcher and her attitude towards science fiction. Kingsley Amis had been invited to a party at Downing Street and had decided to take along an inscribed copy of his latest book Russian Hide and Seek. Mrs Thatcher, a little suspicious about what she was being handed, had apparently asked what it was about.

Amis had explained that it was set in the future when the UK had been under Russian occupation for 50 years.

“Can’t you do any better than that?” the Prime Minister is reported to have said. “Get yourself another crystal ball.”

Aldiss recounted this story as he felt it illustrated how Mrs Thatcher totally misunderstood what science fiction was about. It was not about prediction of the future, but for people who “liked the disorientation” (the essence of science fiction in Aldiss’s view) of portraying an unfamiliar landscape and trying to work out what would hold true under different circumstances.

It seems to me that this is also what being an actuary is about. Actuaries are not about prediction either, but they are prepared to embrace the disorientation of asking what ifs and exploring maybes, and, by so doing, try to quantify what different currently unfamiliar landscapes might look like.

Science fiction has many forms but two main camps politically: the camp which believes a more enlightened form of society is possible (although what that means might vary considerably between different campers); and the camp which doesn’t but instead believes that all we can hope to do is survive a remorseless universe governed by nothing more than the laws of physics and evolutionary biology.

I think actuaries may have leaned more towards the second of these world views, particularly in fulfilling their statutory roles in recent years. We have worked within the remorseless universe of regulators and assumed that increasingly complex systems will make us safer in a Darwinian financial world. However the group think this has inevitably promoted has made us all less safe. As a result, we have heard many voices in the discussions about the financial crisis, including many what ifs and maybes, but few of these voices have been actuaries’. To quote Bob Godfrey (admittedly he was talking about animation at the time), the professionals are in a rut and the amateurs aren’t good enough.

Actuaries need to put themselves about as much as the amateurs do. Sometimes that will be uncomfortable. Sometimes we may look a little foolish for a while. But in my view it is the only way we are going to contribute meaningfully to the construction of a better society. And we might even produce some decent science fiction in the process.

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