Skin in the right game

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

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

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

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

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

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

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

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

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

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

Prediction markets can help with all of these problems:

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

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

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

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

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

The Wizard of EIOPA

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

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

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

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

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

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

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

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

a1

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

b1

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

d3

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

e4

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

i3

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

 

DA = CB

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

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

Pension active membership

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

Source: Office of National Statistics

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

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

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

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

Decile savings

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

Source: Office of National Statistics

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

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

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

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

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

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

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

And we really need to start now!

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.

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