Deus Ex Macchiato

Phil Hogan’s review of The Age of Absurdity in Sunday’s Observer made me realise that I had not explained myself very well a few days ago when I was talking about the baby boomer generation and pensions. Let me try again. First, Hogan:

Modern life … has deepening our cravings and at the same time heightening our delusions of importance as individuals. Not only are we rabid in our unsustainable demands for gourmet living, eternal youth, fame and a hundred varieties of sex, but we have been encouraged – by a post-1970s “rights” culture that has created a zero-tolerance sensitivity to any perceived inequality, slight or grievance – into believing that to want something is to deserve it.

What has this got to do with pensions? Well, three things.

1. The sense of entitlement has made it politically impossible not to make bigger and bigger promises. In some sense this is a good thing: looking after the elderly is a sign of civilisation.
2. However, because of the competing sense of entitlement of the current generation, these promises have not been funded. That has created an intergenerational tension that – at currently mortality and economic growth rates at least – is not resolvable. At least one generation is going to end up very unhappy, and possibly more than one.
3. At the same time, increasing selfishness has made the situation worse, in that structures have been designed which offer a bad balance between pensions risk and pension return.

That last point should be elaborated.

Suppose you have the choice of two pension schemes: one of which gives the return distribution in solid blue; the other the one in dotted green. The dotted green distribution has a higher average pension, but more volatility, and hence a higher probability of underfunding. It’s riskier. Most people, given the importance of their pensions as a fraction of their assets, would opt for the pension in blue.

Now though suppose that there is a backstop at the level indicated by the dotted line. Then the situation changes: we might well decide to take the extra risk, given that catastrophic underfunding is protected against.

Collective pension schemes provide two forms of diversification. Firstly they have asset diversification – by investing for many people together, they can access asset classes which require high minimum investments, such as some alternative investments. Secondly they have temporal diversification – we only need enough money to pay claims as they become due, not cohort by cohort, so periods of markets falls are offset to some degree by later or earlier rises. Mean reversion in asset prices works in the pensioner’s favour. Moreover regulation usually means that some form of backstop is provided for collective schemes either from the sponsoring company, or the state, or both.

Thus collective pensions can take greater risk than individual ones. If you are investing just for yourself, you rationally should take less risk and hence expect a lower return than if you participate in a collective scheme. This is downside of selfishness: if you don’t want your funds to be available to help other people, then your expected return is lower. No matter what your political persuasion, you should want the red flag flying over your pension fund.

Posted in: Economic Theory, Pensions, Politics by David /
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We begin with something interesting, if wrong. Did Woodstock hippies lead to US financial collapse? (HT the Economist’s View). The sense in which there might be something to this rhetorical (at least in the author’s mind) question is that changes in morality which started in the 60s in some sense contributed to the current crisis. But so too did flows of money which intensified with the rise of the baby boomer generation, combined with other social and political changes.

Consider the big picture:

• Morality first. There is no doubt that the attitude to debt has changed. North Americans, in particular, used to view repaying debt as more of a moral obligation than they do now. Thus we get more opportunistic (negative equity related) defaults than we used to. This was not a major driver of the credit crunch, but it did have an effect.
• Baby boomer pensions were a major cause. Those dang hippies were just too successful: they made all this money which needed a home. Government bond yields were derisory, so some of this cash was sucked into AAA rated ABS. The same goes for the riches of the newly industrialising BRICS. This wave of hot money, more than hippy morality, was a key crunch driver.
• Transactional, as opposed to relationship capitalism led to the originate-to-distribute model and so to making loans without worrying about whether they would perform. That is not a 1960s invention: it dates back at least to the 19th century, and arguably much further.
• Finally, wealth growth. If GDP keeps growing, and you can tax it at more or less a constant rate, you don’t have to fund current promises as the future will pay. This mañana attitude to government and pension finance allowed higher levels of consumption during the good times. But now times are not good, we need (in Interfluidity’s apposite phrase) ‘redistribution for which there is no overt legal framework or political consensus’.

The make love not war generation didn’t help, then, but it was not permissiveness that was primarily to blame: it was systemic weaknesses in Anglo Saxon capitalism that interacted with a wave of hot money to create the Crunch and its damaging aftermath.

Posted in: Economic Theory, Mother of all Bailouts, Pensions, Politics by David /
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Time magazine has an interesting article about Roy Smith, a NYU professor and former Goldman partner. (Hat tip Felix Salmon.) Smith picks up a point that was originally (so far as I am aware) made by Willem Buiter in the FT, namely that a major enabler of financial crises is a large amount of money looking for a home.

There is now about $140 trillion in market capitalization in the word’s financial markets looking for investments. That money can now move around very easily. But even if a relatively small portion of that money goes after something — say, mortgages — it can quickly cause a bubble and a crisis.

This is absolutely true. Remember, we could not have had the crunch without buyers of AAA ABS risk. Who bought it? People looking for a safe home for their money that had a bit higher a return than AAA government bonds. Without all that money from the BRICs countries, baby boomer pensions and so on, we would not have had a crisis. We need to get better at finding genuinely safe ways of investing that amount of liquidity without introducing the risk of massive instability. Hot money naturally moves when there are problems. The right answer isn’t obvious.

I’ll make two observations, though.

The first is that the historical answer was to hide the instability. That’s what accrual accounting does. If money is in bank deposits, and is used to make loans, as in the classical banking model, then the same instabilities are there, but they are damped first by deposit protection and secondly by accrual accounting. The investors can’t see the problem with their investments (namely rising credit risk in the bank’s loan book) until it is almost too late. Therefore they don’t run, and so mostly we don’t have banking crises. It’s just that when we do, as in Japan, they are hugely costly and long lasting.

The second is that in the past there was significant inter-temporal subsidy. The classic defined benefit pension is a good example of this: an investor doesn’t get what they put in, but rather a benefit that is only loosely connected to it. If their contributions are invested well, everyone in the fund benefits; whereas if their contributions suffer a period of poor investment performance, everyone’s contribution rates are raised to cover the shortfall. As we have moved to more personalised investments, this form of cross subsidy is much less common.

My suspicion is that we need to find ways of damping down the flow of hot money without sacrificing too much growth. (Hence ‘the Bears problem’ – we want the velocity of investment funds to be high enough that credit can be obtained, but not so high as to endanger stability. It needs to be just right.) But what those dampers should be remains a difficult problem.

Posted in: Liquidity and liquidity risk, Pensions, Rules by David /
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Population is a hugely emotive topic. It seems that few people want to be told that they should not have many children as they wish. And certainly the history of population control is littered with oppression. But, as David Attenborough points out

The growth in human numbers is frightening. I’ve seen wildlife under mounting human ­pressure all over the world, and it’s not just from human economy or technology. Behind every threat is the frightening ­explosion in ­human numbers. I’ve never seen a problem that wouldn’t be easier to solve with fewer people

The mid point estimate for the Earth’s population in 2050 is over 9 billion. To meet our climate change targets at 9 billion, we will have to cut average emissions per person by 72%. Put simply, the planet cannot stand the weight of our numbers. It is time to acknowledge this hard, horrible fact and start a debate about what to do about it.

The downside of decreasing population is that it will have a large impact on several key parts of the financial system. In particular, as Zoe Williams discusses, pensions policy is based on the possibility of intergenerational subsidies. Current workers pay for current pensioners, at least much of the time in some countries. It will not be politically acceptable for this to continue, especially when fewer current workers have to pay for more pensioners. Again, this is political dynamite and given the entrenched interests, it is hard to discuss the issue. Problems this hard tend to inspire little more than depression in me. Still, at least the depressed don’t tend to breed.

Posted in: Pensions, Politics by David /
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Further to the discussion on Saturday, here are some more thoughts on risks in pensions and who should bear them.

Pensions are complicated things. Consider a typical defined benefit scheme. Here the pensioner has a right to a certain level of pension – often index linked – and the employer has an obligation to provide it. The pension is simply collateral against that obligation.

The first risk, then, is that the employer cannot meet that obligation, typically because they have defaulted, and the pension fund is not adequate. It is this risk that pensions protection legislation is meant to address.

The second risk is that the fund is not judged be adequate to meet the employer’s liability, causing the need to ‘top up’ the fund. I say ‘is not judged to be’ rather than ‘is not’ because the law requires an assessment of the future likelihood of adequacy to be made rather than a spot assessment. Ignoring for a moment the veracity of the assessment – which is questionable – let’s look at how a fund might fail to be sufficient to meet an employer’s liabilities.

There are two moving parts here: the fund assets, and the fund liabilities. Funds are typically invested in some or all of corporate bonds, equities, and inflation linked bonds, plus perhaps other asset classes. Therefore they are typically:

• Short credit spreads (if credit spreads increase, the fund loses money on a MTM basis);
• Short nominal rates (because if rates increase, fixed rate bonds are worth less);
• Long equities; and
• Long CPI inflation (to the extent that they hold inflation-linked assets).

On the liability side the fund is:

• Short longevity (if people live longer it has to pay a pension for longer and hence loses money);
• Short wage inflation (if final salaries increase, so do pensions);
• Short CPI inflation (if inflation increases, so do index-linked pensions);
• Long nominal rates (because future liabilities are discounted back to today along some interest rate curve).

The risk is then that the spread assets – liabilities goes negative. In a DB scheme then the employer has to top up a fund if this spread falls beneath some threshold value, and hence they are short an option on the spread. In a defined contribution (’DC’) scheme the pensioner bears all the risk and hence they are short this complicated spread cap: if their funds don’t meet their pension expectations, then they have to find the cash for their retirement from somewhere else.

The details of the cap in any particular situation of course depend on how funds are invested, but typically it will have some elements of equity risk, interest rate risk, corporate credit spread risk, and both wage and CPI inflation risk, together with the risk of the comovement of these factors (which you can simplistically think of as correlation risk). Given it is a very long dated instrument – perhaps as much as ninety years for someone entering the workforce now – and very complicated, it is hardly a surprise that it is difficult to know what it is worth.

Note in particular that because we have a long-dated problem, the details of the dynamics of each component of the spread are crucial. It might be reasonable to assume that some of them, such as corporate credit spreads, are mean reverting. This makes the problem easier. For others, notably inflation and equity returns, there seems no reason at all to assume long term mean reversion. This means there is an awful lot of model risk in pensions analysis.

Some dimensions of pensions risk can be minimised: for instance if the scheme holds inflation linked gilts then it can hedged inflation risk and bears no equity risk. However it still have longevity risk, and (absent a liquid longevity swap market anyway) contingent inflation risk (since if longevity increases the fund is mismatched on the duration of its assets vs. its liabilities and hence has inflation term structure risk). Moreover, of course, a low risk pension fund has to be much more comprehensively funded than one that is taking market risk in multiple dimensions (equities, corporate credit, property, alternative investments, …) Finally note that longevity risk is remarked considerably less often than other risk components so it is less visible – but that does not mean that it is not there.

The key policy question, then, in pension is who should bear the risk of underfunding, i.e. who should write the spread cap. Recently, there has been a suggestion that rather than one party bearing all of the risk as in current DB and DC schemes, perhaps it should be shared between employers, employees, perhaps with a far out of the money state backstop*. (See here for a further discussion.)

This is certainly a policy option that could be considered. Pensions policy is bedeviled by a failure to address risk issues openly, not least because most pensioners do not want to face the harsh reality that either a pension has significant risk or it is extremely costly to fund. Education is needed to address this point. Once we are ready for the debate, though, I would suggest there is room for a creative sharing of risk. There are no easy options here, not least because of the considerable uncertainty in estimating the size of the risk. But the problem is hard enough without artificially restricting the domain of possible solutions.

*One issue not addressed here is the use of DC schemes to reduce employer contributions. DC does not imply lesser employer contributions and legislation could (and probably should) stop employers using DC as a way of reducing their funding obligations.

Posted in: Inflation, Insurance and Actuarial Practice, Pensions by David /
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Here’s what an actuary used to do.

Unsurprisingly that strategy didn’t work that well which is why we have a pensions crisis (as I discussed earlier: see here or here). The latest in this slow motion train wreck is that UK life insurers have finally woken up to the continuing improvements in longevity and are now shoring up their reserves, again, to account for this.

Over the past hundred years, life expectancy in the UK has increased by four months every 10 years. Now all we need is for insurers to start to appreciate that they are not just short longevity but they are also short longevity vol…

Posted in: Insurance and Actuarial Practice, Pensions by David /
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Given Gordon is soon (one hopes, anyway) to ascend to the throne, one cannot help think that the timing of the recent objections to his abolition of tax credits for pension funds is partly political. Still, it is worth examining whether the objectors have a point: is Gordon partially responsible for the pensions crisis? Clearly the answer is no: if scheme actuaries had thought that reduced dividend income would have caused a problem, they should have increased contributions when it happened in 1997. Broadly, they didn’t: some even gave employers a contributions holiday. With tax credits the holidays would have been longer and more widespread. The only people then who would have profited had El Gordo been less aggressive would have been employers. But I guess ‘It was the actuaries wot dunnit’ doesn’t make for such a good headline.

Posted in: Insurance and Actuarial Practice, Pensions by David /
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Now my point in Part I was not to be the latest in a long line of people to point out how foolish the actuarial assumption of equity returns being 10% forever are.

Rather, it is that the rules of the system have produced the behaviour.

If you set things up so that you are given advice where the ‘best’ thing to do today is purely defined by what happened in the past, you run a lot of risk that the future will be different to the past and hence that the advice will be misleading. One of the pieces of information missing in the old actuarial advice was some measure of the probability of things going sufficiently differently that pension obligations could not be met: perhaps if trustees had had that, they might have invested differently?

In the absence of any theory which we have reason to believe governs the behaviour of a variable, didn’t David Hume point out the error of thinking the past behaves like the future? For the financial markets this is even more clearly silly than elsewhere: the global economy is obviously very different now from the one we had in the 80s, let alone the 50s. So why should stock prices follow paths characterised by statistics from long ago? That is not to say that we should not pay any attention to the statistics: just that we should be aware that there is model risk in how we use the past to predict the future, and for the sake of the next generation of pensioners, perhaps that risk should be considered along with all the others involved in running a long term investment portfolio.

When we use mathematics to model the world, as in fitting a return distribution of some financial asset, there is the danger that we use the maths that is convenient rather than the maths that captures the essential features of the problem. In finance, for instance, we are so obsessed with normal distributions that we use them whereever possible. Part of the reason for this is that so much is known about them — we have a lot of tools to hand. Also, the errors made by using a normal distribution are often small for typical financial applications (especially once we hack in the implied volatility smile). That doesn’t mean that the assumption that (log) returns are normally distributed is always good, though.

Phillipe Jorion has a insight into the dangers here in his paper on the fall of LTCM ( then search for Long Term Capital Management): he shows how making an modelling assumption, that correlation is stable and the return distribution is normal, leads to a dramatic understatement of risk. Sometimes, which tool you pick makes a lot of difference, and familiar tools can be the riskiest ones, not least because everyone else is using them too.

This is an education issue: the next generation of mathematical modellers needs to be taught how to model, but also about the dangers of modelling, about the need to look at a problem through the prisms of different models.

Turning back to actuarial advice, we have people trying to model the future using the past but without a theory that explains the dynamics, a system that encourages them to give their best guess with quantifying how wrong that guess might be, and a predilection for using tools that have nice mathematical properties but fail to capture significant features of the real world. Is it any wonder we have a pensions crisis?

There, I managed to talk about actuarial advice without mentioning the Ljung Box statistic once…

Posted in: Insurance and Actuarial Practice, Pensions by David /
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Pensions are hot, possibly for the first time ever. There is a lot of press comment about underfunded pension funds and many people are becoming aware that their retirement may not be as comfortable as they had hoped. So it is not a bad time to look at one of the systems which underlies pensions, that of actuarial advice, and what it does.

Now what pensions actuaries do is rather complicated and any attempt to summarise it in blog length is at best vainglorious. But here goes. Firstly the problem. A pension fund takes money from people over some fraction of their working lives. The cash is invested. The fund has the liability of providing a pension, either based on pensioner’s final salary (defined benefit, or DB) or on how the investments have done (defined contribution, or DC). In the absence of free money (aka a government guarantee) the amount a fund can pay in a pension depends on how much has been contributed and what the investment performance has been.

In a DB scheme, a individual’s pension is determined by how the whole scheme has done; more recently for most DC policies, individual pensioner’s assets are ring fenced.

So where do the actuaries come in? For a DB scheme, they advise on the investment strategy and the contributions needed to meet the liabilities. I’ll concentrate on this kind of scheme, as they are the most interesting and the most problematic.

An aside on the individual versus the collective: In a DC scheme the typical member chooses how to make his contributions. If they do well, the member has a great retirement income. If they do badly, forget about that villa on the Riviera. The problem is that many people, myself included, find managing investments fundamentally boring. Most also have little or no education in it. So the growth of DC schemes combined with low education in investment fundamentals is likely to result in a significant number of pensions which will not provide their beneficiaries with a good standard of retirement income. This is hardly good for society. In a DB scheme, in contrast, short term mistakes in investment performance can be corrected by higher contributions by everyone: the scheme is a pool with money always coming in from current contributions and (after an initial delay) always going out to pensioners. In this setting, if more goes out than comes in, everyone suffers. So we have a classic prisoner’s dilemma: to what extent should the individual subsidise the collective, and to what extent should he or she be able to rely on them for support in the event that things go badly?

Next, actuarial advice. A range of assets – different equities, bonds and so on – are available for the pension fund to buy. Which ones should they pick? In the very long term, it seems so far, investing in equities has resulted in higher capital appreciation than investing in safer assets like good quality bonds. On the other hand, in the very long term we are all dead, and in the shorter term there have been several extended periods where equities have underperformed bonds. DB pension fund trustees have to invest members contributions in order to have enough assets to meet the required pension liabilities. The advice they receive from actuaries in the past has often highlighted the historical outperformance of equities and hence influenced trustees to pick higher risk investments (the mean of the return distributions). What it sometimes did not highlight was the risk that equity markets might not outperform (some measure of the sample variance*).

What some actuaries did, in other words, was to build a model based on the past to predict the future. This is not a model in the sense of Newtonian mechanics or Relativity: extrapolation might be more accurate than model as there is very little theory underlying the idea that if something has grown at 10% for the last ten years it will carry on growing at the same rate for the next ten. The risk of doing this is obvious: if the world does not behave as your prediction suggests it should, decisions taken on the basis of the prediction can seem to be rather bad ones. And of course this is what happened with DB pension funds: investment decisions were made on the basis of the outperformance of equities, then when equity markets fell in 2001-2002, many of those funds did not have enough cash to meet the promises they had to keep. Hence the pensions crisis.

In part II, why the way actuarial advice was framed made this more or less inevitable.

* Assuming there is a process rather than just a sample variance is another modelling choice which might or might not be sound.

Posted in: Insurance and Actuarial Practice, Pensions by David /
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