Monday, 6 March 2006

Actuarial Advice & How It Serves Us, Part I

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.

Labels: ,


Post a Comment

Links to this post:

Create a Link

<< Home