pensions – Louise Pryor

Last autumn I was at an actuarial event, listening to a presentation on the risks involved in a major civil engineering project and how to price possible insurance covers. It must have been a GI (general insurance), event, obviously. That’s exactly the sort of thing GI actuaries do.

The next presentation discussed how to model how much buffer is needed to to bring the probability of going into deficit at any point in a set period below a specified limit. It sounded exactly like modelling capital requirements for an insurer.

But then the third presentation was on how to model the funding requirements for an entity independent of its sponsor, funded over forty to sixty years, paying out over the following twenty to thirty, with huge uncertainty about exactly when the payments will occur and how much they will actually be. It must be pensions, surely! A slightly odd actuarial event, to combine pensions and GI…

The final presentation made it seem even odder, if not positively unconventional: the role of sociology, ecology and systems thinking in modelling is not a mainstream actuarial topic by any means.

And it wasn’t a mainstream actuarial event. It had been put on by the professions Resource and Environment member interest group, and the topics of the presentations were actually carbon capture, modelling electricity supply and demand, funding the decommissioning of nuclear power stations, and insights from the Enterprise Risk Management member interest group’s work – all fascinating examples of how actuarial insight is being applied in new areas. And to me, fascinating examples of how the essence of modelling doesn’t depend nearly as much as you might think on what is actually being modelled.

Don’t count your chickens

Take reports of changed pension deficits with large amounts of salt. It’s always important to put news in context, and to think about what’s going on underneath, especially when you read a story based on a survey or report produced by a consultant. And yes, I am a consultant, and that applies to surveys or reports I put out, too.

In yesterday’s FT there was a piece (£) about the pensions funding position. Apparently it hasn’t changed much since December 2010,

partly because the gap between yields on government bonds and those on corporate bonds has widened, which has the effect of reducing liabilities.

No it doesn’t. Absolutely not. The liabilities have not changed an iota because of any change in bond yields. The pension schemes are still on the line for the same payments in the future as they were. The only thing that has changed is one estimate of the present value of the liabilities, in other words how much money should be set aside now to pay the liabilities in the future.

But let’s get this straight. Nobody knows how much the pension schemes will have to pay out in the future. It depends on all sorts of things — including how long the pensioners live, what survivors they leave when they die, what future inflation rates are, whether members of the scheme transfer out before starting to draw their pension, what options they exercise when they do start, and countless others. And that’s without even considering what can happen to active members (those still in employment). So the actual payments out are uncertain.

And the payments in are uncertain too — investment returns, employer contributions, member contributions.

It’s fairly easy, nowadays, to estimate the value of the assets — just use the market value. Which is of course highly volatile, especially in the short to medium term.

It’s much less easy to estimate the value of the liabilities. You project the likely future payments, and then use a discount rate to come up with a present value. Which could be volatile too, as well as uncertain, if the discount rate you use is volatile.

So the deficit (or surplus) is the difference between two large numbers, at least one of which is highly volatile and the other is highly uncertain. No change that occurs over just a few months can be really significant, if nothing else has changed.

Just apply some common sense. If the assets are the same assets (no big changes in investments), and the liabilities are the same liabilities (no big changes in membership or benefits), then the long term position simply can’t have changed significantly. Pensions is a long term business. Transient changes in estimated current values are bound to happen, but in the end what matters is that the benefits are paid out when they fall due.