Some would call it a storm in a tea-cup, some the great pension debate of our time. This morning I am publishing Anthony Hilton’s tirade against actuarial valuation methods, Dawid Konotey-Ahulu’s refutation and by way of synthesis, this article by Con Keating, regular guest blogger on this site.
Oblate spheroids and complete balls.
Dawid’s blog, in response to Anthony Hilton’s concerns with current pension accounting and management, is amusing, but it takes almost a thousand words to reach its first material issue with Anthony’s position. There is such a thing as taking a joke too far; and that seems an apposite description of the situation with DB pension schemes. For the avoidance of any doubt, I shall state my position here: I shall continue to think of the earth as an oblate spheroid, as I find Dawid’s circular arguments less than convincing.
Let us begin by unpacking: “Some of us prefer to believe, despite eloquent arguments to the contrary, that it is only by measuring and managing the pension scheme’s liabilities there can be any assurance of reaching a state of full funding; that a deep understanding of the complex relationship between assets and liabilities is the sole basis for an expectation of success.” The whole thrust of the disagreement and argument centres on the mismanagement of pension schemes arising from their mismeasurement under current protocols.
However, Dawid has also sneaked in the idea that full funding should be an objective. The promise has never been: I promise to pay you 1.5% of your final salary for life in retirement, and I promise to maintain a fund or any other such nonsense. The promise was clear; it was the right to an income in retirement. Why Dawid should specify full funding is not at all clear either, given that a fully-funded fund, were it unsupported, would have a fifty percent chance of failure prior to the discharge of all pensions. In common with many, Dawid persistently describes the present value of liabilities as the liabilities, an estimate however derived; a cynic might take this as an attempt to lend credibility to those figures.
The arrogance of that next “deep understanding” sentence is, at first sight, breath-taking, but of course becomes far less so when we realise that the complexities involved have been created by those who wish to ‘provide solutions’. The pension promise was made, and accepted, independently of any assets or investment. In fact, it is only by trying to match the sensitivities of the market value of assets to those of the present value of liabilities derived under bizarre protocols that these complexities are introduced, and of course, these are the illuminati of the protocol.
Dawid’s blog continues with: “We also believe that, by virtue of managing their assets against their liabilities, there is, right now, a select group of pension funds which find themselves well-funded and relatively untroubled by vicissitudinous and capricious markets. On the other hand, those pension funds that have not carefully measured and managed their assets against their liabilities, now find themselves in a dark and dangerous place.” The self-referential nature of these assertions renders them fatally flawed and of no argumentative substance. Some pension schemes did some time ago buy into the matching of assets and the present value of liabilities under the current protocols, and it is reassuring that the illuminati were sufficiently competent that under these protocols they were successful. However, the immediate question is: at what cost were these successes achieved? The schemes in “dark and dangerous places” are in fact only in these places under these protocols and Dawid provides no objective evidence outside of these protocols that this is a dark or dangerous place.
The blog then invents some history:
“Some background:
They did not do the math!
Companies that offered defined benefit pensions to their staff, had no idea when they first offered them, what it would actually cost to pay out those benefits. Amazing, but sadly true. Over the years, lots of people who worked for socially-minded companies like Tesco, British Airways, John Lewis, et al, accrued a stream of life-long pension benefits. Those benefits are linked to inflation – which has the effect of future-proofing them, and which is very, very expensive. All those benefits have to be paid out in due course and the numbers are mind-bogglingly enormous.”
This is a rewriting of history; the new narrative. Companies, or rather their actuarial advisors, did do the mathematics at the time of award, and those awarding inflation linking explicitly considered this. Benefits have risen because of unexpected and sustained increasing longevity and the statutory requirement introduced to offer limited price inflation linking affected schemes which had not previously offered this. The agenda here is to maintain that DB pensions are now and always were unaffordably expensive; they were not and are not. Do the maths. In recent times the overwhelming majority of the increases in DB pension provision cost have in fact come about as a result of actions associated with liability ‘management’ such as closure to new members and future accrual.
The blog continues with a further narrative surrounding the equity risk premium, that is so tired from overuse that I will pass over it. It is notable that this section of the blog is illustrated with share prices rather than cumulative returns, which are nowhere near as alarming. It also shares the problem of being self-referential or circular.
“As I said, the essence of the problem was that across the board, well-meaning companies agreed to pay generous inflation-proof pensions without, as the Americans say, doing the math. To be fair, they did some basic math, but it was very basic and not, as the lawyers say, fit for purpose. Eventually, the math rules got changed, but by then, the lifelong benefit promises had been made.” No-one has changed the rules of mathematics; they did introduce an inappropriate, incorrect and pernicious protocol. Moreover, the mathematics done at the time of award was fit for purpose under the protocols and practices then prevailing.
“Via their pension funds, our corporations now have huge obligations owed to millions of defined benefit pension plan members, and the brutal truth is that there are insufficient assets backing those liabilities. How do we know that? Because even a cursory measurement of those liabilities when mapped against the assets held by pension schemes shows that to be true. There is no accepted measurement basis on which UK defined benefit pension schemes look healthy.” There are at least four alternative protocols which might be employed for the analysis of pension schemes and their funds. For example, Paul Boyle, then CEO of the FRC, began a speech on this topic in 2009 by considering measurement in terms of future values rather than the discounted present value now employed. There are also many who employ cash flow analysis in the best traditional of financial analysis. We might also use the bankruptcy-consistent approach advocated in Keating, Settergren and Slater, ‘Keep your lid on: A financial analysts view of the cost and valuation of DB pension provision‘; this is certainly accepted as it is the process employed by the courts. Moreover, we should not forget that the Local Authority Pension Fund Forum obtained a formal opinion from Mr G Bompas QC which considers that the current protocol breaches the more fundamental requirement of company law that accounts should present a ‘true and fair’ view of affairs. In other words, the existing protocol is very far from accepted, and certainly not unique.
The blog continues with a bizarre meandering around rogue traders and suggests that a pension fund deficit is in some way equivalent to a short position in marketable securities or derivatives. This is complete nonsense; the company has promised to pay its former employees an income in retirement, no more, no less.
The continuation grows ever more strange: “We have a collective obligation to make absolutely certain that pension plans can pay those benefits. Inflation-linked and all.” Where did that come from? Perhaps more importantly, how might any of the nostrums of the illuminati help that come about?
“Pension funds are fully responsible for taking decisive action to ensure they can pay everyone what they are due to receive”. This is simply not true; this is not a fiduciary or other obligation of scheme trustees. In any event, should the pension scheme be unable to meet pensions on time and in full, it has recourse to the sponsor employer.
“That’s why pension funds have to be certain they can meet their obligations. That’s why they have to hedge their short long-dated, inflation-linked positions.” Pension funds have no such obligations; schemes might, under the most charitable of interpretations, but that sloppiness just typical of the prognostications of members of the illuminati. Truthiness is all. Note that now they have to hedge; a further untruth.
“Those liability driven investment strategies which Mr Hilton so dislikes, are in fact the mechanism by which a pension fund can close out its short position in index linked cashflows, and invest in a diverse pool of assets which offer an attractive yield. That’s the whole point of a liability driven investment strategy. You get to close out that unmanageable short position!” Dawid has failed to consider the sponsor position; most corporate sponsors are exposed to and gain from inflation. The net position between the limited price inflation of pensions and the full price inflation in the economy works to the advantage of these sponsors. In this regard, and many others, the protocols under which schemes are valued and now managed add to the real risks faced by a sponsor. The last sentence is most intriguing; the illuminati claim to be able to manage (close out) the unmanageable. This makes base metal into gold look viable.
But there are yet more internal inconsistencies such as “There is very little growth and no inflation to speak of.” which might equally be expressed as: so all the hedging of inflation about which the illuminati are so proud has been pointless. They have hedged a risk that has not materialised. But these illuminati don’t want to recognise the fact that one of the few things known about risk is that it means that more things may occur than will. Risk is the bogeyman with which to scare the children, or in this case, trustees.
Then of course, having criticised the equity risk premium at length; the blog would be failing if it didn’t include at least one free lunch: “On a point of detail, pension funds haven’t been restricted to purchasing government bonds in order to close out their short positions; there are many other instruments that achieve the same thing at a lower cost.” The advocates of the current protocol make much of the law of one price, but here that is directly breached.
The original Anthony Hilton article is far from perfect, but as a rebuttal, this blog is incoherent and inconsistent, to the point that it is difficult to dismiss the strongly denied self-interest. The most egregious of the claims made by Dawid is that without this approach, a generation of pensioners would be facing penury: “Rather, it is because we have believed passionately for well over a decade that the unforgivable sin is to allow an entire generation of elderly pensioners to sink into a mire of poverty.” The reality is that valuation and management under this protocol has led directly to, that is caused, the closure of pension schemes and significant harm to the companies that sponsored them and with that society’s well-being. The harm done by this protocol does not merely affect current members, it extends over the generations of as yet unborn who will not be offered defined benefit pensions. It has already diminished, and in many cases ruined, the retirement prospects of many millions of people.
Dawid’s rebuttal even offers a repugnant defence: “Ask the members of those pension funds that have finally reached full-funding and achieved the cherished buy-out whether they believe in managing the liabilities, and whether they are delighted their trustees opted to measure and manage their assets against those liabilities.” These are of course among the few that have profited from the protocol at the expense of their neighbours; these are the polluters who have poisoned the pensions environment for the world at large. I shall continue to view the world as an oblate spheroid and this rebuttal as complete balls.