Fundamental concern with pension regulation.


Con Keating on the political economy of UK pension scheme regulation

John Woods’ paper “The political economy of UK pension scheme regulation” should be read closely, and repeatedly in both the FCA and the DWP, and used to inform their current consultation processes. Some of the concluding remarks are worth quoting: “Our wide-ranging critique is not limited to what the Regulator and the PPF do because their approach is the same as that employed by most UK pension schemes, as recommended by their consultants.”

The paper recalls that, in his 2005 review of the actuarial profession, Derek Morris concluded that their professional formation gave them no expertise in asset management or portfolio selection. In light of which the increasing complexity of consultant-sponsored remedies to the perceived ills of DB schemes is surprising and their move into fund management astonishing   .

The meat of the paper is an examination of three ideas which are central to regulatory practice: liability matching, standard deviation as a risk measure and the Beebower, Brinson and Hood (BBH) idea that strategic asset allocation dominates performance in portfolio management. Woods observes that these are underpinned by two “unobtrusive postulates”: the efficient markets hypothesis, whereby price is a good indicator of value, and that schemes should hold only low-default likelihood securities. With any part or combination of these falsified, then the whole regulatory edifice begins to disintegrate.

The paper reports a new, and ingenious test of the BBH hypothesis, which compares inter asset class performance (bonds versus equities) with intra asset performance (value versus growth). It finds no support for BBH. Quite apart from removing a significant foundation of the regulatory architecture, this represents a huge challenge for the investment consulting community, on many levels.

The paper concludes that current arrangements encourage speculation rather than investment. This can be verified by another approach. With speculation defined by returns being primarily dependent upon price change and investment by returns being primarily dependent upon income, we can even take the analysis much further.

In the long-term, equity returns are dominated by the dividends received and price variation is insignificant. These returns are higher than those from government or corporate bonds. Long-term investment in equity delivers more cash flow than bonds; they provide a better source of income than bonds. This reinforces Mike Otsuka’s recent call for USS, a long-term institution, not to de-risk its portfolio. On the other hand, a closed scheme with just a few years remaining, should be buying bonds rather than equities. The fulcrum is determined by the relative importance of price changes to income. In a speculative, short-term world, bond returns contain more cash flow than equities.

Hedging, de-risking and matching can be considered in similar light. The only perfect hedge of an asset is its sale, which leaves the fund holding cash. It has been de-risked but clearly results in no investment. With a liability hedged, cash has been expended, but there is still no net investment. It is worth remembering that 90% or more of defined benefit pensions are sourced in investment returns.

The paper notes that the risk metric in regulatory use is standard deviation while the reality is that we face uncertainty. The construction of the statistic as variation from time to time from an expectation is short-term in nature. Many years ago, I offered a definition of risk as the unwanted subset of uncertainty[i] and recently I wrote a series of articles for Portfolio Institutional on the subject of uncertainty and fund management[ii]. It really is surprising that this risk measure and its offspring such as value at risk should persist given their patent failure in the financial crisis. As the paper shows, in the case of the PPF, uncertainty renders both the expected and the unexpected claim in their levy determination formula questionable.

I worry greatly about related ideas such as self-sufficiency, and prudence in scheme valuation and management, which this Woods paper could be extended to consider.

I will offer one simple insight here, which should have a place in such an extension. Assets exist as distributions located on the positive half of the real line. There may be negative returns in this distribution but the central location must be positive. The corresponding liabilities are rigid rotations (multiplication by minus one) of these assets. They are not translations of the asset (distribution). The extreme high returns we observe in the asset are extreme low values in the liability. Asymmetries have changed sign. However, there is a further major and most important difference; that variability which is unequivocally harmful to the geometric return of the asset (lowering the geometric relative to the arithmetic average) is now unequivocally beneficial to the liability. Perhaps the easiest way to view this is as both geometric means being located closer to the origin that their arithmetic. This risk preference reversal – we dislike risk in gain propositions but like risk in loss propositions – is well-known in the empirical behavioural literature, though perhaps little understood, as it is usually presented as a puzzle. Faced with a loss, it really may make sense to gamble.

One weakness in the paper is that its analysis of the PPF 7800 index considers this index as if it had been invariant in construction. In point of fact, the section 179 valuation process has changed considerably since 2005. After changes in legislation in 2013, it has, since 2014, been the cost of buying PPF level benefits from an insurer, a higher value than previously. To gauge the extent of this shift, we can note that in 2005 the ratio of full buy-out to the s179 valuation was 160% and now it is 133%.

The real problem with this paper is that, while it exposes the problems well, it does not offer any way forward, any guidance as to how to go about altering the institutions and the political economy of pensions. That may be a long haul.

If you would like a copy of John Woods’ paper, you should contact

Guy Edwards   Senior Publisher  Law, Humanities, and Social Sciences Journals | Oxford University Press, Great Clarendon Street | Oxford | OX2 6DP | UK

Con Keating  is currently a member of the steering committee of the financial econometrics research centre at the University of Warwick and of the Société Universitaire Européenne de Recherches en Finance. As a research fellow of the Finance Development Centre he published widely on the regulation of financial institutions and pension systems, and also developed new statistical tools for the analysis of financial data, such as Omega functions and metrics.

From 1994 to 2001, Con was chairman of the committee on methods and measures of the European Federation of Financial Analysts Societies and currently is a member of their Market Structure Commission. Con has also served as an advisor and consultant to the OECD’s private pensions committee and a number of other international institutions.

In a career spanning more than forty years, Con has worked as an infrastructure project financier, corporate advisor, investment manager and research analyst in Europe, Asia and the United States. He has served on the boards of a number of educational and charitable foundations and as a trustee of several pension schemes. He is currently Head of Research for the BrightonRock insurance group.



About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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