Here be dragons – Z59; Con Keating

con-keatingguestMany of the opponents of CDC pensions have argued that, if introduced, they should be tightly regulated, as they are “untried and untested”. Some have even suggested that the Dutch system of regulation, with its stochastic models, risk buffers and other complexities should be adopted.

Great emphasis is placed upon the risks and uncertainties of these pensions; apocalypse looms. Perhaps unknowingly, these commentators are invoking the precautionary principle, in one of its harder, more rigid forms. Notwithstanding its widespread application in environmental contexts, and its recognition in homespun saws, this principle has some fundamental problems.

Not least among these is that any sense of proportion is lost, no cost-benefit analysis conducted or considered. The tail is wagging the dog. This is a pervasive issue: the potential partial loss of pension for a few is deemed to outweigh the full amounts received by very many.

The creation of an atmosphere of uncertainty, of great apprehension and dread, along with the promotion of remote possibilities to probabilities, is a symptom. Experimentation and innovation are then much simpler to depict as irresponsible and dangerous. It paves the way for millennium bug hysteria at its most extreme. We would do well to remember that if we make precautionary provision against every possible future event then we may well be unable to feed or clothe ourselves adequately today, let alone save for pensions. One of the few things we know with certainty is that risk means that more things may happen than will.

My central objection to the application of the precautionary principle is that it is unscientific, in both meanings of that word. It reverses the burden of proof; we now have to prove that something is not harmful, which of course is not possible. As Karl Popper noted, a hypothesis may only be refuted, not proved. The irrationality and inconsistencies arising make the precautionary approach unsustainable, as application of the principle to itself immediately makes obvious.

The risk management problem for CDC does differ from those of DB and of insurance and banking. For traditional DB pensions there is recourse to an external sponsor should deficits between scheme assets and liabilities arise; further, new money, contributions are then made. The classification of Dutch schemes as CDC arose only when they discovered such deficit repair contributions were not legally enforceable. By contrast, for the security of depositors and policyholders, banks and insurers rely upon the structure of their liabilities; the presence of two or more classes of liability holder, whose claims upon the company’s assets have different priorities. Equity holders are junior having only residual rights following discharge of policyholder or depositor claims.

With a CDC scheme there is only a single class of liability claim holder, the member. It is pointless to partition the assets of a CDC scheme in any manner, though it is done in the Netherlands with their risk buffers; it is no different from moving money from one pocket to another. Total wealth is unchanged, though some may now be less accessible. The security of the “promise” to members is not enhanced. However, this is possible by exploiting another property of pensions, their time dimension or temporal priority.

Risk management in banking or insurance consists of specifying some proportion of equity in the overall balance sheet, so-called risk buffers, that must be maintained. The response to adverse developments is restoration of the buffer deficit, by balance sheet management.

Balance sheet insolvency is not usually a binding condition. Even companies may continue to trade while balance sheet insolvent if the directors believe that such trading will rectify the insufficiency. It is cash flow delinquency which is usually binding; the non-payment of a sum now due constitutes an event of default in almost all circumstances. To an extent, it may be argued that the period allowed by the Pensions Regulator over which deficit repair contributions may be made is recognition of this.

For a pension scheme, cash flow insolvency is very remote in time, occurring long after balance sheet insolvency. If in deficit, when the scheme pays pensioners in full, it is overpaying them absolutely and relative to other members. The potential to over-disburse funds to current pensioners to the detriment of subsequent beneficiaries is a material concern; a “commons” problem.

It is with payments to pensioners that difficulties arise. The obvious manner in which to manage this risk in CDC is to operate on that payment, by making the deficit binding. If the scheme is in deficit, say 80% funded, then only 80% of the current payment should be made. No attempt is made to repair the deficit; tomorrow is another day.

In order to limit the magnitude and frequency of cuts, a scheme may introduce equitable risk-sharing among members. These are rules as to the magnitude and duration of support that may be undertaken before cuts are enforced; the detail is scheme specific. The magnitude component is analogous in purpose to a risk buffer.

This cashflow based risk management differs from the familiar balance sheet approach. In a sense it is more objective and efficient, being driven only by events which have occurred; there are no false positives here. The difference of CDC from those other institutions warrants a different approach, but perhaps they might learn from it.

We should not lose sight of the prime objective: alleviation of old-age poverty for as many as possible. According to the World health Organisation: “The world’s biggest killer and the greatest cause of ill-health and suffering across the globe is listed almost at the end of the International Classification of Diseases. It is given the code Z59.5 – extreme poverty.”

Con Keating is an internationally acclaimed genius


About henry tapper

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