This is an explanatory note relating to questions posed to us arising from our series of blogs on the proposed Funding Regulations. Our fourth blog led to correspondence questioning our interpretation of the fundamental flaw in these proposals, which is that the Regulations are in search of certainty. While such endeavours come naturally to human beings, throughout history, whether, recent, ancient, or anything in between, this is a futile pursuit. We deal with this first in this blog. A repeated theme among many of the questions raised has been maturity, duration, and progress towards the significant (maturity) date, which follows in the second part of this blog. We end with reference to research considering the feasibility of so-called ”safe” asset portfolios.
We follow the same conventions as we have used in earlier blogs. Links to the previous blogs are provided at the end of this blog.
The Search for Certainty
In support of that hypothesis, we would cite the eminent US jurist and legal scholar Oliver Wendell Holmes. In his 1897 paper: “The Path of the Law”, he observes “The language of judicial decision is mainly the language of logic. And the logical method and form flatter that longing for certainty and for repose which is in every human mind. But certainty generally is illusion, and repose is not the destiny of man.” Moreover, in a later, 1918 article: “Natural Law”, he observes “Certitude is not the test of certainty. We have been cocksure of many things that were not so.”
Karl Popper’s notion that the path to certainty leads to authoritarianism and justification of almost any act is one that has also been questioned. However, these ideas were not new, as is evident from the philosopher, William James, in his 1916 paper “The Will to Believe”:
“When, indeed, one remembers that the most striking practical application to life of the doctrine of objective certitude has been the conscientious labours of the Holy Office of the Inquisition, one feels less tempted than ever to lend the doctrine a respectful ear.”
The problem with the proposed Regulations is that they do not recognise the role of uncertainty. The seminal 1921 work of Frank Knight “Risk, Uncertainty and Profit” gave us
“The key to the whole tangle will be found to lie in the notion of risk or uncertainty and the ambiguities concealed therein”,
with uncertainty being that risk not susceptible to measurement, and in result there is insufficient data to undertake meaningful statistical analysis.
Keynes in his contemporaneous “Treatise on Probability” similarly considers uncertainty to be immeasurable risk, and states that when that prevails, we may not even to able to rank probabilities ordinally. In later work, 1936, Keynes offered:
“By ‘uncertain’ knowledge … I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the probability of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper or the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.”
Simply put, uncertainty is the lack of knowledge on which to calculate probabilities.
There have been other economists such as George Shackle who have addressed these questions and sought answers which lie in between the binary distinction of uncertainty or risk.
“At the heart of Shackle’s theory of choice is the idea that, when people consider the possible consequences of taking a decision, they give their attention only to those outcomes that they (a) imagine and (b) deem, to some degree, to be possible. This set of outcomes is not guaranteed to include what actually happens, which may be an event they had not even imagined, and which comes as a complete surprise to them[i]“
It is worth emphasising that the distinction between risk and uncertainty is not an abstract philosophical conceptualisation or an academic conceit. It is a fundamental part of scientific analyses in many fields including politics, military strategy, engineering, medicine, and climate science to name but a few areas. In economics and finance, however, there was a debate on whether this distinction is meaningful and it can be argued that this debate was “won” by the Chicago School.
In Milton Friedman’s book, “Price Theory” Friedman states,
“I’ve not referred to Knight’s distinction between risk and uncertainty because I do not believe it is valid. We may act as if we can define probabilities in relation to every conceivable event. So that’s taking comprehensibly on board the idea that people have an articulated or articulable set of subjective probabilities about everything.”
This is one of the fundamental underpinnings of financial economics, which is the basis for the current regulatory regime, but it is clear that this is founded on a belief as opposed to a fact, and the consequences of this belief are far reaching.
Readers interested in more should read John Kay and Mervyn King’s “Radical Uncertainty: Decision-making beyond the numbers” and Jon Danielsson’s “The Illusion of Control: Why Financial Crises Happen and What We Can (and Can’t) Do About It.”
There is one further book on this subject which is worth reading as it takes an empirical approach to these questions. The book is “Beyond Mechanical Markets, Asset Price Swings, Risk, and the Role of the State.” by Roman Frydman and Michael Goldberg. However, though the subject matter is interesting, beware, this is a tedious read (even compared to our blogs on the proposed Regulations). The first half of the book, and it felt much longer, is a devastating and near comprehensive critique of the rational expectations hypothesis. Borrowing heavily from Katherina Pistor’s 2013 synopsis of the book in her paper “Towards a Legal Theory of Finance”, the relevant aspect of their empirical work
“…shows how investors change the indicators (firm-specific information, macroeconomic trends, psychology, political factors) they use for determining their investment strategies at different times. Rather than following a predetermined strategy built on a fixed set of indicators, investors demonstrably engage in non-routine change. They do so if and when there is compelling evidence that current prices no longer reflect trends. This can be gauged not only from data but also from behaviour of other market participants. Re-interpreting Keynes’ famous beauty contest, they argue that investing is not so much a guessing game about other people’s preferences, but results from a rational decision-making process in which the judgment of others factors into one’s own judgment.” [Emphasis Added]
This is the environment under which the Regulations would have us make long-term forecasts, highly specific asset allocations and much, much more. There is perhaps one saving grace for such a set of Regulations in that they define a set of conventions to be observed by all, but the problems with such conventions in financial markets are well-known. Keynes again:
“In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention — though it does not, of course, work out quite so simply — lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely. The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalise our behaviour by arguing that to a man in a state of ignorance errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities.
For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads to absurdities. We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation.
In point of fact, all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield. Nevertheless, the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention.” [Emphasis Added]
Given the propensity of government to tinker with pension regulation, should anyone want to rely on that?
We could have supported our arguments as to the non-feasibility of forecasts at the horizons to be imposed by these Regulations with lines such as
“It is difficult to make predictions, especially about the future”
which has been attributed variously to Niels Bohr, Yogi Berra, Sam Goldwyn, and many others. Given its origins as a Danish proverb, we would have been drawn to attribute it to K.K. Steincke, the Danish parliamentarian and Minister of Justice, whose 1948 book “Farvel Og Tak” places it, without attribution as having been said in the 1937-1938 parliamentary year.
We could have introduced H.L. Mencken’s
“For every problem there is an answer that is clear, simple and wrong.”
or Ezra Solomon’s[ii]
“The only function of economic forecasting is to make astrology look respectable”,
to add weight to our criticism.
A quotation from Roman Frydman is also apposite:
“What economists imagine to be rational forecasting would be considered obviously irrational by anyone in the real world who is minimally rational.”,
particularly so, as the context for this was explicitly credit risk evaluation. We might also have reverted to Karl Popper’s observation that since we cannot falsify a risk forecast, it is not scientific.
Everyone Has a Plan Until They Get Punched in the Mouth (Mike Tyson)
The proposed Regulations smack of central planning, with their emphasis on the control of resources, long-term journey plans and much more. The failures of central planning are well-known. Rather than relying upon Knight and Keynes, we might have invoked Ludwig von Mises or F.A. Hayek. In his 1945 classic “The Use of Knowledge in Society”, F.A. Hayek states the problem as:
“If we possess all the relevant information, if we can start out from a given system of preferences, and if we command complete knowledge of available means, the problem which remains is purely one of logic. … This, however, is emphatically not the economic problem which society faces.” and he goes on to say: “This misconception (about the nature of the economic problem) in turn is due to an erroneous transfer to social phenomena of the habits of thought we have developed in dealing with the phenomena of nature.”
In his 1974 Nobel lecture, entitled “The Pretence of Knowledge”, F.A. Hayek offered:
“I prefer true but imperfect knowledge, even if it leaves much undetermined and unpredictable, to a pretence of exact knowledge that is likely to be false.” as well as: “If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. … The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society – a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.”
These Regulations if enacted will undoubtedly have deleterious effects on the capital markets. In the words of Dwight Lee, a reviewer of Hayek’s work:
“In his critique of central planning, for its inability and inefficiency in allocating society’s resources, F. A. Hayek summarizes his reasons for preferring the price system to the planned economy” and “Informed economic decision-making requires allowing people to act on the information of “time and place” that only they have, while providing a system of communication that motivates us and informs us on how best to do it. Market exchange and prices generate the information and motivation.” and ends with: “The market is essential precisely because it allows people to benefit from widely dispersed knowledge when no one has more than the smallest fragment of that knowledge, not even government planners. Every time a government plan restricts market exchange, ignorance is substituted for knowledge.”
A further disadvantage to this approach is that it is the Pensions Regulator’s single narrative that sets behaviour and performance for all. Narratives and the shifts among them are an important element of market pricing. To quote Robert Shiller, the author of Narrative Economics:
“We need to incorporate the contagion of narratives into economic theory. Otherwise, we remain blind to a very real, very palpable, very important mechanism for economic change, as well as a crucial element for economic forecasting.”
We have described the fundamental problem as being the uncertainty associated with the timespans of pension schemes. In this, we are not seeking some form of pre-emptive exoneration of any possible future problems arising from the occurrence of unknown unknowns or other unforeseen events. We are not saying that management to those long timescales is impossible. We are saying that the techniques appropriate for use at these time scales differ from those in everyday use for asset or liability management. The analogy of the differences between climatology and meteorology highlight this. We can say that it is likely to be warmer in summer than in winter, but we cannot forecast the weather in Leeds on some given, far distant date. We are saying that the prescriptions of these Regulations, where even feasible, will not deliver sound management of schemes. The proposed Regulations, it could be argued are using the tools of weather forecasting to predict the climate in 50 years from now.
Of course, the passage of time will resolve much existing uncertainty; some unknown unknowns will become known unknowns. The dominant narratives driving prices and yields at that time will become knowable as we approach that time, but the future beyond will remain uncertain to an unknown degree.
With behavioural insights much in favour with government, we might have expected the Regulations to have adopted the approach advocated by Cass Sunstein, who, in his 2011 essay “Empirically Informed Regulation.”, stated:
“A general lesson is that small, inexpensive policy initiatives can have large and highly beneficial effects. In the United States, a large number of recent practices and reforms reflect an appreciation of this lesson. They also reflect an understanding of the need to ensure that regulations have strong empirical foundations, both through careful analysis of costs and benefits in advance and through retrospective review of what works and what does not.”[Emphasis Added]
With that in mind, we welcome the review to be conducted within five years of the date of implementation of the Regulations referred to in the final section of the Impact Assessment, though the ex-ante cost and benefit analysis, where conducted at all, has been woefully inadequate.
“The requirement is aimed to improve scheme funding. Better scheme funding is anticipated to improve the security of members’ pensions – i.e., to increase the likelihood of members ending up getting their pensions paid in full. It is not deemed proportionate to monetise this benefit.” [Emphasis Added]
Given the remaining lives of closed schemes, and the amount of damage that can be done in the meantime, we wonder as to the practical utility of a review after five years.
Maturity, Duration and Progress to the Significant Date
As noted earlier, we have been asked repeatedly about duration and the rate of progress of schemes towards ‘significant maturity’. We present here a worked example.
We consider a closed scheme, which has total projected liabilities of £236.2 million, which have an average life of 18.29 years – the average life of a series of cash flows at zero discount rate is numerically equal to the ‘Duration’. We show, in Figure 1, the distribution over time of the pension projections for deferred and pensioner members. At a 3% discount rate, the scheme has a present value of liabilities of £145.7 million and a duration of 14.72 years.
Figure 1: Benefits Projection Change over Five Years
Figure 1 also shows the deferred and pensioner cash flow projections as they are expected to be five years in the future, with all assumptions unchanged. At this time, the total of projected liabilities has fallen to £202.6 million, and a total of £33.6 million would have been paid out, of which £8.0 million would be lump sums taken at retirement. The average life of the scheme is then 15.83 years, and the present value of those liabilities is £132.8 million, using the same 3% discount rate as previously, a decline of £12.5 million.
Pensioners in payment account for 43.9% of all liabilities initially, and 49.1% at the future five-year point.
The undiscounted total risk to members, on immediate sponsor insolvency, at 15% of deferred member projected benefits, is £19.8 million, 8.37% of total liabilities. At the five-year point, this risk has declined to £15.5 million, 7.62% of total liabilities. The risk exposure essentially has the profile of deferred beneficiaries, as shown in Figure 1. If the likelihood of sponsor insolvency is one percent, the risk can be seen to decline to £198,000 and £155,000 respectively (.05% of the total pensions). If we assume that the cost of the proposed regulations is as little as a one percent decline in investment returns, the total cost would currently be £23.3 million or £18.4 million if deferred until the five-year date.
Figure 2 extends the analysis to ten years in the future.
At this point, the total undiscounted liabilities have declined to £173.1 million, of which pensions in payment are £98.3 million, 58.8% of the total. The average life of the scheme is 14.09 years. With a 3% discount rate, the present value of the liabilities is £118.6 million, and the duration is 11.61 years. The scheme reaches a duration of 12 years after 8.8 years have elapsed. Over the ten years shown, the scheme has paid out £63.1 million, of which £15 million were lump sums. Figure 2 shows the pensioner and deferred cash flow projections initially and after five and ten years.
Figure 2: Cash Flow Projections of Pensioner and Deferred Liabilities
The risk to members of the scheme has declined to £11.2 million, 6.45% of total liabilities. In present value terms, with a 3% discount rate, the risk to members is 3.78% of the scheme’s present value. If we again assume a likelihood of insolvency of 1%, the scheme risk is just £112,000.
At this ten-year forward date, again assuming a 1% return cost to the new Funding Regulations, we have a cost of £14.7 million. With the risk to members being less than one percent of the cost of this remedy, there is simply no way this can be considered proportionate.
As an indication of the interest rate sensitivity of duration, the initial set of liabilities have a duration of 12 at a 6.0% discount rate, the five-year set have this 12-year duration when the discount rate is 4.1%, and finally, the ten-year set have a 12-year duration when the discount rate is 2.46%.
The youngest member of the scheme reaches normal retirement age 33 years from now. From that time on, there is no risk to members other than for increases; all will be pensioners in payment eligible for full compensation from the PPF. In terms of today’s provisions, these amount to £27.5 million of the total deferred values of £132.5 million. The average life of the remaining pension payments at that time is 7.14 years and the duration at 1% discount rate 6.86 years, at 3% 6.35 years.
That last deferred member will, as the scheme is closed to future accrual, also have a very small entitlement, just two years of pensionable service. Indeed, as we move forward through time the average length of pensionable service declines and with that their entitlement and the risk to them associated with that pension. A member with full service, approaching normal retirement age, would face risk of 10% of their full pension, but those with less than full-service face less. Indeed, the modelling of schemes at long horizons faces the problem in that members with small entitlements may well commute their pension at any age from age 55, and for the quantum of that, there really is no reliable statistical evidence.
Perhaps the more important lesson from this is that the risk to members declines rapidly. If a 12-year duration is to be applied, this scheme should only be concerned with having adequate funding for full cover from year 9 until year 33. The duration concept fails to capture any of these real-world complications.
As we have not made this point elsewhere, we should make the point that risk is latent and cannot be measured, only inferred, and that can be expected to create problems for the supervision and enforcement of Regulations, such as these, in which the word risk appears no less than 27 times in their 13 pages, with no clear definition.
The Illusion of Safety
By way of an ending to this blog, we should like to draw attention to research conducted by the US Federal Reserve’s Thomas Eisenbach and Gregory Phelan: “How Can Safe Asset Markets Be Fragile?”. That paper considered an episode when
“The market for U.S. Treasury securities experienced extreme stress in March 2020, when prices dropped precipitously (yields spiked) over a period of about two weeks.” Among its conclusions are: “The risk of market break-down can be self-fulfilling, as it leads investors without pressing liquidity needs to sell pre-emptively in order to avoid the possibility of having to sell at lower prices in the future.” [Emphasis Added]
This is a classic illustration of the feed-back loop of endogenous risk. It is also worth noting that this precipitous decline in US treasury prices only ended with the intervention of the Federal Reserve and large-scale asset purchases. Is it really appropriate that DB pensions should be reliant on the Bank of England in comparable fashion?
We also note that the consultancy XPS reported the returns shown below (Figure 3) for the month of August 2022; a month in which the Retail Price Index was reported as growing at 12.3% annually[iii].
Figure 3: Returns for the month August 2022
It seems to us that the concept of an asset allocation that is “highly resilient to short-term adverse changes in market conditions” is a chimera.
Links to previous DB Funding Regulations blogs
[i] E., Earl, Peter. G.L.S Shackle. ISBN 978-1-349-44836-4.
[ii] Ezra Solomon’s 1963 textbook “The Theory of Financial Management” was central to the training as a financial analyst of one of the authors of this blog. He also served on the US Council of Economic Advisors from 1971 to 1973, a most interesting period given the departure of the US from the Gold Standard and the break-down of the Bretton Woods regime.
[iii] For the period to the end of July.