Stefan Lundbergh – why the watchdog’s got it wrong on pension projections


“Who watches the watchdog?”

Do you think that historical volatility of a fund is a good predictor of its future returns? Stefan Lundberg doesn’t – but apparently the UK FRC does. Here is a blog on how good intentions by a regulator can lead to perverse incentives . regulation volatility SMPI projections pensions


A blog by Stefan Lundbergh

The intentions of regulations are good, but sometimes implementation can arguably be counterproductive. I’m not going to dwell on BASEL III or Solvency II but instead I will focus on something less well-known: the Statutory Money Purchase Illustration (SMPI).

The SMPI prescribes how UK pension providers must project future potential investment returns in their statutory member communications. The fine print of this legislation is governed by the Financial Reporting Council (FRC) which is the supervisor for auditors, accountants and actuaries.

Good intentions…

Pension providers need to illustrate what members could expect to receive at retirement. To do that, projections of the future outcomes are based on a set of assumptions. In the UK, it was up to the provider to set the risk/return assumptions for their investment strategy. The challenge with this was that providers were tempted to provide overly rosy projections of future outcomes to appear better than the competition.

Understandably, FRC did not approve of that and decided to prescribe the return assumptions for statutory member communication and reporting. Instead of providing a ‘return’ assumption per asset class/category, like in many other countries, FRC decided to walk down a different and uncharted path.

The FRC prescribe that providers must use realised volatility of their investment fund/strategy as a predictor of future nominal investment return of that specific fund/strategy, as well as prescribing  projected nominal return for given volatility bands. This creates break points, like in the fiscal system, encouraging what economists refer to as perverse incentives.

Source FRC, AS TM1v5.0

As of October 1, 2023 the new prescribed methodology know as ‘AS TM1v5.0’ will come into force. This is a regulatory approach that in my opinion has two fundamental flaws; financial and behavioral. Contrary to mathematics, in regulation multiplying two negatives does not make one positive, it is just doubling down.

Financial flaws

Risk is in the eye of the beholder and risk cannot be observed or measured directly. As an approximation, volatility around a long-term trend is often used as a representation of financial risks. To measure volatility we need to rely on theoretical models where the parameters often are estimated using historical investment returns. In addition to assumptions on long-term investment returns, the volatility measurement is dependent on the sampling frequency and time period over which it is measured. The FRC prescribed that volatility (i.e. investment risk) is best captured by using monthly observations over a five year rolling sampling window. But for a pension saver, the risk is not captured by the variability around the trend. The true risks are that the assumptions of the projected returns does not reflect reality.

Most would agree with the FRC that there is an empirical relationship between volatility and outcomes for most broad asset classes. But using observed volatility for an individual fund, or strategy, to determine projected return of that specific fund is definitely stretching it a couple of bridges too far. The irony is that on the one hand the FCA, the regulator of the financial markets, requires investment funds to add a disclaimer ‘Past performance does not guarantee future results’ in their marketing material. But on the other hand, the FRC prescribe funds to use ‘past volatility as a good predictor of future returns’.

Behavioral flaws

The intentions are good, helping members to compare across different providers with different flavours of target date funds or lifecycle strategies is commendable. But, as ever, the devil is in the details and it is often said that the road to hell is paved with good intentions.

For an individual who works full time until retirement and saves 8% of their salary as of age 21, the difference in projected outcomes between a 5% investment return or 7% is roughly 60-75 percent, so the SMPI creates perverse incentives. We should not be surprised if some providers will be tempted to increase the volatility of their growth assets to reach a 15% historical volatility over a five year period. As Peter Drucker once said “what gets measured gets managed”.

The FRC framework, fundamentally goes against what all investors try to achieve for their clients – generating a high return at low risk through careful portfolio construction and diversification. In addition, in the FRC framework, illiquid assets will be a ‘burden’ since their observed volatility does not reflect the underlying risk – this is a measurement artifact since illiquid assets are only valued quarterly and that valuation is often based on appraisals.

Relative Insights or Absolute Madness

Don’t get me wrong, projections are not inherently bad, they just need to be used for the right purposes. To help members make informed decisions, projections are very helpful for providing insights on the relative effects of a particular decision. For example, answering questions like: if I increase my pension contributions by 1%, how will that affect my outcomes? To answer this question, projections makes perfect sense since they illustrate the relative consequences of a decision compared with the current situation.

Using projections as a way to predict what you will have at retirement in absolute terms is not that helpful given the inherent uncertainty of the financial markets. But it is absolute madness to introduce an approach that creates perverse incentives, punishes tried and tested portfolio construction practices such as diversification, and endorses investment strategies with low information ratio.

And that leads us to the critical question, who watches the watchdog?

Published by

Director Cardano Insights

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
This entry was posted in pensions. Bookmark the permalink.

Leave a Reply