For many pension plans, the actuary is a sort of shaman, a person with supra-human abilities in foreseeing the future of assets and liabilities, and special powers to control the solvency level of the pension fund.
However, the belief in actuarial shamanism has recently been fading somewhat. Many things have not quite turned as expected and the funding position of many occupational pension plans has become more critical. As shareholders and members get hit in real economic terms, actuaries often – rightly or wrongly – get the blame.
Controversies: Even more, there is currently much controversy within the actuarial profession about the right approach, some of which is hitting the headlines in the press. There is a clash between two schools. The old actuarial dogma favours equities because they are ‘real assets’, linked to the growth of the economy and salaries, and also because they tend to produce higher total returns than bonds in the long term.
Proponents of the new dogma consider pension liabilities as essentially bond-like and therefore prefer liability-matching assets, ie, bonds. The former approach typically implies a higher risk of mismatch between assets and liabilities, the latter potentially a higher cost of pension provision in the long term for sponsors and/ or contributing members.
All these recent problems and controversies have puzzled pension boards. Sailing between Scylla and Charybdis, which direction should they take? This seems a good time to take a fresh look at actuarial advice from a trustee perspective.
The role of the actuary: To start from first principles, an actuary is an expert on the measurement of liabilities and assets. The key job is to value and compare the two, which determines the actuarial deficit or surplus of a defined benefit pension plan. Typically, the actuary will also calculate the contributions needed over time to balance the two sides, that is, to make sure enough money is there when the pensions are due. In addition, there are some other smaller but still important jobs such as the calculation of transfer values and doing the paperwork as required by law.
The actuary uses a range of mathematical and statistical tools. In practice, actuarial work is much less of an exact science than it may initially appear. Pension liabilities are typically long term and uncertain. In Rumsfeld’s poetic speak, there are “known knowns” (such as the profile of the current membership of a pension plan), but there are also “known unknowns” (most prominently the life expectancy of members), and even “unknown unknowns” (such as unpredictable future changes to pensions regulation and taxation). The actuary needs to make a number of assumptions when calculating the present value of liabilities, including the discount rate (another important “known unknown”).
Looking at the other side, current pension assets are more easily valued at market prices but predictions still need to be made for their long term returns. When doing this, government bonds are, of course, more predictable than riskier assets such as equities, for which a critical risk premium is somehow guessed.
It is clear from this that the work of actuaries is technically rather complex. There is no need for pension directors to know every detail of it, but it is advisable to have a general understanding of the main issues such as:
o Actuarial methods (for valuing assets and liabilities)
o Economic theory and financial history (to assess assumptions about demographic developments, financial returns etc)
o Legal requirements (for example, indexation of pensions, transfer rights)
o Risks (most importantly solvency risk).
Profile and influence of actuaries varies considerably across countries and pension schemes. The recent European pension directive requires that “all technical provisions shall be computed and certified by an actuary”, following the prudent person principle. However, in some European countries, there is no statutory role for actuaries while in others the job of a – internal or external - quantitative pensions expert is still rather rudimentary. At the other end of the spectrum, in some places big actuarial firms are accused of being too much in the driving seat as they give advice on a range of additional areas, eg, performance and risk analysis, investment, manager selection and benefit arrangements.
What trustees can do: Actuarial advice is coming under stronger scrutiny by pension plan boards, mainly for three reasons:
1. Problems: Funding problems, for example, may lead to a review of the incumbent actuary.
2. Governance: Increasingly, pension boards realise the need for a more regular, structured monitoring of all their advisers, including the actuary.
3. Core competencies: The synergies in using a single, all-mighty consultancy firm is being questioned. In the UK, for example, the Myners report recommends separate mandates for actuaries and investment consultants.
4. Costs: Trustees are forced to become more cost-conscious.
Looking forward, pension boards need to develop their own policy of what they could and should expect from their actuarial adviser. What are key questions from a trustee’s perspective?
o What are the legal and regulatory requirements for trustees in relation to pension fund valuation, funding, minimum rates of return etc?
o What are the statutory duties of the actuary?
o Is it sufficient to have an actuary “in the narrow sense”?
o Or does the pension plan require actuarial advice “in the wider sense”, including more sophisticated scenario and sensitivity analysis, asset-liability-modelling or risk budgeting?
o Do trustees prefer an individual specialist or a big international practice?
o What role for actuaries in DC or hybrid plans?
o How should they communicate best with trustees, sponsors and members?
o If things go wrong, is there insurance cover?
Once these decisions are made, the general principles of good pensions governance also apply to this most important principal-agent relationship. This includes formal selection and regular review processes, explicit assessment of actuarial risks, benchmarking of the actuary’s performance and the trustees’ own education in actuarial matters.
Some specifics of actuarial advice should be clarified from the outset: How often should the fund valuation be updated? Is the actuary expected to be very proactive in suggesting changes? Should he/she be communicating about shorter term developments? It is obvious that all this goes much further than a standard formal agreement between the two sides.
o Pitfalls: Let’s put the spotlight on one crucial issue – how can you judge the performance on an actuary? This is more easily said than done. Whatever method and assumptions actuaries use, the real outcome after many years will inevitably be different from the forecasts. Ex post, the actuary is always wrong. But how wrong? And why? How can trustees decide whether this is because of wrong actuarial assumptions, a temporary market turmoil, or a bad approach to matching liabilities?
It is in the human nature to look for simple rules, such as repeating what worked in the more immediate past or doing what everybody else does. However, there are pitfalls in this. History may not repeat itself. Also, herd behaviour and pro-cyclical advice may feed booms and busts on markets that eventually are costly to pension provision.
Is the solution to present the pension board a whole funnel of results, based on different assumptions, so that they “pick and choose”? This seems unlikely.
There is a final element to be aware of. Actuarial advice is, after all, a business and requires happy clients. As there is great room for manoeuvring, results can easily be biased in a direction liked by the client. Unfortunately, the managers of the sponsoring companies tend to have incentives that are shorter term than the time horizon of a typical pension plan member. Excessive contribution holidays in the 1990s are a prominent example of this.
Georg Inderst is an independent consultant based in London