Why Anthony Hilton is Wrong on Pensions 

“Expected returns don’t pay benefits, cash does”

Anthony Hilton recently wrote a stinging attack on pension consultants -like myself- who advise defined benefit pension schemes to measure, and hedge, their liabilities with reference to gilt yields.

Here’s one (of several) reasons why he’s wrong.

His argument – that you could fund based on the much higher expected returns on risky investments – might perhaps be justifiable in a world where all corporate sponsors were rock solid and would last forever (clearly we do not live in this world – and even then it would expose companies to some needless nasty surprises along the way, but anyway).

However this completely misses the point that a major reason we fund pensions at all is precisely to provide security in a situation where the corporate sponsor ceases to be able to make payments itself. The reason we need to measure deficits is to get a picture of how secure the benefits might be in the absence of the employer, and to take corrective action (eg topping up contributions) if the situation is off-track, before it is too late.

And in those situations of sponsor company failure, we would hit a major snag under Mr Hilton’s approach: it’s hard cash that must be used to secure the benefits – Mr Hilton’s expected returns won’t cut it I’m afraid. Just ask the pensioners of BHS scheme, or indeed the allied steel and wire groups, still campaigning for their pensions over a decade later. This second example pre-dates the Pension Protection fund, so thankfully pensions today are better protected, but the conclusion for scheme funding – that you can’t rely on high future expected returns to discount liabilities – remains valid.

Pensions need to be paid to members in real cash, and it flies in the face of both accepted theory, and common sense, that the amount of money needed to provide these benefits can be reduced depending on the assets held to deliver them.

Today’s unfortunate reality is that the defined benefit system in the UK is on average chronically under funded compared to the benefits it has promised. Time and effort would be far better spent on considering the tough choices that might need to be taken, rather than on attempts to deny the existence of a problem in the first place.

Unfortunately Mr Hilton’s ill-judged remarks from an otherwise respected journalist damage the hard work that many of us in the industry have been doing for many years to try and secure the benefits and financial futures of those members dependent on defined benefit pensions for their retirement.

Grim Summer for DB Pensions

It’s not been a good summer for the financial health of UK DB pension funds.

Data released by the PPF in September underlined a summer of bad news for schemes and scheme sponsors.

A continued trend of falling gilt yields have seen liability values increase dramatically – adding more than £200bn to the aggregate deficit compared to the start of the year. The aggregate funding level (on the PPF basis) fell to 76% at the end of August, the lowest value in the 10-year history of the series. For context the funding level on this basis was close to 100% at the end of 2013.

Long-dated gilt yields have fallen from around 2.5% at the start of the year to around 1.2% by the end of August.

The result of the referendum vote certainly added impetus to the move lower in gilt yields, as “lower for longer” became a more likely scenario, and this was re-enforced by the BoE’s announcement of renewed bond purchases (quantitative easing) and a cut in interest rates to 0.25%.

While asset markets have generally performed positively – especially overseas equities in £ terms, these good results have been insufficient to keep pace with unhedged liabilities.

It seems likely that actuarial valuations as at 30 June or 30 September are likely to contain bad news for corporate sponsors, prompting tough conversations such as those happening at plastics manufacturer Carclo, and negative headlines such as those at Associated British Foods. These are likely to become more and more common as we move forward, as highlighted by LCP in their Accounting for Pensions report.

august-2016-a-decade-of-db-pensions

 

Black Box Thinking

The best book I read over the summer was Matthew Syed’s Black Box Thinking.

The central theme of the book is really fear of, and reaction to, failure.
We have an allergic aversion to failure. We try to avoid it, cover it up and airbrush. The phenomenon of cognitive dissonance  is the name for the deeply-rooted behavioural trait that causes us to naturally reject ideas or even evidence that conflicts with our own worldview. This can be incredibly damaging to progress in many cases.
There’s a huge need to learn from failure, it can be extremely helpful (Syed cites the example of the aviation industry learning from air disasters to vastly improve the safety record).
Readers of similarly themed books (eg the work of Charles Duhigg, Khoi Tu or even David Eagleman)  will find a lot of the examples used by Syed a little tired and overdone by now. However I found that Syed was able to extract sufficient new insight from some of these well trodden case studies and weave them together with the central theme effectively.
Creating  by experimenting is often more effective than creating by blueprint.

Cognitive dissonance / confirmation bias

There are some powerful behavioural psychological forces at play that can be quite counter-productive to progress in today’s world. For example, the tendancy of reframing when faced with evidence that we’re wrong … divorces us from the pain of recognising that we were wrong. It’s not even conscious when it happens.
For example –

Open vs closed loops.

Syed defines open loops as operating by benefiting from feedback for example aircraft black box & medical randomised control trials.
Closed loops do not systematically collect feedback AND more seriously do not have the mindset to confront, recognise and learn from failure. Closed loops systems are dangerous because they  block progress – whether that be progress in safety, improving care, innovation or surviving in the commercial world.

Evolution itself is the best example of learning from failure.

Narrative fallacy Vs RCT

Narrative fallacies arise inevitably from our continuous attempt (need) to make sense of the world around us. The explanatory stories that people find compelling are simple and concrete. But they often assign a greater role to talent/stupidity/intentions than to luck and often rely on a few events that did happen rather than the countless that didn’t.
Stories are good but beware the narrative fallacy. Eg scared straight. Statistical biases.
Need counter factual and control group.

Marginal gains & feedback loop

Marginal gains is not about making small changes and hoping they fly. Rather it is about breaking down a big problem into small parts in order to rigorously establish what works and what doesn’t.
Break a performance into a component parts & you can build back up with confidence > brailsford
Some programs are hard to create controlled trials for, eg aid to Africa. Break down into component parts >> marginal gains
The existence of a local maximum reveals the inherent limitation of marginal gains. Sometimes you need a big leap forward to get past a local maximum. Need to do both marginal gains and big-picture thinking.

Innovation

Contradictory information jars us psychologicaly. It nudges us into looking for unusual connections. Innovation comes from making new connections between familiar things.
Find a hidden connection to solve a problem. Failure and epiphany are linked. Brilliant ideas can emerge from engagement with a problem for months or years.
Innovation is context dependent – a response to a particular problem at a particular time & place.
Big picture & small picture. Innovation + discipline = success. There exists a threshold level of innovation required for a firm to be successful, beyond that it depends on the discipline to implement.

Book review – Smarter, Faster, Better 

After really enjoying Charles Duhigg‘s excellent first book The Power of Habit, it was an easy choice  for me to grab a copy of his second book on the way to my holiday, having been given a recommendation from Mitesh. I wasn’t disappointed!

Essentially the book looks to explore ways in which we as individuals and teams can be more creative and productive. Some of the points and ideas are familiar, but I really like Duhigg’s style of weaving neatly summarised academic literature into memorable real world stories and characters.

Here’s my top 4 takeaways-
1. Single most important tip for teams: build a commitment culture through fostering psychological safety.

A commitment culture (as opposed to a star culture) is one where the whole team is genuinely committed to helping each other reach a common goal. Psychological safety means that each person on the team can speak up, contribute ideas, and critique ideas. Everyone gets their turn to speak and meetings are not dominated by a couple of individuals.

2. Motivate yourself and others by making choices that put you in control.

It turns out that the need for control is pretty fundamentally hard wired into us from an early age (I don’t have kids, but my friends that do tell me this is something they experience frequently from the age of about 2). A perceived lack of control over a difficult of demanding task can be stifling for our motivation (just ask any student approaching revision for exams!) But as adults we can use this to our advantage. For ourselves, approaching draining or difficult tasks can be easier if we start by framing a choice (choose the location for a difficult meeting, taking control of your availability). When managing others it can be incredibly powerful and motivating to pass control to them – allow them to take key decisions relating to the project. This also ties in with agile principles.

3. Build mental models

Our brains are set up to build models of the world around us and constantly evaluate information received against the model (David Eagleman writes more on this in his excellent book on neuroscience, incognito). We can harness this in a working environment by constantly building a model of how we expect a given day, interaction, meeting or project to play out. Evaluating what happens in reality relative to this model can help better decision making. In the book, Charles Duhigg uses some excellent contrasting examples of aviation incidents to really bring this home.

4. Make data disfluent, in order to understand it better

We live in a world that has never been richer in terms of data. We each generate huge amounts of data everyday and carry in our pockets devices capable of processing data that previous generations couldn’t dream of. But how do we turn that data into actual information and insights?

Paradoxically a great way of doing this is often to go back to basics. Make the data harder to interact with at first. Draw graphs by hand, write datapoints out longhand on flash cards. By doing this we are forced to interact with the data more. We build theories about what the data contains, and in testing these theories we learn the important lessons. This is also why taking handwritten notes can be more powerful than typing notes, precisely because it is MORE labour intensive.

There’s plenty more in this very readable book, granted not all the concepts are revolutionary, but I would be surprised if you couldn’t find a few real actionable insights to take away and apply day to day. I certainly did and I look forward to implementing these with my team.

Two Days Among Actuaries

Just back from a couple of great  (sunny!) days in Edinburgh for the institute of actuaries conference which importantly this year incorporated pensions, investment and risk components together for the first time.

Quite a lot of interesting takeaways and observations from around the industry. As Marian Elliott said in the first session  “To the worm that lives in horseradish, the whole world is horseradish”. The point being it can be helpful to get a different perspective on things from the one you usually have.

Here are the big 3 things I took away:

 1. Integrated Risk Management (IRM). The pensions regulator continues to stress the importance of IRM in the latest funding statement here, and the IFoA working group has made progress thinking about the issues.

My  takeaway was that this remains a work in progress in that no-one has (yet) put forward the “perfect” framework for looking at these three components and bringing them together in an intuitive and practical way  (possibly, that doesn’t exist). What the working party has done is given considerable thought to a number of worked examples that act as  “corner cases” and challenge people to  think qualitatively about those different components of risk, what investment and funding strategies should result and  key metrics to track to best monitor.

With some of the current high profile cases in the news, the examples seemed very pertinent.  It’s clear that thinking in some of these cases has to come back to the member perspective, and what gets the best outcome for members benefits, and this inevitably includes thinking about the possible interaction with the PPF, something that clearly has to be handled carefully.

While this remains a work in progress I think the thinking that went into the worked examples, including legal opinion on certain points, is a welcome contribution to this important area. The suggested further reading (including  the Blake / Harrison paper  The Greatest Good for the Greatest Number looks interesting and I look for ward to reading further)

The session ended with a challenge to the audience – someone needs to take the initiative and bring these strands together. The working party proposed that actuaries are well placed, I would argue that the investment consultant is, too. The WP expect to communicate more toward the end of the year, I look forward to continuing the conversation.

2. British Steel

Not surprisingly this seemed to be one of the major talking points of the conference over many a coffee and beer. It’s putting the issue of pensions on the front pages of mainstream papers and into the general public discourse in a way that I haven’t really seen during the rest of my career (possibly you need to go back to the 1990’s and Maxwell to find a similar time). The panel discussion organised to address the consultation and the profession’s possible response was remarkable both for the number of people filling the room, and the strength of views expressed. This session was explicitly under “Chatham house rules” so I won’t share too many details, but fair to say there was a lot of questioning of the need to make this scheme a special case, and the danger of making up legislation and precedent “on the hoof”. A couple of interesting prior cases were mentioned including British Midland/Lufthansa which I need to read up on.

The discussion of the individual consultation options was interesting, albeit somewhat drowned out by the wider question of whether creating a special case is the right thing. What was clear is that there is an increasing acknowledgement that the ability (or not) of any scheme to move benefits from RPI to CPI may essentially be an accident of drafting and in effect is a lottery. I strongly suspect that whatever happens to British Steel we haven’t heard the last of the CPI/RPI debate which looks set to continue rumbling on.

3. Endgame & Self sufficiency management

Paul Sweeting of LGIM wrote a recent paper on a blueprint for self sufficiency management, and this got quite a few mentions. It’s a welcome contribution to the area and ties in with a lot of our thinking. The use of contractual cashflow, and alternative metrics for risk, with a nod to the practice and mindsets of the insurance industry makes a lot of sense.

the key findings of the paper are:

  • Focusing on the probability of paying all benefits is a helpful metric for end game schemes (more so than VaR or volatility);
  • For schemes that are well funded enough, corporate bonds are the best asset to hold to maximise this metric;
  • Allowing for defaults, downgrades and being dynamic with decision to reflect changes in spread level is important;
  • Conventional mark-to-market volatility becomes less of a consideration;
  • Where liability present values are needed, the corporate bond spread  can be embedded into the discount rate, to create matching of assets and liabilities.

While probably not that many schemes are in the end game yet, as we noted in this blog it is important to set out with this destination in mind, even if it is some way off. And as we know from survey data many schemes have self-sufficiency in mind as a goal. A useful first step is to make sure they have advisors and fund managers in place with a clear and sensible plan to construct and implement a strategy to deliver the scheme’s self-sufficiency goal.

Ri_End_Game_Infographic

Roboadvisor Europe 2016 – The Future?

The future of asset and wealth management?

A thoroughly excellent event was organised by Level39 in London on 25 May 2015, featuring speakers from all the key players and analysts in the fairly nascent European roboadvisor scene and around 250 delegates.

My five top takeaways are below, or you can read my storify story here.

1. Mind the 2016 inflection point

Rohit Krishnan of Mckinsey made this point, but it was echoed by others. The growth rates of the two longest stablished US roboadvisors (Betterment and Wealthfront) have stalled somewhat, possibly co-inciding with the robo launches of two large incumbents Vangard and Charles Schwab. With significantly lower AUM than is probably needed to justify costs and valuations, 2016 could be an inflection point, which way will things tip?

2. Customer acquisition cost is key

It’s a closely guarded secret when it comes to individal firms, but surveys and other data in the public domain suggest that customer acquistion costs can be in the region of $300 or higher, but lifetime value of an average client may only be $250. If that’s true, then it would seem to pose a challenge to the business model.

3. But Europe is a bit different

Several of the European robos made the point that the European market is a bit different to the US. With less competition on fees in the traditional advised space, European robos charge in the region of 40-70bps rather than 20bps in the US. This means the breakeven point in AUM might be somewhat lower, 0.5-1bn was suggested.

4. It’s all about the api

There was a fascinating panel covering the tech aspects. The main takeaway being that we have entered a new era of openness, and what’s important is opennes with regard to architecture & api , to enable other components “plug in” to create an ecosystem.

5. Scale & brand are hard

These two comments stood out to me from all the points made by the startups. Firstly, building the right scale to reach 1m+ customers is difficult (more difficult than we thought said Shaun Port of Nutmeg). Secondly, several panellists commented that building the wider brand and customer awareness was key, no-one had really done it yet, and many firms were in a race to try and do so.

that’s it! plenty more I could say (and check out the storify for more).