Precision forecasts without precision

Innovations in Pension Fund Management
January 23, 2003

Actuarial science is seriously mathematical. The key principles are based on projections of longevity and retirement age, and, from these, the size of contributions and return on funds needed to pay pensions. In the case of defined-benefit (DB) schemes, such as the Universities Superannuation Scheme, pension projections are precise: contributors know how much they will receive when they retire. Other pension formats are usually less certain, in particular defined-contribution (DC) schemes, which depend on stock market investments and lower-than-average employer contributions. Hardly a day passes without press reports of companies bent on saving contributions closing DB schemes to new employees. Actuaries and academic pension specialists should not be surprised to find themselves in great demand.

For more than two centuries actuaries have been crunching numbers and developing models to forecast retirement and savings. Scattered through the history of the profession are stories about actuaries who sharpened up their work and changed the fortunes of funds. The mathematicians recruited in the 1920s by Standard Life, for instance, worked out that equities would rise after the second world war while the capital value of fixed interest bonds and gilts would decline, and their savers benefited accordingly. Now that the profession is facing new complexities, they should draw solace from past successes, and not just dwell on mistakes; no crisis remains unresolvable, and there are issues here that the profession should address without being panicked by short-term declines in pension assets. These include political problems.

This book concerns the precision engineering side of the profession. The advent of faster computers enables formulae to be tested automatically and to produce new models from "what happens if" scenarios. Out of vast quantities of historical data patterns emerge, which, if not exactly predictions, at least offer a best fit to what may happen in normal times.

The profession also manages regular assessments of fund performance. The assumption here is that "corporate and public pensions are being reformed worldwide, with an increasing emphasis toward funded systems, whether they are (DB or DC), with assets managed by professionals". In plain English, this means external managers, with trustees and actuaries employed by pension funds setting parameters for returns from investments in the global marketplace. Essentially, though, decisions on investment will be made externally utilising appropriate models and computing power.

The 11 contributors to this volume tackle familiar ground on DB and DC funds and what efficient management means to external professionals. Three case studies on investment decisions and three more on risk management are advanced, followed by chapters on the purchase of assets and performance benchmarks. The various skills the authors feel ought to be available to fund managers are given attention. Most readers and pension trustees will not find the mathematical part of these discussions at all easy. Indeed, the work takes us away from non-mathematical expertise; as the editor suggests, "marginal improvements in asset performance can prove to be a much more politically viable alternative to increasing contributions or reducing benefits".

This book was completed in 2001, and most citations fall in 2000 and earlier - that is before the unravelling of markets. The pensions industry faces a changing world. Some funds have been wise enough to switch from equities to gilts, bonds and cash. But what will happen if markets remain unsettled and deflationary pressures continue? In such conditions ought employers and governments be obliged to provide what can be regarded as a reasonable recompense for a life's work? This will require more than juggling about with models and fine-tuning margins.

Richard Saville is a historian, Coutts and Co.

Innovations in Pension Fund Management

Author - Arun S. Muralidhar
ISBN - 0 8047 4521 8
Publisher - Stanford University Press
Price - £41.50
Pages - 3

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