Jul 9, 2015

Optimal Pension Fund Investment Returns

How to manage a pension fund investment portfolio in economic uncertain times and shifting financial markets? Let's try to answer this question from a more practical point of view instead of a pure scientific approach......

Historical Performance
Let's take a look at the performance of two large and leading Dutch pension funds

First of all we take a look at the historical (1993-2014) yearly returns of both pension funds and try to figure what n-year moving averages results in a stable and mostly non-negative yearly performance.

Smoothing Returns
If our goal is to 'smooth' returns to pension fund members and to prevent negative returns as much as possible, a '3-year moving average return approach' as basis for sharing returns to pension fund members, could be a practical start. 

In this approach, a single maximum cut of around 3.3% is largely compensated by the returns in other years as the next chart of  '3 Year Backward moving Average Yearly Return' shows:

Of course if we want to protect pension members also against systemic risk and crises, an additional investment reserve of around 15%-20% would be necessary.

The  next slide gives an impression of the effects of a 10 year moving average approach. I'll leave the conclusions up to the readers. of this blog.

Main conclusion is that the analysed pension funds ABP and PFZW are able to generate a relative stable overall portfolio return over time. They manage to do so, despite the fact that their liabilities yearly fluctuate as a result of the fact that they have to be discounted by a risk-free rate. 

A risk free rate that itself isn't risk free at all and - on top of - is continuously 'shaped'(manipulated ) by the central banks to artificially low interest levels.

Managing Volatility instead of Confidence Levels
A strategy based on managing the funding ratio of a pension fund given a certain confidence level and given the actual method of risk-free discounting of liabilities, is doomed to fail in a low interest environment. Discussions about confidence levels are also a waste of time, as long time confidence - at any confidence level - eventually will turn out to be an illusion.

As long as pension funds are able to demonstrate that that they are able to manage and control the volatility of their assets within chosen limits (risk attitude 1; e.g. 10%) and within a chosen time horizon 
(risk attitude 2; e.g. 20 years) , they will be able to fulfill their pension obligations, or to timely adapt their chosen risk-return strategy to structural market changes.

How to curb volatility?
Managing the volatility of an pension fund investment portfolio within a certain risk attitude is one of the greatest challenges of a pension fund board.

In short, the traditional instruments to curb volatility are:

  1. Diversification
    With the help of diversification the asset mix of a  pension fund can be tuned to optimize long term risk-return in relatively 'normal' market circumstances.
  2. Capital Requirements & Management
    By defining and maintaining a well quantitative risk-based capital and investment reserve policy, a relatively smooth yearly return available for pension fund members can be achieved in a systematical risk environment.
  3. Economic Scenarios
    By studying portfolio outcomes under different economic scenarios, a short term 'best fitting' near future volatility asset strategy can be developed.
  4. Trigger points
    By defining asset portfolio actions that will 'fire' once particular trigger points of specific asset classes are met, all measures based on 'damage control' are in place.
Unfortunately the above measures all fall short in case of systemic market events.

In case of crises, like the current Greece crisis, agent based models, also called behavioral models, can help to manage systematic volatility.

Behavioral Asset Management
A way to minimize systemic volatility in an investment portfolio is to apply new 'Behavioral Economic Stress Test' models. These kind of tools, as provided y a FinTech50 2015 company called Symetrics, enable pension boards and investment managers to model and to anticipate crises.

More is explained in the next short presentation "The value of economic scenarios from a risk perspective" by Jos Berkemeijer, one of the four managing partners of Symetrics.

Used Links
- Agent based Models
- Behavioral Models by Symetrics
- Spreadsheet wit data used in this blog
- Presentation: The value of economic scenarios from a risk perspective

Jun 13, 2015

Professional Empathy of an Actuary

The most important hard skill in any profession is a soft skill called Empathy.
Without empathy, any project or business goal is doomed to fail.

Just a small humorous illustration to get the picture....

Adding Rabbits

One day, the math teacher asks six year old Johnny, "If you have 200 rabbits and you add another 100 rabbits, how many rabbits would you have?"

Johnny thinks for a moment and then answers: "I think the answer is 337 Sir".

"No, Johnny. That's the wrong answer. Try again.

Johnny takes another five seconds and answers: "Still probably 337 Sir" "

Now the math teacher slightly loses his temper and baffles: "No Johnny, wrong again. You know nothing about mathematics!".

Immediately Johnny answers: "And you know nothing about rabbits Sir"

Actuarial Skills
A recent (May 2015) Investopedia article sums up the five skills every actuary needs
  1. Analytical Problem Solving Skills 
  2. Math and Numeracy Skills 
  3. Computer Skills 
  4. Knowledge of Business and Finance 
  5. Communication and Interpersonal Skills
Although in a classical sense this powerful summary of an actuary's professional competences is perfectly in line wit more detailed descriptions as given by several actuarial associations, something essential is missing.

To be successful as an an actuary you'll need to develop what is called

Professional Empathy

What is Professional Empathy?
Professional empathy is the ability to see the world through the eyes of other professionals.

As actuaries we're trained to view and resolve our projects, challenges and issues in a primarily quantitative manner with the help of actuarial techniques, models and formulas.

Through study and experience we can develop "Professional Empathy" that allows us to look through the eyes of other professionals or clients and feel and understand what their view and perceptions are.
In doing so, we're able to optimize our advice, support or project performance.

Understanding and response
Professional empathy implies two elements: understanding and response.

To understand other professionals and clients, we need to develop the ability to be sensitive to the needs and feelings of others. To do so, it helps to develop technical skills in other professional fields, read other than just actuarial literature and join other than pure actuarial conferences.

As graduated actuaries we already developed a broad multi-professional basis that includes professional areas as: mathematics, statistics, finance, insurance, asset management, pricing, administration, business analytics, ict, organization, marketing, etc. Therefore, if we continue to develop this multi-professional ability, we - as actuaries - are are ideally suited to organize combined professional expertise (innovation) projects.

Besides the traditional actuarial areas as insurance, pensions, statistics, and actuarial techniques we'll have to focus and develop skills in the surrounding areas of the actuarial work field:

In order to understand we need to develop the ability to read verbal, paralinguistic and non verbal cues of professionals in other professional fields.

Secondly, our response and attitude to other professional should be in such a way that other professionals recognize that we understand them, appreciate that we speak their (professional) language and invite us to share their professional issues or doubts with us.

Interpersonal communication skills 
This way of responding requires to bring out a professional attitude that's based on interpersonal communication skills like:
  1. showing interest, respect and appreciation
  2. active listening
  3. showing understanding, being accessible, 
  4. having a flexible attitude 
  5. operate steady on basis of ethical principals.

Intrapersonal skills
It also forces us actuaries to continuously work on our intrapersonal skills like: 
  1. Knowing what drives, angers, motivates, frustrates, inspires you
  2. Knowing your own strengths and limitations
  3. The ability to stay calm and balanced in stressful situations
  4. Self confidence

How to start with Professional Empathy?
You can start with developing your professional Empathy as follows:
  1. simply pick out one of the communication issues as mentioned above (e.g. 'active listening')
  2. After a conversation with a trusted professional you work with, simply ask for honest feedback by asking for example: "I try to develop a more active listening style. May I ask you: Do you think I really listened to your arguments. If so, in what way? If not, 'why' and 'when' not? What would you have expected of me?

If it seems difficult for you to ask these questions, congratulations! You now know for sure this approach is applicable to you.

If you think it makes no sense to ask these questions once in a while. Just keep doing what you always did until the final reality check!

SOA Self Assessment
The Society of Actuaries has developed a Competency Framework Self-Assessment Tool. The self-assessment asks you to rate a series of statements about the skills that actuaries should have to be valued for their professionalism, technical expertise and business acumen.

It's a 45 minute test that gives first impression of you improvement areas. However, interpersonal en intrapersonal skills are only limited measured.........

May 14, 2015

Risk Management Ground Rule

Risk Management is a awkward and hard to grasp discipline. Not only in boardrooms, but also in the practice of our professional risk management discipline.

Once you think you've captured risk management, it captures you...... again and again...

By definition risk management is a paradox.

Once you fully 'control' and 'manage' a certain risk, it's no longer really a 'risk' in the sense that it can surprise you.

However..., did you check and do you manage the following risks?

Meta Risk Management Risks

  1. Risk Framework Risk
    All (regulatory) rules and principles you apply in risk management are filters that cause new risks. Therefore every kind of risk management framework is also a source of risk and should be part of your risk management framework.
    Have you identified weak spots in your risk management framework?
  2. Risk Measures Risk
    Every risk measure taken, causes a new risk.
    Have you identified what the risks of risk management measures are?
  3. Model Risk
    All models you use in risk management are dangerous and risky approximations.
    Therefore, always use at least a second 'Challenger Model' to fully understand, check, calibrate and control your risks and risk measures.
    Do you have at least one challenger risk model in place?
  4. Unknown Risk Preparedness
    In the heart of the matter 'managing risk' is not primarily  'risk management'. Preparing for unknown risks is what risk management is really about.
    Do you have a procedure in place for managing unknown risk events?

Congratulations if you have successfully passed the above Meta Risk Management Test.

Ground Rule
Yet, there's still one risk management  ground rule you could have violated.... Denying this ground rule is the same as the ground rule itself!

Never classify any event or reported risk as not relevant  


A. Example Challenger
One of the most classic examples of violating this ground rule is the disaster of the space-shuttle Challenger back in 1986. Engineer reports about the failing two rubber O-rings that caused the accident, where denied by management.

Just recently we can observe another possible example of violation.

B. Stress Test  
On 11 may 2015 the supervisory authority EIOPA launched its first 'stress test' for European pension funds (IORPs;Institutions for Occupational Retirement Provision).

Now take a look at the initial response of a spokesman of the Dutch pension fund association (Source: IPE; translated):

  1. Not happy
    The Dutch pension sector is not happy with a stress test for pension funds, as issued by the European regulator EIOPA.
  2. Unnecessary
    According to the Pension Federation the test is 'not necessary' for Dutch pension funds and the test could lead to "unnecessary European rules'. The test is just a burden for the funds. A waste of their time. Besides the Pension Federation fears that the results lead to all kinds of EU rules which do not require in the Netherlands. We must be careful that there will not draw the wrong conclusions.
  3. Dutch Pension funds cannot Topple
    From a Dutch perspective, the test unnecessary, because Dutch funds cannot topple by what is regulated here in The Netherlands. 

It's clear that this kind of reactions are counterproductive and violate the ground rule of risk management.

To put it in a different way: Perhaps Dutch pension funds cannot topple, but they sure can collapse!

As experts in risk management we're all confident that we can identify, understand and manage risks. Unfortunately, nothing less is true...
We all have our blank space.......