What's that, an actuary? Kamikaze Investors

'Housing' is probably one of the most complex assets and also one of the most interesting.

Wake up...
At the next birthday party when somebody asks you the regular line: 'What's that, an actuary?....'  Don't answer the obligatory way, but demonstrate your actuarial risk management abilities in an interactive way....

Just ask who of your birthday friends would call himself a private - non professional - risky investor?........

After some hesitation and discussion, probably all of them will answer something like:  'No, I would not dare to risk much money, I put most of my savings in a 'safe - as possible - bank account'.

Than, your next question is: "Who owns a house?"
Now, probably more than 60% of your friends will raise their finger......

Congratulations! Now you may congratulate this 60% of your friends with the fact that they are probably a more risk taking investor than an average pension fund, because they are most likely (by far) overfunded  in the asset category "Housing".

After grasping the point of your little quiz, most of your friends will first laugh, than think, and after a while some of them will ask you what they should do about being a Kamikaze-investor?

Now you get to the tricky part of being an actuary:

1. Never tell anyone what to do, 
2. Just show them the possible scenarios
3. Point out and quantify the risks, and 
4. Help them take their own decisions 

House-Pricing
 A lot of research has been done around House pricing and risk.

Although their seems to be a positive relationship between interest rate and housing-price growth, the housing risk is much more complicated than that.

Also housing prices differ strongly by country, as the next Economist table shows:

And because as actuaries, we're little Kamikaze-investors as well, the Economist has developed an interactive application to get sight at the housing-price development in your country relative to others.

Have fun with this House-Price Calculator

Related links:
- Economist House-Price Development Calculator 
- Housing consumption-based asset pricing and residential mortgage default risk. (2009) 
- Home Values and Household Debt Present Global Risks
- Running on funds: Complete (2007) Fitch Table

How to prevent cutting pension benefits?

Continuing increase of lifespan, low interest rates and stock market under-performance are the cause of pension fund's funding ratios (FR) falling to a level of underfunding (< 100%).

Sure..., it's questionable whether valuing assets an liabilities at market value is the best way to value a pension fund (after all, a 'run on the pension fund' is not possible!). However, changing a pension fund's 'valuing method' to a more artificial method (e.g. 5 years average risk free discount rate) seems no realistic option to prevent underfunding. It would be perceived as a cosmetic brew and no solution at all for sponsors that have to consolidate pension obligations in their balance sheet.

Left without alternatives, pension funds are forced by law (and the regulator) to take action. There seems to be no other choice, than to 'cut pension rights'....  Or is there?

Conditional Benefits
A quite simple and effective solution is to split up current an future Pension Benefits (PB) in a guaranteed (certain) part PB_certain (99,9% confidence level) and a conditional part PB_conditional .

The Liabilities of the the conditional part L_cond, can be used to act as a Reserve to guarantee the liabilities of the guaranteed pension benefits  L_certain. In this approach all inflation, longevity and investment results are absorbed by the conditional part L_cond.
As a consequence, the funding ratio (FR) of the pension fund gets 'cured'....

Let's see how this turns out for a healthy pension fund without a shortage:

What in fact is happening here, is that we use the cooperational characteristics of a pension fund to finance its own equity (Reserve + L_cond). As no shareholders are involved, all equity is owned by the members of the pension fund, who profit not by means of dividend, but in the form of conditional pension benefits.

Now have a look at that same pension fund with a shortage on basis of conditional pension benefits:

Undoubtedly this 'new pension model' situation looks much better than the old model and certainly better than the pension balance sheet after cutting pension benefits:

Just imagine what 'reforming a pension fund on basis of conditional pension rights' could mean for your pension fund.

When life gets difficult, we have to turn to simple actuarial solutions....

How Rewards Pay Out

Let's take the 'Candle Test' as constructed by the psychologist Karl Duncker (1930).

Just take a look at the materials on the left picture.

A candle, a box of thumbtacks, and a book of matches.

Here's the simple task:

Attach the candle to the wall so that it doesn't drip onto the table below.

(Please, don't read any further until you solved this challenge....)

Solution

Here's the solution:

Empty the box with thumbtacks. Place the candle in the emptied box. Fix that box to the wall using the thumbtacks. Place the candle in the box.

If you managed to find this solution (without cheating) within 4 minutes, you're still an enlightened actuary.

If not? Don't mind, things will get better after reading this blog.

To find the solution you had to overcome what is called “functional fixedness”: You had to see beyond the thumbtack box as purely a container for the thumbtacks.

Rewarding Performance
In the sixties Sam Glucksberg used the 'Candle Test' to test the impact of extrinsic motivational factors on the problem solving ability.

Glucksberg created two groups of participants. The first group was told they would be timed to establish norms for how long it would typically take people to solve this sort of puzzle. The second group of participants were offered $5 each, if the time they took to solve the problem was in the top 25% of all those tested. The fastest achievement would be rewarded with $20.

The outcome of this experiment was that it took the extrinsically incentivized second group on average three and a half minutes longer to solve the problem. Obviously the incentives narrowed the participants minds and blocked them to think literally 'out of the box'....

From this experiment it became clear that rewards fail and work contrarily in case of complex situations.

Similar experiment....
Then, Glucksberg took a similar experiment in a slightly different way.

He presented two new groups the situation on the left picture.
Can you predict the outcome this time?

This time, the rewarded group defeated the non-incentivized group by miles....

Why???? Because the tacks were OUT of the box !!!!

By placing the thumbtacks out of the box and placing the thumbtack box empty on the table, Glucksberg had changed the problem.

Instead of achieving a heuristic task (i.e. a complex task that requires analysis and experimenting with possibilities to develop a solution), the problem was reduced to a more algorithmic problem (i.e. the solution comes down to a set of simplistic steps down a single pathway to one conclusion).

Conclusion
To summarize: financial short-term rewarding of complex tasks leads to output reduction instead of a better performance.

More than actuaries, professionals like quants, investment managers and bank managers are rewarded on short-term output, while - at the same time - their professional challenges and objectives are complex like a Gordian knot.

A way out

If we want to get out of the current economic crisis, we'll have to stop rewarding short term results one way or the other. Our complete (economic) system should be rebased on rewarding long(er) sustainable results and well calculated risk. Don't wait any longer, just start today at your department.

Excuses....
The issue of "not getting the 'right' professionals if we don't pay enough" is a fable. No matter how professionals like CEOs, Bank managers or actuaries are: if they just go for the short-term money and aren't intrinsically motivated to make this world a little better with their gifts and skills, please let them leave.

Tip: Include rewarding in your risk models!

Let's conclude with an interesting video by Dan Pink who examines the puzzle of motivation, explaining that traditional rewards aren't always as effective as we think.




Related/Used sources:
- Carrots and sticks
- Functional_fixedness