EU: Risk Management Alert!

As faithful risk managers and actuaries, we got used to act in a compliant and regulated governance environment. While we are doing our work like buzzy bees, above our heads a disastrous and horrific risk management game takes place, it's called:

ESM

European Stability Mechanism

In order to end the European financial crisis, a new intergovernmental organisation, the 'European Stability Mechanism' (ESM), will be set up in Luxembourg under public international law .

Euro member countries already agreed and are now waiting for an approval of the EU-countries'  parliaments. The latest version of this ESM treaty has been signed on 2 February 2012 and is scheduled to enter into force on 1 July 2012.

The first ESM guarantee layer has been set at € 700. Here are the sustainable shareholders:

ESM Power & Effects

The ESM severely confines the economic sovereignty.

It violates democratic principles of its member states and provides extensive powers and immunity to the board of ESM Governors without parliamentary influence or control.

It's remarkable and unintelligible that even the European Parliament has no control over the ESM!

In short the power and effects of ESM as defined in the ESM 2012 document, are:

• ESM may demand an unlimited amount of money from European countries (9.1 and 9.2)
  
  
• In case of a demand, countries have to pay within seven days, without any negotiation or discussion. (9.3)
  
  
• ESM is not accountable for what happens to the money; they’re allowed to make high-risk investments. (24.3)
  
  
• ESM has the power to reduce private customer savings of bank accounts cross country without permission of the countries' parliaments or any interference from the countries' governments. (12)
  
  In accordance with IMF practice, in exceptional cases an adequate and proportionate form of private sector involvement shall be considered in cases where stability support is provided accompanied by conditionality in the form of a macro-economic adjustment programme.
  
  
• There are no compliance or control measures defined with regard to ESM. Further, ESM has no targets, cost-limitation and enjoys complete immunity. (32)
  
  
• The ministers of Finance will take a seat in the ESM Board of Governors. There they will receive a salary exempt from taxes.
  
  
• The money supplied by all European countries will be used to save mainly the large (too big to fail) France and German banks with loans in weak European countries like Greece, Portugal, Italy and Spain. The people in those countries will not benefit at all from the money supply.

Netherlands Court of Audit Alert

The president of the Netherlands Court of Audit has written an alert letter to her Euro area colleagues and the president of the ECA regarding this new treaty. The aim of the letter is to contribute to the preparation of the next ESM-meeting of Euro area SAIs on 14 March 2012 in Bonn.

The letter addresses the next shortcomings:

• There is no reference to the use of international audit standards in audits by the Board of Auditors
  
• The different types of audit that should be possible for the Board Of Auditors – regularity, compliance, performance, risk management – are not explicitly mentioned
  
• The possibilities for open dissemination of audit results by the Board of Auditors are limited. The Board of Auditors can establish one annual report,which the Board of Auditors cannot send itself to national parliaments and SAIs. This has to be done by the Board of Governors. 

It's clear that it looks fishy.....



Conclusion

Let's hope our parliaments will show some governance sense before it's

too late....

Otherwise most of European people's savings will eventually be used to fill the endless financial gap of those European countries that are not able of mastering their own financial future....

And how many countries will that be?????

Links/Sources:
- ESM 2012 Documen9 (English)
- ESM 2012 Document (Dutch)
- Austria: Objections and Reservations to ESM 
- The EU architecture to avert a sovereign debt crisis (2011) 
- ESM: Technical (PDF/PPT)
- Alert Letter Netherlands Court of Audit 
- Interview (Dutch audio) with Albert Spits

- Dutch protest

Aftermath...

Pension Cuts, Why?

So here we are in the 21st century of 'Pension cuts'. How could this happen and can we do something about it?

No flood of words in this blog, more staccato text and illustrations.

Let the images do their work......

Risk Management
is all about

'getting the picture'

instead of endless calculation and deliberation.

Cappuccino

Let's start with comparing your pension with a cup of coffee......

- Most Pension agreements started in the fifties and sixties of the 20th century
- Employees were promised a nominal pension (plain coffee, so to speak)
- Any additional returns meant indexation (steamed-milk in your coffee)
- Fabulous returns in the seventies and eighties made (full) indexation possible
- The idea of 'free indexation' caught fire
- Cappuccino = Coffee + steamed-milk = Nom. Pension + Indexation, was born
- Common opinion, Science up front, started to redefine our pension concept...
- Credo: 'Pension is only pension if it's "Real Pension" (indexed)  
- The 21th century's first decade returns made it clear: no room for Indexation!
- Things (returns!) got worse; Stock markets underperformed, Low Bond rates
- Nominal Pension under pressure: Pension cuts seem inevitable

Key question: How to cut pension rights?

1. Cut Nominal Pension and keep room for Indexation?
2. Cut on Indexation as much as possible, before cutting Nominal Pension?

Return wrap up

Looking backwards at 10Y T. Bonds and Stocks (S&P 500) as an example, this is - in short - our 'back-up' challenge for the future :

Table 1

Period	Average Arith. Returns		Risk (Standard Deviation)
	Bonds	Stocks	Bonds	Stocks
1960-1980	4.04%	8.06%	5.39%	15.95%
1980-2000	10.21%	18.38%	11.14%	12.51%
2000-2011	7.56%	2.37%	8.39%	18.45%
Period	Average Compound Returns
	Bonds	Stocks
1960-1980	3.91%	6.82%
1980-2000	9.64%	17.69%
2000-2011	7.22%	0.53%

In addition, due to implementing Market Value Principles in the nineties and later, Bonds have become more risky on the balance sheet.

To paint the dilemma of pension funds even more,
- actual artificial low interest rates (how long?)
- extremely overvalued stock market (Total Market Cap/GDP=95%)
- increasing covariance of asset classes in times of crisis
- systemic risks everywhere
- worldwide unsure economic outlook
- unregulated and non transparent hedge and debt markets
- unidentified risk in derivatives; central clearing on its way
- upcoming unsure supervisory legislation (e.g. Solvency)

make it very hard , if not impossible, to take sustainable underpinned decisions.

To illustrate the investment part of this dilemma, take a look at the next chart:

Confidence Level

As a consequence of the above development (and longevity effects) our pensions got screwed up.

In short the next chart illustrates what happened to the (1 year) confidence level of our pensions on basis of the historical returns and risks as defined in
Table 1 on basis of a 'Return Portfolio'  approach:

The above chart clearly shows that our initial cautious (Nominal⁺ Pension) approach in the sixties, was replaced by an (retrospective) much too optimistic (Real Pension) belief in the eighties and nineties. 

A real pension objective puts the nominal pension at risk
Even more important is to realize that - as the approach 2000-2011 shows - it's only (questionable) possible to achieve a kind of Real Pension (with a corresponding substantial (needed) return of 5% or more) by putting the Nominal Pension (extra) at risk!!!!

More in detail:

Long term view

Looking not just at '1 year return risks', but also at 3 and 10 year return risks, we may conclude the risk of underperformance is still substantial.

Therefore, the challenging question  that still remains, is:

Is it wise to put our 'nominal pension' at substantial risk to achieve a highly unsure real pension?

Outlook
Mean Variance analysis in historical perspective, gives food for thought....
The 2012-2020 outlook seems tricky and is not directly showing a 'shiny future'...

Some remarks...

• Last decade⁺ (2000-2011) with higher Bond than stock returns (see Table 1), shows a  major optimizing problem
  
• Future approach (2012-2020) is based on the current low 10Y Bond rate of about 2% (SD=8%), which will keep low as a result of the FED's low rate strategy,  and low expected stock returns of about 4% (SD=16%). 
• Even if the outlook returns would be slightly higher, this wouldn't change the picture..... 

Investment Management: What a fool believes
As  risk or investment manager these are challenging times. Perhaps the only truth in investment land is:  What a fool believes




But what a fool believes ... he sees
No wise man has the power to reason away
What seems ... to be
Is always better than nothing
And nothing at all keeps sending him

NB All (above) calculations, tables and charts are indicative and strongly simplified to make it possible to 'get the picture' and 'get feeling for the direction', in order to support complex decision making  without straying too far from reality..... 

Related Links:
- Gold-plated pensions lose shine (2012)
- Where Are We with Market Valuations? (2012)
- Value-at-Risk: An Overview of Analytical VaR (JPM)
- Solvency II nightmare still looms but worst-case scenario averted


Spreadsheets (Raw, download):
- Real ambition
- Risk Return

What became of my Pension Plan...

It's sad but a bitter reality, pension cuts are on their way....

We have to admit.., our once so ambitious pension plans got shattered.

What's left is the cartoonized view of an average pension member:

Dutch Perspective
For Dutch pension members and pensioners the situation has become (extra) paradoxical.

Top consulting firms like Mercer and Towers Watson (regularly) rank The Netherlands as one of the best pension countries ever.....

These announcements only bring little consolation......

On top of the Dutch State Treasury Agency illustrates the relative 'strong outlook' of the Netherlands in European perspective.

All this looks quite hopeful, but does it generate the necessary trust?

New Risk Management Definition

What comes to mind is: was our our pension plan based on hope or calculations we can trust? Is our (Dutch) country recovering plan based on underpinned facts and actions or is it 'pink cloud thinking'.....?

Hmmmmm...., all these reflections lead to a kind of new mathematical definition of Risk Management:

Risk Management = Trust - Hope

In other words, Risk Management is managing the difference between Hope and Trust......

Faith alone seems not enough.....


What's next?
Key question is in all this pension fuzz is of course: How could this happen?

More technical details in my next blog on Actuary-Info :

Pension Cuts, Why? 

Mean time, keep breathing, you're living a longer live......



Sources/Related Links:
- Dutch State Treasury Agency (2012)
- Global Pension Assets Study 2012

- The Melbourne Mercer Global Pension Index (2011)
- List of Top Consulting Firms 
- Is Faith Enough?