Actuarial Cookery in the Boardroom

Suppose your friend gave you the recipe for a delicious 'Paleo Tomato Soup'.

Does that recipe also guarantees you a delicious meal ?

Undoubtedly you answered this question with a clear "no".

Why?

As we all know, it is the 'touch of the chef' that determines the quality and final taste of the meal. The recipe is the score and the chef the performer of the culinary piece of music, that will end up on your plate.

Although the above example probably sounds logical to us, the actuarial cooking practice appears different. Let's take a look at the next example.

An Excellent ALM Advice

What about a 'plate of five' asset mix advice that's on the board's breakfast table, as the ultimate outcome of your excellent ALM analysis...

Illustration: Colin Daniel

Does this ' computer recipe' actually guarantees a sound decision about an adequate investment policy?

Actually, the answer to this question can hardly be other than 'NO'.

Your advice is a static advice in a dynamic world and - on top of - the final question remains whether the asset manager is able to 'spice up' your recipe.

The actuary as Risk-Director

Key question is whether we as a profession - keeping ourselves inadvertent in the role of  'technical experts' - merely feel responsible for delivering the recipe for a cold asset mix salad on basis of 'expected values' ​​and variances.

Or ... that we actuaries are willing to act as 'risk-director' in the interactive process of creating a dynamic investment policy that's based on a nonlinear constructed healthy and varied based asset mix over time. Albeit..., without taking the driver's seat in the advice process, but with the obligation to report the eventual existence of any GMCs ('Genetically-Modified Cickens') in the asset-mix.

Economic Risk Management or ALM?

In the thorough process of adopting a dynamic investment policy, financial boards more and more take decisions based on the study of different future economic scenarios.

This development challenges actuaries to invest more in the development of "Economic Risk Management" (ECRM) models instead of traditional ALM modeling. In ECRM 'asset class data' (as in ALM) and economic data (GDP, inflation, consumer confidence, etc) are mixed in an integral set of data, that's analysed and - with future expectations, 'stress-test conditions' or of 'believes' -  (nonlinear) translated and optimized in a dynamic asset mix.

This economic risk approach requires new nonlinear economic-asset models that urge for a close cooperation between economists and actuaries, resulting in an serious interactive board discussion (board members and economical & actuarial experts) of the ECRM models.

This approach is not limited to the well-known three or four so-called 'muddle through scenarios', but covers the outcome and impact of a large number of more precise formulated possible economic scenarios on the asset mix and the investment strategy.

Scenarios that help determine the overall risk appetite and result in a major impact on the composition of the strategic asset mix.

New Q&A's

In other words, new scenarios that give answers to questions like:

• What happens if China suddenly withdraws from U.S. bonds?
• What happens when the U.S. Fed stops its QE program?

As with the current ALM approach, the focus should not be only on the quantitative outcome of the ECRM model, but more on the discussion and wider perception of how economic risk affects the optimal asset mix and the dynamic asset policy, allowing boards to take more informed and underpinned investment policy decisions.

In this approach, ALM and ECRM are helpful but not dominating decision support tools in the creation of the final investment policy and not an unintended consultant's dictate that's implicitly adopted ("take note") by the board and then subsequently implemented.

How to Check the Quality of your ALM or ECRM Advice?

Fortunately, it is easy to check whether your ECRM or ALM advice is actually a good quality decision document or just a bite-sized chunk.

If your advice offered only 'one option' or was adopted without a serious debate or any amendments, then -  to put it euphemistically - your advice is 'ready for improvement'.

Actuaries: Backroom to the Boardroom

Finally, it all comes down together whether we as actuaries want to profile ourselves as 'recipe writers' or pick up the 'risk-director role' as an 'actuarial chef'. If you choose the latter, please stand up and help to bring out actuaries from the Backroom to the Boardroom. Success!

Pension Egg Choice

Imagine you're a new pension fund member and your pension fund offers you the next simple proposal regarding your future pension income.

With closed eyes you are allowed to take out two 'pension eggs', either from nest I or nest II. Which nest do you choose?

Think about this proposal and remember: your complete financial old age depends solely on the nest of your choice.

I discussed the above dilemma  last week (august 2013) in a presentation with an across-section of Dutch pension representatives. This dilemma illustrates in a simple way the precarious choice Dutch pension funds and their members have to make in deciding between a traditional Nominal Pension with conditional CPI-indexation (nest I) and a fully CPI-indexed 'Real' Pension (nest II).

Key point is that to achieve a higher Real Pension, you have to put your Nominal Pension 'at risk'.

And who is consciously willing to put 'future income' substantial  at risk?

As 'pension income' is in fact 'deferred income', there's also a kind of implicit understanding that your future retirement income security should be 'in line' with your actual income security and not substantial lower.

Retirement Income Security  ≈ Actual Income Security ?

No wonder that all of the 23 attendees at my presentation chose Nest I (Nominal + Indexation) as favorite.

Remark

After the meeting one of the attendees stated that the '10'-valued egg in Nest II should have been valued at at least a value of 20 or higher to create an equal or higher average expectation, as higher risk would implicate also higher return.

I positively smiled for a moment... told him that his remark (and many others that followed) was formally right and suggested that he would test the 'Pension Egg Choice' in his pension board, including an extra voting with an 20-valued egg instead of a 10-valued egg. A day later he called me back and told me the extra voting didn't substantial change the voting outcome.......

Remember that more risk doesn't automatically imply more return. If volatility (risk) increases without a well-argued expected increase in 'average return', the 'compound average return' will (even) decrease with half of its variance.

Worldwide Pension Funds Alert

Not only Dutch pension funds face the Pension Egg Dilemma, but in fact all pension funds worldwide do. To fund their pension liabilities they have to make average returns of more than 5%, 6% or even 7% for more than 50 years on a row or more. And to achieve those kind of return levels with a (nominal) risk free rate and a treasury bill outlook, both varying between 2 to 3.5 percent, implies that they'll have to invest in risky asset classes.

As a consequence the ultimate pension outcome could be lower than on basis of a risk free approach that guarantees a nominal pension. In other words: your Nominal pension is at risk.

Example

To illustrate what is happening, let's look at a 30 year old Dutch pension fund member (Tom) with an retirement age of 65.

The pension fund (theoretically) offers Tom the next options. Tom values these options on basis of a 20 year period:

1. Option 1
   Tom's contribution is invested in totally risk free assets at 3% (orange line), resulting in a sure (€,$,£,¥)  10000 yearly pension
    
2. Option 2
   Tom's contribution is invested in 30% risk free and 70% risky assets (purple line), resulting in a 25.9% (100%-74.1%) change of an outcome below his yearly 10000 (nominal) pension, but also an almost 50% probability of a pension of around 23904 or more.
   
   Looking closer at the downside, there's also a 10% probability of ending up with a negative return, corresponding with a yearly pension of 4255 a year or less.

However, Tom suddenly realizes the limitations of a linear model approach. If the 'risk free asset part' of his investment  is really completely independent (can't be dragged down) from the risky part and also insensitive to market conditions, there's a downside risk limitation.  A 30% really 'completely market valued risk free' would in Tom's case  imply a total minimal guaranteed portfolio return of nearly 1% (30% of 3% = 0.9% ≈ 1%) , corresponding with a minimal yearly pension benefit level of around 5645.

In case of 70% risk free investment approach (green line), the downside return risk would be limited to a minimal 2.1% return corresponding with a minimal pension of around 7506, approximately 75% of Tom's nominal pension target.

This 70% risk free approach could be quite acceptable for Tom, as he realizes there'll be no extra return without taking extra risk...

Nevertheless..., pension fund life and its member's choices ain't easy. So Tom asks the pension fund's actuary what his pension outcome would be on a 50 year evaluation basis.... here it is

Now Tom's risk of ending up with a yearly pension outcome of 10000 or less has decreased to a 15.3% (100-84.7). Tom could decrease this downside risk further to 8.6% by choosing a less risky asset mix of 70% risk free and 30% risky assets. However, this drops his upside potential. On average (50%) his pension outlook of around 23904 will drop to a little less than 17850.

Now Tom fully starts to grasp the impact of long term return assumptions...  After all, is assuming a 6% or 7% 50-year return not way to optimistic?

Your own Pension Confidence Level Calculator

As shown in the examples above the key questions are i.a. :

1. How much of your guaranteed* nominal pension P are you willing to risk to end up with a higher pension P+U
2. How much uncertainty (100% - confidence) are you willing to accept that your pension is lower than a certain amount?
3. What's the real (nonlinear) downside risk of my pension?

To find the answers to these kind of questions and to calculate your own pension perspective, you may download the

Pension Confidence Level Calculator

in Excel.

With the Pension Confidence Level Calculator you may calculate your pension confidence with all kind of asset mixes, co-variances, (pension) ages and several user definable life tables.

Remember the calculations are only illustrative and indicative approximations, to be used for instructional purposes. Ask your pension fund to make a more detailed and personal calculation.

Next

Now that you've experienced that most pension funds need an ambitious return that may put your nominal pension at risk, the question is what to do?

Main problem is that pension funds do not act in this alarming situation. As a kind of sitting duck they play a kind of 'waiting game' in the hope that bond yields and other markets recover.

Meanwhile you could at least do something to get the fuzzy pension picture clear. Simply follow this Cookbook :

Pension Fund Restructure Cookbook

1. Your Retirement Income is not a one point estimate, so ask your pension fund's actuary:
• to calculate what future average return rate is needed to (100%) fund the liabilities, given the actual market value of the assets of the pension fund
• to calculate (estimate) your future pension at different constant future return rates
• to estimate the probability level of achieving each future return rate or more (confidence level) for the rest of your life, in accordance with the applied actuarial models
2. Next, ask your actuary to formulate his advised investment risk approach in line with the Pension Eggs presentation as presented in this blog, but now with more nests.
3. Now let your board and pension members determine their risk appetite by voting which nest they choose
4. Finally, let the actuary in cooperation with the investment advisory committee, propose an 'investment strategy' that is completely in line with the new defined risk appetite 
5. Take a decision to (phase-wise) implement this new investment strategy.

Result

Perhaps the outcome of the above exercise will be a lower pension than you expected, but:

• probably not as low as you would have got if you kept on gambling on uncertain high returns 
• and certainly not lower than what you need and define as a decent minimum pension income 

Anyhow, enjoy the Pension Confidence Level Calculator....

Links/Downloads

- Download the Pension Confidence Level Calculator

- Long-range confidence interval projections and probability estimates

- Portfolio-optimization by the mean-variance-approach

- 'Employee Retirement Income Security Act - ERISA'

Humor: How Actuaries Can Help

Sources/Downloads
- Original artist Meera Sapra at Toondoo
- Blog 'Life is a Comic Strip' by Meera Sapra
- Download Powerpoint Version of this comic strip
- Download PPT-JPG Version of this comic strip