Tuesday, February 02, 2010

Sucks to be us

I get a lot of emails from the Institute of Actuaries, the professional organisation of which I am a (student) member. One running theme is a rather plaintive request for people to view actuaries as more trustworthy. They write endless editorials on actuarial ethics, they arrange super-special "professionalism" training, they commit us all to worryingly restrictive codes of conduct... the list is endless.

I've always been a bit surprised by this. I don't have a pension, I don't have life insurance, I don't have a car to insure, so pretty much my first contact with the actuarial profession was when I signed up to become one. I've been wondering for some time now what the fuss is all about...

Well, it turns out that they're not wrong to fuss. I just came across the following passage in a book on scams that I'm reading:

Hundreds of thousands, if not millions, have been disappointed and forced to complain about 'with-profits' bonds, endowments and pension plans. And these all come from highly respected - and really big - life insurance companies.

How do these complicated schemes work? Well, no one really knows, often not even the people who should know. It's all down to the 'experts' at the insurance companies which run these schemes. Using obscure mathematics coupled with a finger held up to the wind, they make up the numbers year on year.

Wait a minute. That's us he's talking about. This sucks.

Do actuaries deserve this slagging-off? Well, partly yes, partly no. (Equivocation never harmed anyone...)

Where's the money?

Let's take an example: that with-profits thing he mentioned. With-profits is superficially rather a clever idea. Let's say you're putting money into a pensions fund for your retirement. There are two main kinds of investment fund: fixed interest and unit-linked.

With a fixed interest fund you are guaranteed (say) a 3% per year rate of return. In a way this certainty is good - that money is as good as in the bank. But in a way it's bad, because you are going to get a very crappy rate of return. This is because, if the market crashes, that 2% is going to start looking like quite a large number. No fund provider wants to be caught out that way, so they will all low-ball their figures to compensate.

With a unit-linked fund, a certain amount of money is put into a pot for you. That money is used to buy shares in various companies, in the hope that their share price will go up. Usually you'll just specify some broad criteria ("I want all my money in Asian shares") and a fund manager will sort out the investment specifics. This approach generally gives a much higher rate of return - e.g. you might get 10% instead of 3%. But it is inherently risky - you might also get -50%.

As pensions actuaries, we want to get the best of both worlds. How can we do this? There are three main approaches (that I'm aware of):

1) Shuffle money from unitised to fixed-interest funds as the member approaches retirement (I mentioned this last time as a good use of SAMs)
2) Invest in an index-linked fund (see footnote*)
3) Invest in a with-profits fund

Technical interlude

A with-profits fund is where you take a fixed interest fund and strap a unitised fund to the roof. The fund provider will keep a pot of money, which it will invest in various companies etc. They will guarantee you a relatively low rate of return (3%, say) on your contribution to this pot.

Then, at the end of every year, they will take a look at how their investments have done. If the investments are doing much better than the guaranteed rate (10%, say), they will tell you "we declare a bonus of (say) 5%". The value of your investment will thus increase by 8%, with the remaining 2% being kept in the pot for a rainy day**.

The point is that, under the with-profits model, the fund provider doesn't need to plan ahead so carefully - if they overdo the bonuses this year, they can just make it up by under-doing it in future years. With-profits funds allow the provider to wing it. They don't have to be as cautious as they are with fixed-interest funds. And that reduced risk translates directly into better rates of return.

What are the characteristics of a with-profit fund? In any given year, there's a limit to how badly they can do (handy if a recession strikes just before you're due to retire). However, in the long term, they won't do as well as unit-linked funds (because they have that extra protection, which must be paid for). They're generally quite a good solution, and fill a very useful niche.


Now, being smart people, you've probably noticed a gap in the above explanation: how precisely is the bonus calculated? That's an excellent question.

And the answer is very fuzzy. The provider's actuaries will look at the state of the market, look at the state of the fund, and make an educated guess as to what bonus they can afford. There is no hard-and-fast method, and no requirement to document their method. From the point of view of the paying public, the actuaries all go into a dark room and come out a week later saying "right, you're getting 8%". In the words of my generation: What The F***?

Now there are actually good reasons for some of this reticence. An example: many of these calculations use stochastic asset models (see last post) that are just too damn complicated to explain to the general public. Due to the huge pile of regulation hanging anvil-like over our heads, it can often be legally safer to shut up than explain what you're doing. Especially if there's any chance of being creatively misunderstood***.

Regardless of this, the opacity of the system - the secrecy, the lack of information, the argument from authority - definitely promotes suspicion. It's a fricken' invitation to conspiracy theory. I personally would be surprised if the bonus system had ever been abused too badly, just because there are so many people breathing down the average actuary's neck. But you can see how people could come to that conclusion, and there's no way to refute them. Skepticism FAIL.

What can the Institute of Actuaries do about this? Bugger-all, sadly. They don't have the power to compel all these companies to open up, which is really the only way to fix the situation. Hence the rather frantic "oh we're so professional and ethical" song and dance - it's the only thing the poor sods can do to stop their collective street-cred going down the pipe.

Who does have that power? The UK government (in the UK, anyway) and its regulator the Financial Services Authority. Will they act? On existing funds this is very unlikely - it would be too much of a can of worms to open. However, the general trend is towards greater transparency with financial information****. Maybe one day we'll get this mess sorted out.

And the profession will breathe a sigh of relief.

Disclaimer: I am not a subject matter expert, please take all the above with a pinch of salt.

* An index-linked fund guarantees you (say) 1% plus your central bank's base interest rate per year. This removes some of the risk that the buying power of your money will fall (e.g. due to hyperinflation). So although the amount of money you'll get when you retire is uncertain, the number of mars bars you'll be able to buy with it is closer to being fixed.

In terms of returns, index-linked funds are less good than unitised funds, but not nearly as bad as traditional fixed-interest funds. In terms of risks, the order is reversed (as you'd expect).

** There are some complexities (e.g. various bonus types, market value reductions, etc) - this is just an overview not a technical manual.

*** In the UK, the life office Equitable Life went bankrupt at least partly because A) people managed to creatively misunderstand their pensions' guarantee structure, and B) a court decided to hold them to the most expensive interpretation.

**** For example, under the new Solvency II requirements (basically saying how much money an insurer needs to put by in case everything goes wrong at once), the rather complicated models used by each company to calculate their funding requirements must be disclosed. I consider this a very positive step, not least because I want to play around with the models (and possibly blog about them!).

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