My proposal for one fund with a smoothed return

Brendan
What are the liabilities?
The smoothed value is not the liability. The liability, or obligation if you like, is to deliver the benefits as determined by the smoothing formula and of course the rules of entry and exit. This can only be tested by stochastic methods and the paper goes to some lengths to explain how the formula withstands such a test.
 
Sarenco said:
To me, that makes the entire scheme a non-starter.
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I addressed that very question, satisfactorily, I hope.
I agree that it depends on the creation of a buffer account for when cash flows eventually turn negative (remembering that this is projected to occur around year 50, probably quite a bit after that on less conservative assumptions). You say that the fact that the margins to create that buffer account come from fees implies that the fees are too high. First of all, I'm putting my hand up to say that I don't know what the costs and required fees will be, but I do know that the costs will be significantly less than the costs of running a whole series of 'lifestyle' accounts with a lot of different providers, for the reasons explained in the paper. Partly on that basis, I'm reckoning that the 0.5% charge will be about right** for the first 15 years, but that it will be too high from then on. I'm saying that the margins in the 0.5% charge after (say) year 15 will be used in the first place to create the buffer account. Eventually, I see most if not all of it going back to the members. As noted in 12.22, even if the two Armageddon simulations are realised, the money in the buffer account will still be more than enough to prevent the 'insolvency vortex'. And remember that one of those Armageddon simulations (see 12.17) has market values falling 75% over the last 13 years, to just 25% of their starting values, while the other has negative returns on cash flows over the entire 60 years (down 55% in the last 11 years). Both of those simulations would be rejected out of hand on 'reasonableness' grounds. There is the final failsafe of a provision allowing the trustees to increase the charge beyond 0.5% if needs be. For what it's worth, many insurance companies have similar provisions in their fund charge sheets.
** I should clarify that the costs will equate to more than 0.5% in the early years (see 10.12), and less than that towards the end of the first 15 years; however, the trustees will have to borrow in the early years to cover the shortfall and part of the excess in the years leading up to year 15 (or whenever) will have to go to repay the borrowings in the early years - but we're into the honours class now!
 
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Brendan
One of my objectives in this is to debunk market values. I think we've both seen how ridiculous they can get at times, so I don't want to give them more respect than they deserve. That's my main reason for being less than enthusiastic about your suggestions.
Also, I think that people will have considerable freedom in relation to withdrawal amounts post retirement - anywhere between 3% and 8% a year (higher maxima over age 80). OK, they can't flip between the lower and upper limits: I'm suggesting a maximum movement of (top-of-the-head) 5% between successive withdrawal amounts. Nevertheless, they will enjoy far more discretion in how much to withdraw than they would ever enjoy with a DB pension. There is also the administrative point that the administrators won't fancy people keeping changing their withdrawal amounts each month or quarter. (Remember that the amounts involved here will be quite modest, representing the pensions of ordinary wage-earners by and large) .
You made the point yourself about AVC's being in a separate scheme.
 

Well the sooner you start the process the better the chance you see it reach fruition and blossom? And government is not typically a synonym for speed...
 
I think that there may well be merit in this idea. However, I come at things from the "if it sounds too good to be true", "measure twice, cut once" and "kick the tyres good and hard" perspective - so I have two main questions:

1. How would the proposal cope with a sustained pandemic that makes Covid-19 look like a picnic - say a multi-year pandemic brought about by a virus that is significantly more virulent and deadly than what we are currently experiencing and is always one or two steps ahead of the vaccine? Presumably, it could fail under such severe pressure and what then?

2. What are the key differences between the current and previous proposals?
 
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Gregmill said:
"kick the tyres good and hard"
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I have kicked the tyres good and hard - 120,000 times, to be precise (2,000 simulations, each of 60 years' duration).
Gregmill said:
How would the proposal cope with a sustained pandemic that makes Covid-19 look like a picnic - say a multi-year pandemic
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First of all, the worst pandemic in a hundred years doesn't seem to have done much damage to the stock market - not yet anyway - but we'll leave that question aside for the time being. I'm sure that many of the 120,000 kicks cover the sort of situation you're talking about. For example, Section 8 looks at what happens if there is a 55% drop in market values over three years, a 65% drop over 18 years and markets haven't recovered fully after 30 years. Yet the smoothing approach comes through strongly. The historic 10-year smoothed return is never less than +10% (Section 8.19) . I'm not a magician, though, and neither is smoothing. As I write in Section 12.6, "Smoothing cannot undo the wreck caused by the collapse in market values, but it does make the pain more bearable."
Gregmill said:
What are the key differences between the current and previous proposals?
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I haven't checked, but I think the current proposals are essentially the same as what I submitted to the DEASP a couple of years ago. One difference however could relate to the fact that I have been working with a professional mathematician recently on a different (much less contentious!) problem. I have learned from him to be careful about making assertions that I cannot support. A fair proportion of the 65 pages is providing the supporting evidence for my assertions.
 
Thank you for taking the time to reply.

I would like to watch your presentation but am unclear from the link whether it's for actuaries only? In the meantime, I'm working through the 65 pages which are, to be fair, very readable. In relation to the paper, I do have some questions already which I may address in a later post.

What I meant by a really, really bad pandemic is one where there is a dramatic and sustained fall in economic activity and that this fall is reflected, not alone in a sustained slump in the stock market, but also by chronic and structural unemployment., i.e. a proper long-lasting depression. Wouldn't contributions fall off the cliff at such a time on account of people having lost their jobs? Imagine, in particular, a scenario where the economy was already fragile entering into such a pandemic.

Ultimately, there must come a point where the towel is thrown into the ring. Realistically, won't the state be called upon at that point - in much the same way as it has had to step in with pandemic payments of various sorts? Wouldn't this call on the state be made irrespective of whether there was a contractual obligation on the state or not? The size of this fund upon maturity will be massive relative to the then GNP - especially in relation to the anticipated GNP post a contraction, as described.

I say this as I was involved in the finance side of our company's DB scheme. Our worldwide head of treasury, who was driving the closure of our company's DB plans worldwide, consistently argued that the problem with the DB plans, was not the cashflow/funding demands but the risk associated with the sheer size of the plans relative to the size of the company.

Finally, in this regard, it must be remembered that the state will already have massive, unfunded social protection and public sector pension liabilities which are already quite a big elephant in the room - especially as the anticipated drain on public resources of these liabilities will fall upon significantly fewer shoulders due to changing demographics - and fewer again, should the depression-like scenario that I depicted above, materialise.


The reason for my second question is related to Brendan's comment about the scepticism with which your first presentation was apparently received. I note your penchant for quotes - isn't there one about repeating an action and expecting a different result? If the proposal is "essentially the same", is there not a strong likelihood that the reaction will similarly remain broadly unchanged? I suppose I'd like to understand more about the reasons for the scepticism in round one. Also, from a presentation point of view, I'd imagine that it's a pretty savvy audience - won't they want to know what changes have been made versus the original script?
 
@Gregmill In the doomsday scenario that you portray there would probably be calls for government intervention no matter what form of Auto Enrolment is implemented.
 
@Gregmill
My understanding is that anyone can download the paper and log on to the webinar. You do have to register though. There is a possibility that members of the Society of Actuaries will be given precedence if more people want to contribute to the discussion than can be accommodated within the allotted time. This is reasonable.
You're right to think of what might happen in a doomsday scenario. As in all such situations - even for children worried about being left in the dark - the solution is to put flesh on the fears, to see how they might manifest themselves in different ways, will they be just national, will they be EU-wide, or world-wide, can Helicopter Money be used to solve the problem, how will stock markets react, what sorts of reductions will there be in contribution income, etc.? Then, after putting all that information together (I presume we would need some group like the ESRI to do the scenario planning on behalf of the government), you put the numbers through the sausage machine, i.e., the smoothing formula, to see what pans out. Speaking of the smoothing formula (given in 6.2), someone wrote earlier that it's complicated. Far from it. It is about as simple as you could get. It just has two terms involving only multiplication and addition, not a hint of division, nor any 'to the power of' or square roots, and definitely not an imaginary number in sight. There is a bracket OK, but we could get rid of that for slow learners, and there is no need to learn subtraction until around year 50. It is definitely not complicated. In fact, as a member of a profession who are supposed to be good at maths, I'm embarrassed by its simplicity!
In relation to Brendan's comment about the scepticism with which my earlier presentation was received, he may have forgotten that my earlier presentation to the Society of Actuaries was about smoothing for Group ARF's. That's a different kettle of fish and definitely a more difficult sell (although I still think it would work, but let's not go down that road). It is much easier to apply the smoothing approach to Automatic Enrolment, for lots of reasons. Of course, I'm still not expecting an easy ride on the 20th. I would be disappointed if I were. One of the problems I face is that generations of actuaries and professionals in all areas of finance and investment have been brought up on the sanctity of market values. They feel they have to genuflect, possibly even say a decade of the rosary, as they pass them by. Market values are the gods that must be adored at all times. It is difficult to convince them that this does not have to be the case, that we should make them our servants, not our masters. Yes, market values are important when you're forced to sell (or when you're buying), but not otherwise. I'm confident that I'll get that message across eventually.
 
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@Duke of Marmalade
I agree to a certain extent. However, my sense is that the volume of those calls would not be quite as loud (justified) in other forms of AE. The reason being that with "standard" AE, the individual still controls his investment decisions and therefor there is a substantially greater overlap with other pension schemes. In contrast, Colm Fagan's proposal is a different animal completely - it would stand very much apart from other plans and the investment mechanism would be seen as having the government's imprimatur because substantial state involvement would be required in order for this plan to get off the ground.

@Colm Fagan
Thanks re the webinar - I'll look into registering.

Apologies - I did not realise that the previous presentation was in respect of the application of your idea to group ARFs - that changes things somewhat.

I'm not sure if I fully understand what you are saying regarding the attachment of actuaries to market values. I am an accountant and remember clearly the actuary of our pension scheme bemoaning the introduction and then, the progressively increasing importance, afforded to market values (of assets and discount rates) which were mandated by the various accounting standards (FRS, FAS, IAS, etc.). Indeed, there is little doubt that the change in the treatment of the DB pension expense in the P&L from the funding/cashflow cost to the market based cost was a definite factor in the gallop out of DB plans.
 
@Gregmill I see your point.
But as for political risk, I don't know if you are aware of the original Government proposals - the strawman. It envisaged that most people would not make their own choice but instead would be directed to "the default". The default? 4 providers were envisaged each with their own view of how best to plan for your pension, maybe even one or two picking Colm's proposal. Members would be allocated their provider by lot, DEASP described it as a carousel. I kid you not! Now in a litigious society as we are this was bound to backfire as the ones unlucky enough to draw the dog would surely mount a class action.
Any proposal which has the appearance of Government endorsement is open to political risk. It is not clear whether Colm's proposal is particularly thus exposed but it is certainly less exposed than the strawman.
 
Ah! Truth be told, now that you say it, that does ring a small bell but I was blissfully not conscious of those details when posting earlier! That original strawman seems to be the proverbial horse designed by a committee!
 
Colm Fagan said:
I do know that the costs will be significantly less than the costs of running a whole series of 'lifestyle' accounts with a lot of different providers, for the reasons explained in the paper.
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I really don’t understand how you arrive at that conclusion.

The major asset managers (Vanguard, BlackRock, etc) all offer TDFs with TERs in the region of 0.15%. With a predetermined glide path, TDFs are really no more complicated to manage than funds with a fixed allocation to different asset classes.

On the other hand, the trustees of your proposed scheme would require a small army of expensive consultants to keep them out of trouble. I actually think a TER of 0.5% is optimistic and would leave little or no room to build a cash reserve.
 
I agree! Here's what I wrote about market values for DB plans (5.2)
  • It is fashionable nowadays to treat market values as sacrosanct. That was not always the case. In my early years in the actuarial profession –a long time ago! – it was not uncommon for pension scheme assets to be valued on a discounted cash flow basis. I am not advocating a return to those days: for one, actuaries had far too much discretion in how values were derived. I am proposing instead that the scheme’s trustees adopt a formula-based approach to valuation, which allows them no discretion in how values are derived, and which also gives due recognition to market values. The proposed valuation approach is set out below, but first it is important to dispel the widely held view that market values should always reign supreme.
We could go on, in violent agreement about the madness of regulators insisting on market values, etc., but nothing can be done about it now.
Sarenco said:
On the other hand, the trustees of your proposed scheme would require a small army of expensive consultants to keep them out of trouble. I actually think a TER of 0.5% is optimistic and would leave little or no room to build a cash reserve.
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I don't understand your reference to 'keeping them out of trouble'. This is members' money, not the government's or do-gooders'. To quote from 13.7:
"The simplest approach to meeting this objective, which has considerable merit, is to invest entirely in a passive world equity fund, the cost of which is unlikely to exceed 0.1% of assets under management. An investment strategy on these lines will also help the scheme cope with an uptick in inflation, which some experts consider a strong possibility in future"
I wouldn't be surprised if all the money is invested in a passive world equity fund from the start, probably for at the first five years at least. Once the market value of the total fund is known, it's just a case of twisting the handle to get the smoothed rate of return that will be applied to all accounts across the board. It will be just like a bank crediting interest rates to deposit accounts (when they got an interest rate!). As I said, they will be so stable, the exercise may only need to be done once a quarter.
The amount of effort involved in a more conventional fund is enormous by comparison, especially considering the variety of funds required across all the providers. Not just maturity date funds, but also different funds for retired people, specialist funds for the 1% who want such funds (including Sharia, etc.), transfers from one provider to another, from one fund to another etc., etc. The fact that fund prices must be quoted weekly, possibly daily, adds to the costs, as does the variety of payroll systems that will have to be allowed for, with different delay times between when money is deducted from members' pay packets and when it is given to the asset managers. Considering the volatility of market values, this could be a source of problems down the line. There is just no comparison between the two approaches in terms of costs.
 

Hi Colm

I have challenged conventional thinking on many issues in the past :
  • You can be too young to start a pension - you should prioritise buying a home
  • Pensions and house buying should be integrated
  • People should be fully invested in equities when they retire
  • If you are unable to clear your mortgage by age 65, it does not mean that your mortgage is unsustainable and you should sell your home.
  • A person living on their own in a 4 bed council house should be required to vacate it or share with others on the Housing List
  • People who don't pay their mortgages should be repossessed
Each one is a huge battle. It's very difficult to change people's basic assumptions, on which they have based their professional lives

I fully support the principles of what you are trying to achieve, but you are asking your profession, regulators, public servants and the government to completely change their thinking on many different issues simultaneously
  • People should be fully invested in equities during their retirement
  • Therefore , lifestyling is wrong
  • Market values are not important unless you are forced to sell
  • So it doesn't matter if the smoothed value is well above the market value for a long period of time
In addition you require a change in Solvency II

Furthermore, you are saying that people should join this scheme at age 24 , make scheduled contributions and withdrawals, and you allow them no flexibility at all to deal with what life throws at them. ( This is the one aspect of your proposal which I have the biggest problem with.)

I wish you well, but I think you are asking people to make a massive leap, and they will be too nervous to do so. So I don't expect you to succeed, but I hope I am wrong.

Your chances of succeeding would be much higher if you reduced the cognitive load on people.
Get them to accept the principles
  • Retirees would be a lot better off if they invested in equites
  • Some form of smoothing would remove or reduce the risk of this
From a persuasion point of view - contributing 7% a year will not be enough to provide adequate pensions. Highlight this as the problem you are trying to solve.

Offer three or more different ways to provide smoothing
  • Your scheme
  • Your scheme with smoothed values calculated at a lower value so that a reserve gets built up
  • An even simpler scheme which holds back excess returns and releases them in the bad years. This is a bit of a con job, but people would instinctively understand it.
It is often easier to get people to make a choice between two different types of photocopier than to agree to buy one in the first place.

And you have to find a way to offer flexibility. Either solve it or highlight the problem and ask your actuarial audience to suggest solutions.
  • Allow people to take breaks from contributions
  • Allow people to make AVCs - maybe in a separate fund
  • Allow people to take more or less than the scheduled withdrawals
If you have a scheme where the smoothed value is usually below the market value, it would be much easier to be flexible.

And don't dismiss the sceptics with "Market values should be our servants and not our masters". Whatever about the rest of us, your actuarial colleagues will bristle when you tell them that.

Brendan
 
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Brendan
First of all, I want to apologise for some of my earlier comments. I was too sharp in my replies to you in relation to your use of the word "insolvent" and your doubts about whether people would be happy to pay more than €100 for €100 "worth" of assets. My views on both are unchanged, but I was wrong to react so strongly. Sorry. Part of my problem is that I have invested so much emotionally in these proposals. Anyway, let's put all that behind us.

Responding to your latest comments, in much the same order as you made them:
Brendan Burgess said:
In addition you require a change in Solvency II
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I'm not seeking any change in the principles underlying Solvency II, i.e. that financial institutions should be able to withstand extremely severe adverse financial conditions. The S2 principles refer to 1 in 200 ruin probability, but in reality they want a much lower ruin probability. I'm saying that the calculations in Section 12, and the earlier analysis (particularly Section 8) indicate that the proposed scheme will have a significantly lower probability of ruin than that deemed acceptable under Solvency II. The only problem is that the Solvency II regulations as currently worded do not allow for a scheme on the lines proposed. The detailed regulations will have to be changed, but not the underlying principles. Greenspan's response to the reporter (mentioned in 12.1) is relevant in this regard.
Brendan Burgess said:
Furthermore, you are saying that people should join this scheme at age 24 , make scheduled contributions
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Under Auto-Enrolment, people are free to decide if and when to join, at any age. They can also stop contributing if they want. But if they don't contribute, they lose the employer's and the state's contribution. So, for every €100 someone contributes, their account grows by €233 (€100 from employer and €33 from the state). I'm assuming that they will act intelligently.
Brendan Burgess said:
and (scheduled) withdrawals, and you allow them no flexibility at all to deal with what life throws at them. ( This is the one aspect of your proposal which I have the biggest problem with.)
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One of my catchphrases in an earlier version of these proposals (which I didn't repeat in this one, but probably should have ) is "It's a pension, not a piggy-bank". This not a general savings scheme for the rainy day. The state should not subsidise people saving for a rainy day. This is for when they get old and need to access their savings.
I did include a paragraph in the paper to deal with a concern you expressed earlier. In 5.8 I write "Other than in special circumstances, savings remain in the fund until the member's retirement or death". In the footnote, I explain that those "special circumstances" could include a provision allowing members to make withdrawals to help meet the cost of their first home.
Retired members are allowed considerable flexibility in retirement, far more than if they had a DB pension. The annual withdrawal can be between 3% and 8% of account value, (more than 8% over age 80) These percentages are not sacrosanct. That is a very wide range.
Brendan Burgess said:
Your chances of succeeding would be much higher if you reduced the cognitive load on people.
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I am trying to reduce the cognitive load, not increase it. This is primarily aimed at ordinary wage-earners. What they have will look just like a bank or credit union account, with 'interest' credited each month. Taking the example of 6.12, an employee who joined on 1 January 2020, paying €100 a month, would see €233 in their account immediately (see above as to how the €100 becomes €233). They will then be credited with 'interest' of 0.28% in January. Another €233 will be added to their account in February when they pay another €100 (but of course they don't have to pay the €100 that month if they don't want to, but then they don't get another €233 added to their account). Interest of 0.18% is added to their full account balance in February, 0.04% in March, etc. I believe that they won't give a hoot how the 0.28% or 0.18% or 0.04% is calculated, other than they're getting more than they would get if they put their money in the bank or credit union. They also know that the employer's money and the government's money is being added to their account, and there are no rip-off front-end charges or policy fees. Complete transparency.
They will know that the 0.28% in January fell to 0.04% in March because market values fell in the period, but they won't be too bothered beyond that, in much the same way that an ordinary saver isn't worried what their credit union is charging borrowers. (Not sure the analogy is completely sound, but let's have a go anyway!).
Brendan Burgess said:
From a persuasion point of view - contributing 7% a year will not be enough to provide adequate pensions. Highlight this as the problem you are trying to solve.
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Remember that this is only for earnings up to €70000. I think that 7% (of which only 3% comes from the employee) will be enough for most people over a full career IF the returns are as I'm projecting, taking account also of their entitlement to state pension. Higher earners will have to pay more. They can do that through a private pension plan, outside of the AE scheme. Remember that I'm claiming that they will get the same or higher pension for 7% as they would get for 14% under a more conventionally structured scheme.
I won't venture into trying to speculate on whether people would value the sorts of choices you mention towards the end. Personally, I think they would serve to confuse rather than enlighten people. How would a carpenter decide between them? I wouldn't have a clue which to go for, and I think I have a reasonable understanding of investments.
Brendan Burgess said:
  • Allow people to take breaks from contributions
  • Allow people to make AVCs - maybe in a separate fund
  • Allow people to take more or less than the scheduled withdrawals
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1. As I said above, people are not obliged to contribute, they can take a break anytime they want to, but they lose out on €233 for every €100 they choose not to contribute.
2. People can always make AVC's, but not in the AE scheme. That's a service that life assurance companies and pensions consultants and brokers will be happy to provide.
3. As I wrote above, they have considerable flexibility in how much they withdraw. There will have to be a rule preventing them going from (say) 3% to 8% in one fell swoop. They can only do it gradually. That's to preserve the integrity of the smoothing process. It's not a major drawback, especially when compared with a standard pension or an annuity.
I think it's also safer to refrain from commenting on your last two sentences!
Once again, Brendan, my apologies for some of what I wrote earlier. I hope that this response has been more measured and has addressed some possible misunderstandings on your part, particularly in relation to employees being forced to contribute. Maybe I didn't explain myself sufficiently.
 
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Boss I presume you don't mean offering punters this choice? Advice fees would go through the roof. I am taking it that you are suggesting that the powers that be should be offered these choices for what they finally implement..
 
Hi Duke

Correct. I don't think that Colm will be able to persuade the government or regulators that market values don't matter and so the proposal as it stands, will go nowhere.

Which is a terrible pity. However, Colm should be able to get agreement to the principles that equity investment is right for the whole term and that some form of smoothing is required. If he sets out three options for smoothing and the pros and cons of each, it would give people more buy in.

Brendan
 
I think Colm misinterpreted you. It was the photocopier analogy which had me thinking you were talking about the punters.
 
Brendan
It depresses me that you keep misinterpreting - unintentionally, I hope - what I wrote and worse, you refuse to acknowledge your mistakes when they're pointed out. For example, I pointed out earlier that
is completely wrong. I made it abundantly clear that no-one is forcing anyone to join the AE scheme and that they can also stop contributing any time. I also made it clear that they can withdraw anywhere between 3% and 8% of their account value each year in retirement and I allowed for the possibility of them taking money from their pension account to help meet the cost of their first home. If that's not flexibility, I don't know what is.
You chose to reply to @Duke of Marmalade when he surmised that I had misinterpreted you on a minor matter, so it's not that you didn't read what I wrote. Instead, you doubled down by adding another misinterpretation:
Brendan Burgess said:
I don't think that Colm will be able to persuade the government or regulators that market values don't matter and so the proposal as it stands, will go nowhere.
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Of course I recognise that market values matter. I state it many times in the paper. For example:
In 5.7, I write: "Market values cannot be dismissed entirely, however. Despite their drawbacks, they are the best, oftentimes the only, available objective measure of value. We depart from them at our peril."
In 6.1, I write: "the next challenge is to devise a valuation approach that smooths the humps and hollows of short-term changes in market values, while recognising their importance in the longer term."
And in 5.2, after rejecting the idea of 'actuarial valuation' of the assets, I write:
"I am proposing instead that the scheme’s trustees adopt a formula-based approach to valuation, which allows them no discretion in how values are derived, and which also gives due recognition to market values."

The smoothed value is derived entirely from market values, just not from the single market value prevailing on the day the employee pays in or withdraws money. This month's smoothed value is a weighted average of this month's market value and last month's smoothed value, but last month's smoothed value is a weighted average of last month's market value and the previous month's smoothed value, which in turn is ......
The nature of the AE scheme allows that averaging. The net result is that employees can get higher benefits for half the cost, and with considerably less volatility than a 'lifestyle' approach.

I have better things to do than to keep correcting misinterpretations of what I've written.
 
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