[Skip to content]

Sign up for our daily newsletter
The Actuary The magazine of the Institute & Faculty of Actuaries
.

Pension schemes and financial economics

Jon Exley (letters, April issue) restates the argument he made at the Institute sessional meeting in January, namely that final salary pension schemes should invest only in bonds and be funded so that their assets always cover their wind-up liabilities. At the same meeting I pointed out the drawbacks of this strategy, which are the high and potentially unstable contributions that would be required of the sponsoring employer.

In a simplistic corporate finance model, in which corporations have unlimited borrowing powers, these high and unstable contributions are not a problem. In the real world, in which corporations have unavoidable cashflow constraints, they would increase the risk of bankruptcy, thereby damaging the job security of employees and, of course, the security of their future pension accrual. In a simplistic economic model, one could argue that employees need not worry about job security, as they can sell their labour at any time in a perfectly competitive market. This not a view of the world, however, that accords with the experience of most employees.

The important point for members of profession to recognise is that this debate is not about ‘traditional actuarial methods’ versus ‘financial economics’. The stochastic decision-making framework outline in our article in the March issue is based on one of the fundamental pillars of financial economics, known as ‘decision-making under uncertainty’. The issue is whether this fundamental approach is more robust than corporate finance models based on the assumptions of perfectly liquid markets and optimally diversified risks. I would urge all pension actuaries to read our written comments following the discussion at the sessional meeting, to appear in the BAJ, in which we have sought to provide a non-technical explanation of both types of model.

e