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The Actuary The magazine of the Institute & Faculty of Actuaries

Marching to a different drum

The theme of this article is that following established wisdom can have dangers. Often, the wisest have been those who have challenged the established wisdom, even if they may have been ignored. I will give some examples of this, and end by suggesting something contrary to current wisdom.
Like all professions, we value consistency of approach and convergence of views. That is what guidance notes are all about. Our strapline tells the world that ‘actuaries make financial sense of the future’.
That is an important role but in the end a limited one; it implies that we stop short of recommending one course of action. And yet in practice the board or the client always wants to know what the actuary thinks. The discipline involved in weighing up all the options and coming down in favour of one on the basis of reasoned argument has always fascinated me. In spite of all such analysis, checking back to compare the outcome with what was predicted is a salutary experience. It keeps even the best of us humble.
The problem decision-makers have is deciding which prediction to rely upon. There is a story about Gorbachev telling Reagan that he had 100 bodyguards, one of whom might turn out to be an assassin, but he did not know which one; to which Reagan replied that he had 100 economists, one of whom was right.

Predictions: the hall of shame
As a regular tracker of predictions, I remember best those that went against the fashion of the time but turned out to be correct. Three stand out in my memory; the first two because I did not take any action on them at the time, the third because nobody else took any notice of it.
JK Scholey, of Watsons, made the first of these predictions, in the mid-1970s. It was during a period when inflation was running at 15%-25%. Funding rates of pensions schemes had increased alarmingly, just when employers had other cost and revenue pressures. Scholey said that it was unrealistic to build in such high salary growth rates and negative real rates of return for other than a short period. He argued that if such a climate persisted, the employer would be unable to continue in business without restructuring. If that were to happen, then people would be laid off and the liabilities would shrink. That is precisely what happened in the early 1980s. Not many people heeded Scholey’s advice, as is evident from the huge pension fund surpluses of that decade.
Who knows? If that advice had been heeded, defined benefit schemes would not have been saddled with much of the legislation that has made them such a burden for employers, our clients. It is not clear to me whether Scholey himself practised what he preached.
The second prediction was in a paper issued by Gordon Pepper of Greenwell in 1989 arguing that house prices would fall. It was an almost heretical suggestion, given that ‘safe as houses’ was almost the first commandment of investment. Gordon drew a compelling analogy with 1973/74 when valuations had got equally high. He showed that in real terms house prices had fallen over the subsequent four to five years, and it was only inflation that hid this, with nominal prices remaining stable. As inflation was low in 1989 (compared with 1973), nominal prices were likely to fall.
I remember being struck by the force of the logic. Regrettably, I did not do anything about it, even though I was working for a composite that had a high exposure to the housing market. I was aware of its exposure to estate agency and mortgage endowments, but there was a more sinister risk lurking in its general insurance business: mortgage indemnity guarantees. Although it was not within my remit to do so, I should have written to the executive directors of the company. Failure to do so is the biggest regret of my career. It would have been too late to avoid the problem but it might at least have been mitigated. And my conscience would have been clear today.
In my defence, I did write a memo to the executive directors of the life company. However, it was merely a ‘Gordon Pepper suggests’ type of communication. I did not pursue it with the passion I invested in, for example, cutting bonus rates, where I was on home territory.
The third prediction was contained in a series of seminars which Bacon & Woodrow held in the UK in 1997 on the implications of Britain’s joining the EMU and adopting the euro. Gordon Brown had already ceded control of interest rates to the Bank of England. Interest rates were under the discipline of market forces, without political interference.
The theme of the seminars was that even if Britain did not join the EMU, the need to shadow the convergence criteria meant that bond yields would fall. A prediction was made that within three years, ie by 2000, bond yields would be down to 4.5%. All sorts of serious implications followed for asset allocation policy and liability management, particularly in respect of annuity options. The message was that, if you believed the story, you’d better increase your bond holdings before others did and yields moved against you. I was at each of these seminars and did not hear a single note of dissent, although some said that the yields would not fall to that extent in three years.
But precious few companies did anything about it. It is almost as if there is greater fear of being out of step than of being wrong. Now, of course, everyone is reducing their equity holdings at a time when the supply of gilts is virtually exhausted. Companies and supra-national institutions such as the EIB are issuing plenty of bonds, but we do not fully understand the risks inherent in them.

What’s happening tomorrow?
Prices are determined by the balance or imbalance between supply and demand. Leaving aside for the moment issues relating to the matching of liabilities, let me postulate a contrary theory. Let me suggest that the risk now is not one of low inflation, but of medium and long bond yields rising. Consider the following:
– It looks as if there will be a referendum on Britain’s joining the EMU, and that the vote would be in favour of joining. Convergence would lead to higher target inflation, although the exchange rate at which entry takes place is important.
– The government appears to be recognising that its pensions policy is in a mess, and it may resort to compulsion. Pickering is suggesting that employers should be able to insist on compulsory membership. In a tight labour market, this could lead to higher prices or the export of jobs to cheaper countries. However, five or ten years from now, it is reasonable to assume that disparity in labour costs between, say, India and the UK would narrow as the Indian workers acquire bargaining clout. If labour was plentiful, compulsion could lead to more unemployment, increasing social security costs.
– The government appears committed to reforming the NHS. The financial support currently promised cannot be spent fast enough, and could lead to higher wages and other costs, ie it could have an inflationary impact. And yet many experts believe that the amount of public spending announced is unlikely to be sufficient so we might then see higher taxation or greater borrowing.
– It can only be a matter of time before Gordon Brown’s policy of stealth taxation gets rumbled. The government is suffering from the ennui of any second-term government with a large majority. It would hardly get re-elected if there were a decent opposition. Blair is, however, an astute politician and would not risk the backlash of a further increase in taxation. So the ‘higher taxation or greater borrowing’ result above would presumably be greater borrowing, which would then lead to higher interest rates.
– By then we may have joined the EMU and locked into European inflation which, while higher than the UK’s, is not high by past standards. The price of long-term gilts is determined by supply and demand, and only indirectly by the level of current RPI. The demand is determined partly by expectation of inflation over the term of the bond. As EMU expands to include other European nations, that expectation might be that inflation would increase (as a trend, not a blip).
– At the time of writing, long gilts are yielding 5.1%-5.3%, AAA corporate bonds 5.3%-5.5%, BBB+ bonds 6.7%-8.5%, index-linked gilts 2.2%-2.3% (real yields), FTSE 100 and FTSE 250, 2.8%. These yields do not suggest that equities are undervalued, especially bearing in mind the doubts regarding the authenticity of earnings of many of the companies.
There is a strong, but not overwhelming, case to be made for long bond yields rising in the foreseeable future. Of course financial economists will say that this and other information must already be reflected in bond prices. Of course it must, as it did with technology prices in March 2000, and as it does in technology prices today. Investors are not immune to the ‘which economist is right’ problem Reagan alluded to, and it is only when information is deemed to be ‘fact’ that prices are affected.

Are life companies preparing?
My point is that, if my contention were valid, would a company want to be locked into long-term gilts? Surely it is better to go short; or to go into equities, if the company believed that the latter would do better in the scenarios painted. Of course, companies would only be able to do this if they had the capital to back such a view, as they would need to be able to tolerate short-term volatility. If capital is scarce, then they may not be in a position to do so, but there would be a serious decision to make in asset allocation and liability matching.
Life companies have suffered the PR backlash of low inflation and low investment returns. One lesson for us all is that, while there is expectation that with-profits products should be able to ride fundamental economic changes, there is little public or regulatory appetite for paying for it.
Should life companies be using the Sandler window to do a ‘deal’ with policyholders?
Making financial sense of the future? I am happy to stand up and be counted in 2010.