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The Actuary The magazine of the Institute & Faculty of Actuaries

The long and winding road

T he North American Society of Actuaries reflected the growing debate on financial economics inside our profession with an entire session on the subject at its Vancouver spring meeting, held in late June. The session was aptly titled ‘The great controversy’ (subtitled ‘Current pension actuarial practice in the light of financial economics’).
The seminar was, in part, prompted by the provocative paper ‘Reinventing pension actuarial science’ published earlier this year by Jeremy Gold and Larry Bader in the Society’s Pension Forum. The arguments in this paper may be familiar to UK actuaries. It advanced the proposition that, when viewed from the perspective of modern (post-1950) corporate finance, the conventional actuarial wisdom of the 1980s and 1990s has a number of serious flaws and the paper argued instead for a framework paying more regard to market values.

Contributions from the UK
The session received presentations by speakers from around the globe, including a large UK contingent (Tim Gordon, Stuart Jarvis, David McCarthy, Jon Palin, and Cliff Speed) that contributed over a fifth of the papers discussed. Indeed, this prompted a recurring, if rather unusual, comparison between the UK actuaries and the Beatles (the North Americans claimed not only to have given us rock and roll but also to have invented financial economics, which we were now simply playing back to them).
Aside from the contributions from the UK, the sessions included a powerful endorsement of modern market-based pensions accounting by Mark Ruloff, who likened the move towards market accounting as an unstoppable train. He argued that the accountants had applied the ‘wisdom of Solomon’ in establishing the current US pensions accounting framework, and simply taken half of the accounting standard from financial economists (regarding discount rates) and the other half from actuaries (regarding the complex smoothing and amortisation rules). It was suggested that if the accountants had regrets about the current state of pensions accounting, they were nothing to do with the parts taken from financial economics!

The US experience
Edward Burrows, an elder of the US actuarial profession who has lived through the development of the complicated ERISA rules, gave a particularly enlightened contribution that illustrated the common ground between very traditional (or ‘classical’) actuarial theory and modern financial economics. He argued that the reason for the existence of the complex rules and indeed, the Pensions Benefits Guarantee Corporation (PBGC), would disappear if funds were required simply to maintain 100% solvency on an old-fashioned wind-up basis. This is a lesson that perhaps the UK government could learn as it dwells on complicated premium structures for the Pension Protection Fund, and grapples with the difficulties of enforcing buy-out shortfall pension debts on subsidiary companies within existing UK and international company law. A lunchtime talk by Steven Kandarian, executive director of PBGC, also appeared to be broadly supportive of these financial economic principles, while remaining diplomatic as far as the political aspects were concerned.
While making it quite clear that her views were personal and not necessarily those of the ‘Fed’, Julia Coronado delivered some thought-provoking results of research undertaken at the Federal Reserve Board suggesting that opaque actuarial accounting may have been partly responsible for creating a bubble in equity prices. The financial economist Zvi Bodie, as ever, gave an entertaining presentation of the fact that equities do not become less risky over longer time horizons. Of course the application of the market value paradigm to defined benefit pension funds is relevant whether or not this risk reduction applies, but his comprehensive demolition of such a major pillar of received actuarial investment wisdom was another highlight.

Arguments against financial economics
The main speaker advancing arguments against financial economics and in favour of smoothing market values was Eric Kleiber. He likened financial economists to communists, and advanced a framework familiar to UK actuaries, where professional judgement as to the ‘value’ of a financial contract is of more relevance than the rigid market valuation doctrine.
From a UK perspective, the debate in Vancouver seemed rather subdued. Possibly there was a silent majority in the audience totally bemused by the financial economics argument, but I don’t think so. Certainly, talking to delegates, there are many issues in common with the UK concerning acceptance of the theory. However, one theme which many delegates returned to was that North American actuarial science had never completely forsaken market valuation principles, and therefore the ideas were far less foreign to them than was the case in the UK. Furthermore, several delegates also noted that the North Americans had never adopted (and had always been puzzled by) the dividend discount model as a means of arriving at off-market asset and liability valuations. Whether the symposium encourages them to reinvent (or perhaps rediscover or reinvigorate) their actuarial theory in the light of financial economics remains to be seen.