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The Actuary The magazine of the Institute & Faculty of Actuaries

The Internet actuary

In the recent past we have seen two significant and apparently unrelated developments: the switch from defined benefit (DB) schemes to defined contribution (DC) schemes, with the associated transfer of investment risk from employer to employee; and the development of financial planning tools that run on the Internet.

The switch to DC schemes
Many traditional pension fund actuaries fondly believe that the current trend towards DC schemes will be reversed. This is probably wishful thinking, as shareholders become increasingly sophisticated and understand the additional risks attached to companies that have a DB scheme. For example:
– A company with a DB scheme should immediately be re-rated if the valuation reveals a deficit because there will be an additional drain on profits while the deficit is being amortised. (The market cap of the company should be reduced by the deficit and the share price adjusted accordingly.)
– A company that switches back to DB should immediately be re-rated because of the risk of an additional contribution towards a deficit at some stage in the future.
The impact that the pension fund has on the finances of the company is more significant in service industries, where the gearing effect of salary-related expenses on profits is more telling.
It is therefore likely that most companies will convert to a DC arrangement in the long term, because of pressure from their shareholders. How is the actuarial profession responding to the possibility of a pervasive DC environment?

The actuary’s role in a DC environment
One significant difference between a DB and a DC arrangement is the number of investment risk-takers: for DB arrangements there is one investment risk-taker the employer; under a DC arrangement, every single member of the fund is exposed to investment risk. Advice and an understanding of the issues is therefore required by a far larger number of individuals. It might be argued that investment is the responsibility of the trustees, but this approach is fraught with potential for conflict members carry the risk and must live with the results of decisions made; they must understand the risks and must be given the opportunity to manage them.
Under a DB arrangement the employer decides on the benefit and asks the actuary how much it will cost. Under DC arrangements each member should be encouraged to target their retirement benefit. The actuary now has a role to assist each member in setting a contribution rate appropriate to his/her target.
Many progressive employers are now moving to a ‘cost-to-company’ basis of remuneration. Under this method of operation, members are able to increase their pensions savings, provided the cost to the company is the same. This opens the door to the targeting of an appropriate pension benefit by members. Even if the employer does not allow a salary sacrifice, it is good practice to inform employees of the total retirement provision that they should be making.
The traditional role of the actuary advising the employer and trustees has not provided a sound basis for advising a mass market. Furthermore, prior to the advent of the Internet the ‘mass market’ actuary was not a practical proposition. The actuary’s role in advising the members of a DC arrangement has therefore been limited to the benefit statement, which has its own particular constraints.

Benefit statements
Given that the main objective of a retirement fund is to perpetuate pre-retirement lifestyle into retirement, it is appropriate to illustrate projected benefits as a percentage of salary. However, the pension at retirement will depend on a number of factors under a defined contribution arrangement:
– pattern of salary increases;
– net retirement contributions;
– return on retirement savings;
– choice of pension (escalation, spouse’s pension);
– cost of the pension at retirement.
It is virtually impossible to cover all of a member’s individual choices or circumstances on a single benefit statement, let alone give the member a feel for the risks involved. Consequently, it is almost inevitable that a benefit statement will create false expectations for at least some of the members of a DC scheme.
Given the practical constraints on the benefit statement and the increasing awareness of DC members about their benefits, members will, as in so many other similar situations, turn to the Internet as the source of all information (and wisdom?). What will they find there?

Internet financial planners
A cursory review of the Internet sites of financial institutions reveals a plethora of Internet financial planners (IFPs). Typically, these tools will adopt some or all of the following approaches:
– A retirement planning tool might ask the user how long he/she expects to live after retirement.
– The user will be asked to set interest and inflation assumptions. No warning is given if a user chooses inconsistent assumptions.
– Modules on investment risk tend to focus on subjective indicators of how risk-averse the user feels. Elements of risk that actuaries have identified and know how to manage are typically ignored.
– There is generally no visible reminder that the results are only as good as the model and assumptions used.
Any actuary using these tools will rapidly conclude that the potential to mislead the Internet public is enormous. Surely the actuarial profession has a responsibility to provide an actuarial model for the Internet. What features should such a model have?

The Internet actuarial model
The most significant difference between traditional actuarial models and an Internet actuarial model (IAM) is that the IAM is aimed at individuals rather than institutions. There is therefore an opportunity to consider all financial risks from an individual perspective and to provide an actuarial analysis of all these risks. The IAM should therefore have the following features:
– It should answer questions like, ‘if there is a market crash, will I recover before retirement?’.
– It should present a holistic view of the member’s future finances by covering the interaction between the following:
retirement planning (including investment choice);
planning for death or disability;
impact of home ownership on family finances;
need to save for their children’s education;
management of medical expenses.
– There should be a clear distinction between the effect of factors in the member’s control (such as the choice of pension) and the effect of factors over which the member has no control (such as inflation).
– Each set of assumptions used should be consistent for example the member could test various outcomes using a conservative, a realistic, or an optimistic set of assumptions. If the member is given the opportunity to set assumptions, adequate warnings should be given where the assumptions are unrealistic.
– The IAM should be intuitive and interactive. The response times should be fast so the user does not lose interest. Help should be available if necessary.
– Results should be displayed in an understandable and graphical manner to assist the user in coming to terms with the issues. An example of such an illustration is given in Figure 1.
Research will have to be undertaken into the development of a robust IAM for the profession. Many of the principles can be borrowed from our traditional actuarial toolbox but the research should cover the methodology and assumptions for a typical IAM. The profession will have to set guidelines for the issues surrounding IAMs.
Given that the development of an IAM is both inevitable and urgent, what will be the role of a future Internet actuary?

The Internet actuary
The Internet actuary will be involved in the following areas:
– design and implementation of an IAM;
– certification of IAM sites both on the Internet (for financial institutions such as life offices, banks, and unit trusts) and on intranets (for use by employees and members of pension funds);
– the setting of consistent assumptions for an IAM from time to time;
– seminars and individual sessions for members to supplement their understanding of the various issues;
– on-line advice to members of the Internet public.

Window of opportunity
The move towards a pervasive DC environment means that the audience for actuarial advice has grown and will continue to expand enormously. The Internet and company intranets provide a practical vehicle for the delivery of this advice. There is a need for the profession to develop an appropriate methodology for an IAM. There is, however, a small window of opportunity for actuaries to recapture the financial advice arena on the Internet. Failure to do so could seriously damage the reputation of actuaries as the profession that ‘makes financial sense of the future’.