Barton Waring's preface sets out his ‘aspiration to provide a thoughtful and persuasive background for those considering how to reform pension finance and accounting’. He also hopes to provide a text to describe the true operations of defined benefit (DB) retirement schemes – predominantly in the US.
The bare bones of his proposals for reform are to require that the present value of the DB pension scheme liabilities are calculated at a risk free rate of interest; that the assets are invested largely in fixed interest assets which will minimize the risk of future investment losses; and that the current deficits should be made good in a relatively short period, ‘say 10 years’, by additional contributions and benefit reductions. He highlights the penultimate chapter ‘Tough love’ as the most important, as it considers how to persuade relevant parties to address the enormous deficits in some of these funds.
The argument of the book is helpfully set out at the start with a list of 22 propositions that are argued in more detail through the book. In summary, these are:
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(1) Accounting rules do not change the ultimate cost of benefits, but they can mislead by allocating costs to the wrong periods and by misstating the value of liabilities.
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(2) Investing the assets of pension schemes in equities is risky both in the short and long runs.
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(3) DB pensions are largely predetermined cash flows and should be valued at the risk free rate, perhaps with small adjustments for credit risk.
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(4) The present value of liabilities and the accrual of pension benefits is therefore not affected by investment policy (i.e., investing in equities cannot be said to reduce the cost of pension benefits).
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(5) The current accrued liability should be negotiated between employers and employees.
The propositions are closely argued with generalized formulae; the variables and terms used being summarized in a helpful appendix. The arguments go into some detail as to actuarial and accounting jargon: Waring has worked extensively as a pension consultant and is adept at explaining the concepts – although perhaps at more length and more repetitively than necessary.
The preface begins with an acknowledgment that the arguments of the book can be seen as controversial. Certainly the author is indignant at current actuarial and accounting practice in the US and believes that pension finance under his approach would be ‘suddenly much more understandable and manageable. Indeed it becomes sensible and rational’.
Waring does not really explore arguments for alternative positions, rather assuming that readers will be familiar with current practice and its justification. These include the practice of using the expected return on the assets rather than a risk free rate, and significant investment in equities. Waring argues that the former arises from a misunderstanding of financial economics and understates the economic value of the fund's liabilities. The latter, he suggests, arises from misunderstanding the impact on the volatility of the real costs of the benefits, and exposes funds and sponsors to excessive risk. In the main, I think he is right, and that all academics, and most practitioners, would largely agree.
The assumption listed at point 3 above can, however, be disputed. There is a view that many DB schemes were not intended to guarantee benefits in this way. Some do not, as Australian academic members of the Unisuper DB scheme are acutely aware. Waring discusses the Dutch system with approval, but does not mention that benefits are also partly dependent on investment returns. To the extent that benefits are variable, the assumption in point 3 is wrong and the consequence in point 4 becomes much more complicated. To the extent, however that most DB funds in the US are meant to be guaranteed, his propositions seem unassailable.
In the US, therefore, the propositions have been widely accepted for some time. Cramer and Neyhart (Reference Cramer and Neyhart1980) made much the same arguments. In 2003, the US Society of Actuaries hosted ‘The Great Controversy: Current Pension Actuarial Practice in Light of Financial Economics Symposium’(http://www.soa.org/news-and-publications/publications/other-publications/monographs/m-rs04-1-toc.aspx). A number of papers made arguments similar to Waring's, and none of the 22 papers presented seem to have even attempted a case against them. The intellectual controversy was already over even then.
One of the themes of the book is the failure of the actuarial literature to recognize the implications of financial economics. As an actuary, I do feel embarrassment at his criticism of actuarial practice. I do, however, think he was unfair to the literature and to Exley et al. (Reference Exley, Mehta and Smith1997) particularly. The overall cost and investment implications of poor practice are covered very carefully in their paper. They also go on to consider the interaction of scheme design with management, remuneration and employee behaviour, which are not addressed by Waring.
My view would be that Waring's indignation would be better directed if informed by wider political and social considerations. The real issue seems to me not so much the failure of actuarial theory to understand financial economics, but how policy decisions have been captured by vested interests: it is not stupidity but cupidity, duplicity and naivety to which we should look.
Cupidity, in that, excessive and unfunded benefits were first ‘negotiated’ by management and unions in many cases knowing that they were inadequately costed and funded. Waring says neither of these groups is at fault, both having been misled by poor information, but he does note that deficits were built up even with overly optimistic reporting.
Duplicity, in that those with power, and their advisors, turned a blind eye to the excesses in order to protect their positions and are apparently satisfied that reporting remains inadequate. Waring does point out that the practice of amortizing new past service benefits ‘does interfere with telling oneself the truth’. As Gordon and Jarvis (Reference Gordon and Jarvis2003) put it:
‘Clients, in most cases, will prefer to have actuaries delivering … advice that minimizes the need for cash contributions or unpleasant financial disclosures. This inevitably creates a pressure to avoid change from the traditional and malleable expected returns-based actuarial approach’.
Naivety, in underestimating the complex nature of the institutional structures underpinning the inadequacies he describes. Klumpes (Reference Klumpes1994) describes the political lobbying in Australia against the disclosure of accounting information. While not all DB fund practices are corrupt, Ashforth and Anand (Reference Ashforth and Anand2003) description of the normalization of corruption applies with some force to the issues deserving Waring's outrage:
‘We argue that three mutually reinforcing processes underlie normalization: (1) institutionalization, where an initial corrupt decision or act becomes embedded in structures and processes and thereby routinized; (2) rationalization, where self-serving ideologies develop to justify and perhaps even valorize corruption; and (3) socialization, where naive newcomers are induced to view corruption as permissible if not desirable. The model helps explain how otherwise morally upright individuals can routinely engage in corruption without experiencing conflict, how corruption can persist despite the turnover of its initial practitioners, how seemingly rational organizations can engage in suicidal corruption and how an emphasis on the individual as evildoer misses the point that systems and individuals are mutually reinforcing’.
Waring's ‘Pension Finance’ is possibly too tendentious to be a good text book. It is to be hoped, however, that it has a role in moving regulators to reform pension accounting and to persuade those that control DB funds to address unwarranted investment risk and unfunded deficits. Those who have the power to make changes need be challenged by books such as this.
