20 December 2023

I prefer true but imperfect knowledge, even if it leaves much indetermined and unpredictable, to a pretence of exact knowledge that is likely to be false. The credit which the apparent conformity with recognized scientific standards can gain for seemingly simple but false theories may, as the present instance shows, have grave consequences. Friedrich von Hayek, Prize lecture in Stockholm on receiving the 1974 Nobel Prize in Economics. 1974 was also the year I thought about pensions for the first time, although, like most people in their twenties, not for long. The long-standing provision of defined contribution pensions for university staff was replaced by a defined benefit scheme, USS. This was an era in which most large employers and many small ones were making similar moves. After a long political debate, Barbara Castle presided over the bipartisan introduction of an earnings-related tier to the state pension scheme, with provision for good occupational schemes to “contract out”.  Following the establishment of the ‘cradle to grave’ welfare state in the decades immediately after the Second World War, this extension of defined benefit occupational pension schemes was perhaps the greatest success of British social welfare policy. The system was not without problems. I recall in the 1980s helping Sir David Walker organise a seminar at the Bank of England to discuss issues in the governance of occupational pensions and their relationship to corporate balance sheets. But as schemes matured, the beneficial results of the growth of occupational pensions became apparent. In 1995, more than 60% of pensioners had below median incomes. By 2010 the distribution of pensioner incomes was in line with that of the working population, as the architects of defined benefit schemes had envisaged. Old age was no longer a major cause of poverty.  But then the foundations of defined benefit provision began to crumble. Famously, the scale of Robert Maxwell’s theft from Mirror Group Newspapers pension funds was revealed when he was found dead in the sea near Madeira in 1991. It became evident, as we had recognised at that Bank of England seminar, that more needed to be done to promote the security of pension promises and this led to the Goode Report in 1993. Less dramatically, in 1997 Exley, Mehta and Smith delivered a seminal address which introduced a generation of actuaries to modern financial economics. I had once been startled to find that actuaries knew little of finance theory – soon I would come to think they knew too much or at least took it too seriously. Accounting practice was shifting from historic cost to ‘fair value’ assessment of balance sheet values, with possible implications for the treatment of pension liabilities, which became a reality with the adoption of new accounting standards – in particular, FRS 17 in 2000 and IAS 19 in 2001. The outcome of these events was a stream – then a torrent, then a flood – of fresh complexity and regulatory intervention. There were several components to the economic contribution to actuarial analysis. It had long been recognised that money in the future is worth less than money today. This idea was systematised in the calculation of discounted cash flow (DCF) valuations, which enabled a present value to be attached to a stream of prospective cash flows. Subjective expected utility (SEU) valued uncertain returns by reference to their variance and the ‘risk aversion’ of an agent, with such ‘risk aversion’ deduced from the second derivative of the function relating utility to income or wealth. Modern portfolio theory (MPT) and the capital asset pricing model (CAPM) emphasise that the uncertainty attaching to an investment portfolio depends not just on the uncertainties (variances) associated with returns on individual assets but on the covariances between them. Finally, the efficient market hypothesis (EMH) expressed the idea that market prices reflected all publicly available information. (Importantly, the empirical observation that historical equity returns substantially exceeded levels readily explicable by these models, described in 1985 by Rajnish Mehra and Edward Prescott as ‘the equity premium puzzle’, still lacks good explanation within this theoretical framework.) This analytic framework was extensively developed in the 1950s and 1960s and contributed to the transformation of the world of finance from one in which well-bred gentlemen exchanged inside information with each other over long alcoholic lunches, to the professional activities of today that sweep many of the most able students of mathematics into the City of London and Wall Street (or Greenwich, Connecticut). And Nobel Prizes were awarded to Harry Markowitz (MPT), William Sharpe (CAPM) and Eugene Fama (EMH) for their contributions; LJ Savage (SEU) had died in 1971 aged only 53. These models have been indispensable tools in developing our understanding of financial markets. But Hayek’s 1974 lecture gave prescient warning of the dangers of their misapplication. He observed “I regard it in fact as the great advantage of the mathematical technique that it allows us to describe, by means of algebraic equations, the general character of a pattern even where we are ignorant of the numerical values which will determine its particular manifestation. We could scarcely have achieved that comprehensive picture of the mutual interdependencies of the different events in a market without this algebraic technique. It has led to the illusion, however, that we can use this technique for the determination and prediction of the numerical values of those magnitudes; and this has led to a vain search for quantitative or numerical constants…” He continued: “…compared with the precise predictions we have learnt to expect in the physical sciences, this sort of mere pattern predictions is a second best with which one does not like to have to be content. Yet the danger of which I want to warn is precisely the belief that in order to have a claim to be accepted as scientific it is necessary to achieve more. This way lies charlatanism and worse. To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely