The Pension Crisis and the Systemic Failure of the Actuarial Profession

The global pension crisis has revealed the need to rethink fundamentally how pension systems are regulated.  It has also made clear a systemic failure of the actuarial profession.

Since the 1970s, most actuaries have developed and come to rely on models that disregard key factors – including political whims, longer life expectancies, and lower investment returns when liquidity is paramount – that drive outcomes in asset and other markets.  It is obvious, even to the casual observer, that these models fail to account for the actual evolution of the real-world economy.  Moreover, the current fee-generating agenda has largely crowded out research on the inherent causes of the pension crises.  There has also been little exploration of early indicators of systemic crisis and potential ways to prevent this malady from developing.  In fact, if one browses through the academic actuarial literature, “systemic crisis” seems to be an otherworldly event, absent from actuarial models.  Most models, by design, offer no immediate handle on how to think about or deal with this recurring phenomenon.  In our hour of greatest need, societies around the world are left to grope in the dark without a theory.  That, to us, is a systemic failure of the actuarial profession.

Up to now I have been plagiarizing the first two paragraphs of Chapter 12 of a collection of essays titled “What Caused the Financial Crisis” with only the words in bold italics replacing the original which related to the economics profession and the financial crisis as the authors wonder how economists could have been so blind.  I wonder the same about pension actuaries.

  • Were the asset fees from 401(k) plans so good that they kept quiet about the inadequacy of these plans for participants?
  • Were the fees from public entities so good that they happily created funding methods to understate contributions and countenanced contribution holidays legislated by their politician clients?
  • Were they too busy generating those fees that they ignored seismic shifts in mortality rates and investment returns that undercut their numbers?

The implicit view behind standard equilibrium models is that markets and economies are inherently stable and only temporarily get off track.  The majority of actuaries thus failed to warn about the threatening system crisis and ignored the work of those who did.*




* This was the third paragraph of the essay with only that one word replaced.  I could go on this way to the end.

9 responses to this post.

  1. Posted by skip3house on May 25, 2011 at 9:10 am

    Most people have no interest in facts based on math, in its various forms. They will have no clue, whatsoever, why there suddenly is no food on their table.


  2. Hey John, I made a thread here:

    I did reproduce your entire entry. If you want, I can just excerpt it — just let me know.


  3. Posted by Tough Love on May 25, 2011 at 11:41 am

    While your last sentence is eminently accurate, I feel your bullet points put too much blame on actuaries.

    With respect to your 1-st bullet, clearly, the inadequacy of (low matching contribution) 401K plans as a retirement vehicle is due to a combination of Corporate greed, the impact of globalization on prices and profits, and the lack of a meaningful way for Private Sector employees to demand a better deal from their employers.

    With respect to your 2-nd & 3-rd bullets, the actuaries acquiescence to minimal funding approaches in Public Sector Plans is far less causative of this mess than the collusion between Public Sector Unions and our corrupt/enabling elected officials more than willing to accept campaign contributions and election support in exchange for favorable votes on excessive pay, pension, and benefit packages ….. the ROOT CAUSE of the problem.


  4. Posted by steveB on May 25, 2011 at 12:09 pm

    John: You make some good points. However, the actuary’s rarely the one who says that 8.0% long-term net investment return is the most reasonable assumption in the all-important ‘formula-generating’ process. A plan sponsor along with investment advisor would always have been wiser to tell the actuary to assume, say 6%, to develop affordable costs for a pension program. And finally, the private sector always freezes the pension formula for the future, and the governmental entities always seem to set the formula in legislative stone so that it can’t be lowered or frozen for current actives. What a mistake that is! So be careful with over-criticizing the actuaries, when the other parties are MUCH more the decision-makers, thus problem-makers.


    • I agree there are far worse villains but actuaries are uniquely positioned to see that villainy yet they are mostly silent since it’s in their best immediate financial interests to play along and hope for the best. There’s an example I like to use:

      You have cancer. You go to a doctor who recommends aspirin for it realizing that’s all you can afford. You pay the doctor for the advice and the aspirin. If the recommendation were for a series of chemotherapy treatments the doctor would only be getting paid for the advice since the treatments would not be affordable.

      Of course the real villain is a health-care oligarchy dominated by insurance and pharmaceutical companies gate-keeping care but how much is the doctor to blame for playing along with it and hoping for the best?


      • Posted by Tough Love on May 25, 2011 at 4:57 pm

        Shortly after California’s then chief actuary Ron Seeling said something to the effect that increased contributions will be needed forever without major reforms, he was gone. Cause & effect ?

        Integrity is a tough nut in this political arena managed by those who care about little but keeping the current Civil Servant gravy train rolling along.

        One of California’s BIGGEST problems is the CalPERS’s proper roll as simply (a) administrator of approved Plan formulas, and (2) and fiduciary/investor of Plan assets, has morphed into a major advocacy roll for bigger and better pensions for participants.


  5. Posted by Larry Littlefield on May 25, 2011 at 3:05 pm

    You should have a beer with Jonathan Miller, real estate appraiser. He noted and blogged about the same phenomenon for real estate appraisals during the housing bubble — the “truth telling” professional who sold out got the contract, while those who stuck to the truth found their firms to be without work.

    But real estate is a telling example in another way, too. If the professionals won’t like, the powerful will come up with a workaround.

    There are lots of foreclosed properties on the market in Las Vegas. That pretty much is the market there. So…

    “Nevada state Sen. Mike Schneider is trying to fight back with proposed legislation that aims to set a floor under prices, which have fallen well over 50 percent on average in the Las Vegas area over the past five years. A few months ago, he sponsored a bill proposing a radical new mandate for appraisers: Stop paying attention to those ‘distressed’ sales. Legislators in other states and industry executives are watching closely.”

    “The legislation’s legality has been called into question because it runs counter to the Uniform Standards of Professional Appraisal Practice, the federal regulations home appraisers are required to follow. Opponents — who include professional appraisers and their trade association, as well as some skeptical realtors — say there’s no way such a law can be worded that wouldn’t require appraisers to violate those regulations.”

    So there are rumors the NYC actuary wants to lower the expected rate of return from 8.0% to (cough) 7.5%. But he notes that he is constrained by the state legislature, which increased the expected rate of return from 7.0% to 8.0% in 2000 as part of a massive retroactive pension enhancement. And has used that rate of return to justify one retroactive pension enhancement after another ever since.


    • Posted by Larry Littlefield on May 25, 2011 at 3:06 pm

      Oopps. If the professional won’t LIE, others will come up with a work around.

      Works for accountants, bond raters, stock analysts, etc, etc.


  6. Having dealt with public pension actuaries for 25+ years, I agree they need to shoulder much more of the blame for the current crisis.

    Aside from the annual valuation report, another key function of the actuary is to determine the cost of specific proposed benefit changes. Never have I seen a actuary’s valuation provide a range of possible costs based on possible “what-if” investment scenarios (i.e. if the plans earns 8%, the cost will be X; if the plan earns 6% the cost will be Y, etc.).

    Instead, the valuation is based on the plan’s assumed rate of return (typically 8%) that we (i.e most reasonable people) now recognize is far too aggressive and understates true long-term costs. Yet the actuaries number is typically taken as gospel by arbitrators and governing bodies and serves as the basis for decision-making.

    As a result billions of dollars of benefit enhancements have been handed out by governing bodies based on woefully incomplete information – information that could have been easily enhanced by simply adding-in some “what-if” analysis.


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