PROJECT M
 
Dirk Hellmuth
Don Ezra
Keith Ambachtsheer

Conference Call: Guaranteed?

Since the financial crisis, guarantees have become a vexatious topic for all parties involved in pension discussions. Dirk Hellmuth discusses the topic with Don Ezra and Keith Ambachtsheer, who are not only two revered senior statesmen of the industry, but also old friends

Conference Call: Guaranteed?

Since the financial crisis, guarantees have become a vexatious topic for all parties involved in pension discussions. Dirk Hellmuth discusses the topic with Don Ezra and Keith Ambachtsheer, who are not only two revered senior statesmen of the industry, but also old friends


Dirk Hellmuth

Don, Keith – thanks for joining us. What is your stance on guarantees as they relate to pensions and retirement systems?

Don Ezra

We have to be realistic about costs. Across the globe, actuaries and providers of guarantees have used all kinds of mechanisms to conceal the costs of the guarantee.

Keith Ambachtsheer

Another point is that traditional DB systems gave guarantees to people regardless of their need, that is, at a point when the guarantee was irrelevant. Trying to give a 25-year-old a payment guarantee 45 years down the road is a rather silly concept. You probably can’t hedge it, and it doesn’t meet the needs of the individual.

Dirk Hellmuth

The problem is that the collective interest in providing retirement benefits is often at odds with the collective interest in sustaining employers and industries. In the last decades, pensions reforms have resulted in a shift from strong first pillar (state) focused systems to second (occupational) and third (private) pillar focused. We have to rethink the multipillar model as an integrated system to balance out the risks of all stakeholders – governments, companies and individuals – to arrive at an acceptable level of overall risk, while achieving adequate income levels.
This means moving away from the black-and-white duality of DB/DC, where one partner – the sponsor in the case of defined benefit, the member in defined contribution – bears all risks. Defined ambition (DA) is interesting, as it shares risks between sponsors and members.

Keith Ambachtsheer

Deductively, there is no good way for employees and employers to share risks in a sustainable, transparent way, so let’s not even try. This is best understood from the John Nash game theory perspective. His theory relates to guarantees, as it predicts that the kind of DB pension arrangements created in the 1970s and 1980s would eventually become win-lose situations because you don’t have the contracting power and vision to maintain what you started through tough times. What happened with occupational and state pensions in 2000 and beyond proves this.
Discussing guarantees, the question is: what kind of legal and economic arrangements do you need for a guarantee to really be a guarantee? A guarantee provider needs enough capital behind the promise to make good on it. For example, in the United States, TIAA-CREF (Teachers Insurance and Annuity Association – College Retirement Equities Fund) has operated in that way for many decades.
There is a clear distinction between people accumulating assets to seek high returns – the CREF part – and then having the opportunity to buy annuities at fair value – the TIAA part.

Don Ezra

Dirk, you are right, we can do better than pure DB and pure DC. People have different needs. Younger people are more pro-accumulation, and older people are more pro-certainty. This reflects goals we have in life: to survive and to thrive. How we split resources between survival and thriving varies.
In a pension context this survival role is important when you don’t have much time on your side. The older you are the more you want to make sure with those guarantees. The younger you are, the more flexibility you want. You want to say, “OK, let’s accumulate as much as possible.”
When it comes to retirement, the question arises of how big are the pools to which you can allocate these risks? Distinction between the pension pillars becomes important. In the first pillar you get the whole nation sharing one pool. But in the second pillar, we have pools where you can distinguish between the goals of pro-certainty and pro-accumulation. I like an idea Keith often talks about, having two pools. A pool for younger savers, one for older savers and a transition pool in between.

Dirk Hellmuth

Guarantees are designed by actuaries, and we have done a poor job of educating peopleDon EzraIs that the reality, though?

Don Ezra

Well, we are geeks, even though I try to be an educational geek. Guarantees are dominated by technicians, they are designed by actuaries, and we have done a poor job of educating people. There are few guarantees in life. However, if you think of crossing the road, driving a car or riding a bike, people are willing to try to reduce risk – by wearing a bike helmet or seat belt, or crossing the street carefully. We do this because we understand the risk. The reason we want guarantees in pensions is because we are afraid that if we don’t have them we don’t know what to do. There is fear of the unknown. We can educate people to understand the unknown so they won’t fear it as much and will be willing to live without a total financial guarantee.

Keith Ambachtsheer

Trust is crucial. Look at the Finnish system. It’s complicated, but the society shows high levels of trust. People are willing to let the geeks run the system – if they trust that they are creating a long-term, fair and sustainable system. The Nordic countries, including the Netherlands, have a collective process for doing that. They have three representative groups: employees, employers and taxpayer representation through the government, involved in ongoing discussions including heavy technical stuff. The results work for people, so they trust the system.

Don Ezra

And the Nordics are also at the top of the list in surveys of self-proclaimed citizen happiness. You can’t find the same feeling of being in this together in the UK or the US.

Keith Ambachtsheer

We also have to be clear about property rights. Employment-based DB plans have all too often obscured those rights. Essentially, there should be no wealth transfers allowed. Clear property rights are especially important in the Anglo-Saxon countries, that is, you want to understand what you own, but it is not the same in all cultures. For example, the notions of solidarity and collective rights have more traction in the Nordic countries.

Dirk Hellmuth

How optimistic are you that we will achieve this level of transparency?

Keith Ambachtsheer

That will be difficult unless we correct the informational asymmetry where the service sellers know more about what they are selling than the buyers know about what they are buying. It relates back to George Akerlof and his work on The Market for Lemons in understanding how well or poorly a market works. Unless you create mechanisms on the buy side of the financial service industry to correct informational asymmetry, you’ll have a problem with transparency and costs.

Dirk Hellmuth

We haven’t figured out how to use guarantees well yet, so why should we expect developing economies to get it right?Keith AmbachtsheerDo you expect guarantees to disappear, as Gordon Clark has suggested? I cannot believe that guarantees are going to become extinct. Some form of guarantee will remain as part of the pension product package available to individuals.

Don Ezra

Humans do better in groups than individually, and that is why we need some notion of risk sharing. In the first pillar, I don’t expect guarantees to disappear, simply because we get the politicians we deserve. And we choose those politicians that promise us everything – with the possible exception of the Nordic countries. In pillar three, it is all about education – not selling. It is an educational issue and a big passion of mine. For the second pillar, I think Keith’s idea of two pools with a transition between them is constructive. This is my guess on the future of guarantees.

Keith Ambachtsheer

I believe NEST (National Employment Savings Trust) in the United Kingdom is an important venture. NEST has good governance and management, and fits nicely with Britain’s move towards defined ambition pension arrangements, which can include a payment guarantee dimension.
Regarding emerging markets, I think even in developed economies we haven’t figured out how to use guarantees well yet, so why should we expect developing economies to get it right? And first and foremost to me is to get the property rights of pensions well-defined. This is still a major challenge in some countries, as we have seen in Hungary, for example, where pension savings were nationalized in 2010.

Don Ezra

I would go further. Don’t provide guarantees. A lesson of the last six years is that countries we thought could provide guarantees are not able to. So the notion of risk-free, which needs to be associated with the notion of guarantee, has to go.

Dirk Hellmuth

Will insurance companies be able to provide guarantees?

Keith Ambachtsheer

To the degree insurance companies are able to do the right calculation at what price they are willing to issue what guarantee, there will definitely be a business. The interesting question gets back to industrial structure: to what degree should you/can you mutualize that need for certainty, and to what degree should/can it be supplied by commercial providers.

Dirk Hellmuth

Insurance companies should not only focus on providing a guarantee. Combining wealth management and insurance products can address two types of uncertainty: how much savings the individual can build up preretirement and how long the individual will live post-retirement.

Dirk Hellmuth

Gentlemen, I am sure this is far from the last word on guarantees. Thank you, it has been a pleasure.

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