Traute Meyer – Research note (work in progress) prepared for: The financial crisis,
welfare state challenges and new forms of risk management. Aalborg 1-3 March 2011
How good are our predictions? Lessons from the shock of the financial crisis for
pension research.
The financial crisis as emergency
The financial crisis - like other “black Swan” (Taleb 2007)1 or “emergency” (Castles
2010) events - came rather unexpected to academia, and comparative welfare state
research was no exception. Do we need to re-evaluate our theories about welfare state
evolution in the light of this shock event? There are good reasons to think this might
not be necessary. Castles (2010) for example argues that because of the density of
welfare institutions in highly developed societies there is now a far more robust
response to emergencies, lessening the pain they were able to inflict in the past.
Existing theories of welfare institutions and their dynamics would be sufficiently well
equipped to analyse even momentous change, seen from this point of view. Taleb
(2007: 154) is adamant that one of the characteristics of a black swan event is its
unpredictability. It would therefore make little sense for the social sciences to
anticipate what type of event with large impact might occur next. Based on both
arguments we would not need to re-evaluate existing theory because of the financial
crisis: institutionalist theory is encompassing enough to give us a sense of how
societies will deal with sudden change; moreover, our limited imagination means we
cannot anticipate the exact nature of it anyway.
Changing perspective, such point of view could be questioned. Firstly, some have
argued, including Taleb, that the modern world will produce more Black Swan events
than took place in the past because it is – “driven by globalization, hypercompetition,
and …events pressed on by the …ceaseless advance of information and
communications technology…” (Runde 2009: 503). In Taleb’s terminology, our
world is more like “Extremistan” – i.e. extreme outliers are much more common and
we cannot rely on a normal distributions of events; this is different from
“Mediocristan”, where extreme outliers occurred rarely in a more predictable world
(Taleb 2007: 36). If we accept this position, it would be appropriate to consider more
carefully how resilient our institutions are. For example some commentators of the
current state of the global financial system are unconvinced that societies most
affected are out of the immediate danger zone, and have raised the question whether
these countries would be able to withstand a second shock. Secondly, the near
collapse is a reminder that confidence about predictions of the future may be
misplaced (e.g. Runde 2009: 504).
This paper will elaborate the latter point. It uses the shock of the financial nearcollapse to reflect on certain firmly established assumptions about the future in
pensions research. Based on this recent reminder that events might develop differently
than anticipated, it examines three types of actors that have been important for the
construction of pension futures and which have contributed to building the argument
for pension retrenchment: demographers and their predictions about ageing societies;
the OECD’s pension analyses, and the International Accounting Standard Board’s
1
Taleb defines a black swan event as improbable, it is an unforeseeable outliers, it has an extreme
impact and post-hoc humans “make it explainable and predictable” (Taleb 2007: xvii-xviii).
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rules about how to define the value of future assets. The paper shows weaknesses of
each type of prediction. It is based on work in progress.
Pension predictions are unavoidable
In pensions predictions are unavoidable: in order to make long-term investment
decisions it is necessary to assume how markets will behave in the long term. For
policy makers pension regulation and pension rights must depend on a view of
societal change, they need to have a vision about future risks and future lives.
Likewise, academics cannot ignore the future when analysing pensions, not least
because they need to be able to say what current reforms mean for citizens in the
future. Indeed, all the above actors – investors, policy-makers, academics have not
been shy in making predictions. One assumption in particular has been repeated so
many times and from so many directions that it has almost lost the status of a
prediction, and acquired that of a truth: pensions research and political actors appear
to have little doubt that the future must bring retrenchment, due to contemporary
economic and demographic trends. The introduction to the Oxford Handbook of
Pensions and Retirement Income exemplifies this position:
“In a world of increasing economic integration and head-to-head competition for
markets, few countries can avoid to impose upon working people and their enterprises
the taxes necessary to sustain long-term living standards for retirees.”
(ClarkMunnell et al. 2007: 3)
The statement makes assumptions about the future and is therefore uncertain, despite
its authoritative tone. If we examine these assumptions and the evidence there is for
making them more closely, we firstly have to engage with the key element that is a
main premise of a lot of pension research and policy-making: populations are ageing.
Ageing societies – demographic forecasts and their critics
Demographic predictions frequently reach decades into the future. By population
ageing demographers refer to an increase of the share of those above retirement age in
relation to those below it. To calculate this old-age dependency rate demographers use
three main indicators: fertility rates, mortality rates and migration (Shaw 2007;
Keilman 1997: 247). Based on information on all three they then project into the
future how the population of a given country might develop. How accurate have such
projections proven to be? Figure 1 compares a calculation of population development
done by the British Eugenics society in 1935 with most recent figures for the UK
from Eurostat.
2
Figure 1
Britain - Economically inactive older population as % of working age
adults, forecasts from 1934 and contemporary data
Over 60s/65s as % of 15-59/15-64
160
147
140
120
100
84
80
60
36
40
25
20
0
1995
Eugenics Society forecast 1935
2035
Eurostat, forecast 2010
The figure shows the predicted old age dependency ratio, i.e. the share of the noneconomically active older citizens as a proportion of adults, i.e. of those between 15
and 59 (Eugenics Society) and 64 (Eurostat) (for a definition Shaw 2007: 1270); the
left pillar represents the projections done in 1935, for 1995 and 2035, the calculations
for the right pillar were done by Eurostat, in 2010, which means that the figures for
1995 are real data. Both groups of statisticians agree that societies are ageing, but
reality has proven wrong by a large margin the assumptions of the Eugenics Society
for 1995; they are 59 percentage points higher than the actual numbers and their
projections for 2035 are much higher.
We may consider unreliable drawing on a 76 year old forecast done under very
different conditions and based on different expert knowledge from today. While
methods and statistical sophistication have certainly changed, the fact that forecasting
is far from precise has not. Indeed, those demographers who do research into the
accuracy of their discipline’s forecasts conclude that they frequently get their
predictions wrong. They list as important examples that demography did not expect at
all the baby boom of the 1960s. After it had happened demographers adjusted their
forecasts accordingly, which led to expected birth rates very much higher than actual
numbers. This was because demographers could not foresee that fertility would
decline again quite sharply in the 1970s. Similarly, demographers have found it
difficult to predict accurately migration figures, because these depend to an important
extent on international events and political decisions. Regarding mortality,
demographers have often underestimated the degree of their reduction.
“Demographers have become increasingly concerned about the accuracy of their
forecasts, in part because the rapid fall in fertility in Western countries in the 1970s
came as a surprise. Forecasts made in those years predicted birth rates that were up to
80% too high and too many young children. The rapid reduction in mortality after the
Second World War was also not foreseen; life-expectancy forecasts were too low by
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1–2 years; and the predicted number of elderly, particularly the oldest people, was far
too low.” (Keilman and Pham 2004: 5)
Moreover, learning from the past does not help to create better forecasts. Those
demographers who evaluated the accuracy of predictions agree that over time they
have not become more accurate (Keilman 2008; Shaw 2007). Because the future is
uncertain and events unique, experts can only learn a limited amount. Thus, Chris
Shaw from the British Office for National Statistics concludes:
“…that it is virtually inevitable that a major projection error in one set of projections
will be repeated not just in the next set, but probably in many projections to come.”
(2007: 21)
Against this background demographers recommend to bear the uncertainty of
forecasts in mind when making policy recommendations (Keilman 2008: 152). Their
call for caution refers to old age dependency ratios. However for good pensions policy
forecasts more complex assessments are needed. What matters more for pension
wealth than the size of age cohorts is for example the relationship between the
economically active adult population and retirees, and the conditions of markets. This
means that more variables need to be added to the prediction, adding to its insecurity.
Incautious forecasting: the OECD
It goes beyond this paper’s limits to consider why the policy-making and academic
communities have so easily accepted the forecast of ageing societies. In the following
I would like to focus on the OECD’s pension forecasts as an example of what might
happen when the assumption of ageing societies is used without caution and when
complexity is not incorporated in forecasts. The OECD is an important player in
research on pensions and other comparative research – its data is referred to by many
academics, in addition OECD reports are also noted by policy makers of member
countries, who refer to its policy recommendations in the public arena. Thus, the
organisation contributes to setting political agendas. This agenda-setting power might
be one reason why the claim that ageing societies must lead to pension retrenchment
has been accepted so widely. Yet as we shall see below, because it lacked a more
complex view of the factors securing contemporary pension systems the OECD was
unprepared for the financial crisis and after it had come it had to change gear rapidly.
In the first of its so far three comprehensive reports on compulsory pension systems
and their outcome it stated in 2005:
“All OECD countries have to adjust to the ageing of their populations and re-balance
retirement income provision to keep it adequate and ensure that the retirement income
system is financially sustainable. Demographers have been warning us for some time
that ageing is looming and that when it strikes populations and workforces will
rapidly age. But many governments preferred to ignore the call for reform and cling to
the hope of postponing solutions beyond the next election or claiming that rather
painless remedies could be found.”
(OECD 2005: 9; OECD italics)
The quote demonstrates the OECD’s strong belief in the ageing of societies, it uses
language that is far more assured than that of the demographers above. Striking a
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headmasterly pose the organisation warns governments of the dangers that lie ahead.
Again, why there is so little caution and quite a lot of emotion is not our subject here;
however, because of its confidence up until the autumn of 2008 the OECD is able to
present a one-dimensional causal relationship between ageing and the need for
retrenchment (OECD 2007: 6).
The events of 2008 forced the OECD to change this one-dimensional picture and to
take the state of the economy and its impact on funded pension schemes more
seriously. The near collapse of the financial system demonstrated how vulnerable
private funded systems are, with painful consequences for many citizens. In 2008
alone, average pension fund returns on investment across the OECD declined by 23%.
This rapid fall affected the most those countries most dependent on privately funded
defined contribution schemes, schemes whose introduction had previously been
suggested by the OECD and endorsed where they occurred. In the United States, for
example, between 2007 and 2008 replacement rates for such schemes dropped from
24% to 15%; this meant that a worker retiring in 2007 would have had 10 percentage
points more than one retiring in 2008, all else being equal (Antolin 2009: 7).
Confronted by the sudden change, the OECD changed gear. In 2009 it suggested that
more state intervention was needed to tame the markets, and it criticised governments
for doing too little.
“While governments have extended blanket guarantees to cover bank deposits, private
pension systems are largely on their own. In particular, systems based on individual
accounts – also known as defined contribution arrangements – experienced major
declines in account balances in 2008.” (OECD 2009: 3)
The suggested remedies also mean stricter regulation and an increase in state benefits
where appropriate.
“Policy makers need to think about how to improve the regulation of defined
contribution systems so that individuals are better protected from financial risks in old
age.” (OECD 2009: 3)
“Understanding the different features of private pensions, their role in retirement
income arrangements, and their performance is essential for policymakers to design
better schemes. To give one example: a pension system that relies on a large, defined
contribution component should be backed by a generous, publicly-managed basic
pension that prevents poverty in old age.” (OECD 2009: 4)
Summing up, the OECD’s pension analysis after the near-collapse focused on how
market dynamics affect pension outcomes, and how countries might control them.
Thus, their previously one-dimensional picture of pension policy driven by ageing
societies had to become much more complex. The organisation is still worried about
ageing societies and their costs, but after 2008 they acknowledged that market
dynamics might affect pension outcomes to a sudden and significant degree, and that
they need to be controlled. Implicitly they acknowledge that in their previous
statements they had overestimated the stability of markets and underestimated the
need for state intervention. This change of position was not openly expressed nor
explained. It is interesting to note how despite changing position the OECD’s
confidence about being right about the future remained stable. The latest reports are as
self-assured as the previous ones and there is no recognition in most recent statements
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that with hindsight the organisation might have been less confident about public
retrenchment in 2005/7. In contrast to demographers, even after the momentous
events of 2008 the OECD are not in the business of reflecting on the accuracy of their
own predictions, and therefore unlike demography does not issue more cautious
policy advice for the future. Considering its politically powerful position this gives
cause for concern.
The future in today’s values: Fair value accounting and its impact for pensions
Finally, I would like to focus on another actor whose predictions about the future have
had important consequences for pensions: the International Accountancy Standards
Board (IASB). This is a private organisation whose member are professional
accountants, which wields global influence. Its main aim is to ensure that global listed
companies use comparable and transparent criteria to present their balance sheets in
order to increase confidence in global trade. In 2005 the European Union made the
IASB’s International Accounting Standards (IAS) compulsory for all companies listed
in the EU. In that regard the IASB is a publicly endorsed private organisation
(Donnelly 2007). For the IASB’s accounting standards employee benefits were not a
priority, but they did issue rules for the representation of pension fund value on
companies’ balance sheets (IAS 19).
The IASB brought about a change that was very important also for occupational
pension schemes: they gave priority to Fair Value Accounting (FVA) over historic
cost accounting. The latter expresses the value of assets in terms of the price for
which they were originally purchased. Because this might no longer reflect well their
current market value this method was widely rejected by accountants. In contrast,
FVA aims to express the current market value of assets. This method also has
important problems. Firstly, current value changes with changes in markets and in
volatile markets it is also fast moving. Secondly, it is not always possible to know
with certainty the current value of assets. This is because they might not be for sale, or
there might not be a market for them at a given point in time. In such circumstances
accountants determine a “synthetic market value”, i.e. they assess what the asset value
might be at a specified date (Perry and Noelke 2006: 561-2). Critics of this approach
have pointed out that Fair Value Accounting does not solve the problem historical
accounting had: both methods are uncertain and cannot know the future value of
assets. As Perry and Noelke put it:
“Since the future is inherently unknowable, any precise value placed on an asset is
ultimately an estimation of the future, rather than a simple fact. This is true of both
historic cost and fair value accounting, with the main difference between them being
the timing of the estimation, and who does it. Under historic cost accounting, the
estimation is made in the past by the buyer and seller, and validated by a transaction.
Under fair value accounting the estimation is made today by the market, or by an
auditor modelling the market, and is not necessarily validated by a transaction.
Uncertainty is unavoidable in both types of accounting.” (2006: 562)
The authors explain the change to FVA by the power of the financial sector which
prefers them, and which has marginalised the manufacturing sector as well as other
societal groups (2006: 565, 578, 580; see also Botzem and Quack 2009). Indeed, in
2010, of the seventeen members of the International Accounting Standard Board
sixteen were from Banking and Auditing firms, manufacturing was only represented
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by one member, the CEO and CFO of Volvo (iasb.org); the fifteen members of the
current Employees Benefits working group of IFRS are only a little more diverse,
three work in manufacturing, and twelve are members of companies delivering
financial services: two come from the “big four” auditing firms, four are employed by
banks and insurers, four are consultants and two are from actuarial companies or
associations (www.ifrs.org).
The above shows that Accounting Standards are the outcome of conflicts between
different groups; they appear as technical solutions that promote transparency, but
they reflect the view of dominant financial and auditing institutions of how best to
frame an uncertain future. This has had important implications for the presentation of
pension value. Fair Value Accounting as defined by IAS 19 means that pension fund
assets and liabilities are expressed in current market value, and that they no longer
rely on nationally regulated actuarial estimates. As a result pension fund value has
become much more volatile for business, and companies that run defined benefit
schemes therefore present a greater risk for shareholders. Thus, FVA has contributed
to the significant closure of defined benefit occupational pension schemes, for
example in the UK and to occupational pension retrenchment in the Netherlands in
the early 2000s, at a time when the stock market declined (for an overview Bridgen
and Meyer 2009: 597-603).
In the aftermath of the financial near-collapse the IASB has become more aware that
certain assets and liabilities, in particular the complex financial instruments that
helped bring about the crisis, have not been clearly expressed in financial statements,
leading to a discussion of how FVA can improve its measurement of uncertainty and
“unobservable inputs”, and the IASB is discussing a change of rules (IASB 2010a: 78; 2010b: 14-5). Again employee benefits have not played a role in these discussions.
Conclusion
In this paper I have used the financial emergency, a sudden event with drastic impact,
as motive to re-evaluate forecasts in pensions, an area where predictions are
unavoidable. I have examined key elements of the pension consensus according to
which ageing societies must lead to retrenchment of generous public benefits,
elements which are frequently used as facts by the academic community and policy
makers. The paper shows that these should be treated with more caution:
In policy terms, the example of the OECD shows that unreflexive use and the frequent
one-dimensionality of explanations according to which ageing is the one key driver
for pension reform is distorting and can have detrimental effects for citizens.
In academic terms, we should be more aware that the economic and demographic
trends on which the pension consensus is based are just one possible version of the
future; demographers are most conscious of the unavoidable insecurity of their
forecasting, yet they issue projections reaching decades into the future whose caveats
are all too often ignored by other academics. The example of the accounting rules
showed how the “…increasing economic integration and head to head competition for
markets…” (ClarkMunnell et al. 2007: 3) identified earlier as part of the pension
consensus is not simply the result of unleashed market forces to which governments
have to succumb, but that interest group dominance and decisions by elected
politicians set the rules for these forces (see also Krippner 2011: 2). The decision to
adopt Fair Value Accounting has been the outcome of conflicts within the IASB over
how best to express the value of assets and liabilities, in which financial actors
dominated. In that sense it was never a purely technical issue, but its outcome served
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the rationale of certain types of market actors better than others. Moreover, it was then
adopted by the European Union, making it a political decision, which can be changed.
Thus, research into pension futures should take more seriously that their forecasts
depend on agreements by different actors on what version of the future seems most
acceptable, for different reasons. Thus, Taleb’s recommendation seems sensible:
“The policies we need to make decisions on should depend far more on the range of
possible outcomes than on the expected final number.” Taleb 2007: 161
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