regulations

How financial regulation suppresses diversity

Financial regulation suppresses ideas that question dominant schools of thought, believes Con Keating.


Executive Summary
• In both natural and social sciences, innovation and progress are best served when there is a multiplicity of narratives, and cross-fertilisation among them. A single knowledge narrative, which defines a particular point of view, and excludes alternatives, is to be avoided.
• Theories deployed hegemonically, when embedded in regulation, block or discourage other approaches, restricting analysis of other aspects of reality.
• The case for a plurality of approaches is overwhelming. It is the presence of both competing and complementary narratives that fosters understanding, innovation and development.

The proposition advanced in this article is that financial regulation suppresses the development, broad dissemination and acceptance of narratives that compete with, or complement dominant paradigms. This has undesirable consequences for sustainability, innovation and growth. UK defined benefit (DB) pension regulation is used to illustrate the issues.

The power of a narrative in the design of research and promulgation of findings is well known to analysts. The focus here is wider: a narrative is defined as a spoken or written account of connected events, which includes the theories, paradigms and concepts of financial analysis. Knowledge narratives are those accounts commonly taught by professional bodies and in universities. This is hardly new territory; as Keynes observed: “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”

In both natural and social sciences, innovation and progress are best served when there is a multiplicity of narratives, and cross-fertilisation among them. These narratives may even be mutually incompatible; wave-particle duality in physics illustrates this point. A single knowledge narrative, which defines a particular point of view, and excludes alternatives, is to be avoided. As David Bohm noted: “One may indeed compare a theory to a particular point of view of some object. Each view gives an appearance of the object in some aspect. The whole object is not perceived in any one view but, rather it is grasped only implicitly as that single reality which is shown in all these views.”

Of course, all models and theories are simplifications of reality, but nonetheless carry with them background assumptions, auxiliary hypotheses, which make the testing of narratives in isolation difficult or even impossible to achieve. It is important that there is true variety among narrative models; viewpoints which are minor relaxations of assumptions or stance will not suffice. The various funding levels required to be reported in triennial pension valuations, technical provision, buy-out and Section 179 values, do not satisfy this diversity test; they are just variations in the amount of liabilities covered or discount rate utilised.

Theories deployed hegemonically, when embedded in regulation, block or discourage other approaches, restricting analysis of other aspects of reality. Regulation imposes its own particular worldview. The 2005 Scheme Funding regulations provide a prime example, imposing a solvency approach and prescribing the manner in which discount rates may be derived. Alternate approaches to valuation, such as future value or cash flow projection, are excluded.

Prior to the 1995 introduction of the minimum funding requirement, the principal actuarial valuation technique involved the projection of liabilities and comparison to projections of the values and flows of the asset portfolio. The current standard mandates valuation of accumulated benefits (ABO). It operates as a present value current solvency regime; compressing time and possible scheme management actions. It is mixed attribute; market values (for assets) and discounted present values (for liabilities) mean that these are not consistently measured, either currently or over time. This introduces bias and volatility to the results.

One useful stress testing adjunct, the projected benefits basis (PBO), with its consideration of awards as yet unmade, has fallen into disuse; it is now confined, in very limited form, to the analysis of deficit repair contribution schedules. Cash flow modelling has similarly atrophied; as recently as five years ago, surveys of trustees showed that less than one in ten then considered the income yield of their assets. With schemes closed and pension outflows often now exceeding investment income, this is changing. These cash flow and future value methods do not need to rely upon current solvency estimation; they are materially different viewpoints. Newer liability valuation methods, such as the use of the contractual accrual rate, have
also been proposed.

Pension regulations state that “it is for trustees… to determine which method and assumptions are to be used…”, only to immediately follow this with “The method used… must be…” The prescriptions do not end there. The fifty-page Code of Practice issued by the Pension Regulator, though appealing to principles, contains prescriptions covering almost all aspects of DB pension funding. It ascribes only a single purpose to the pension fund, when there are actually many possible. While consigning administrative and compliance matters to appendices, this code contains prescriptions covering the employer covenant, investment strategy, funding, recovery plans and extending to “an integrated approach to risk management”.

Coping with diverse narratives
In general, regulation struggles to cope with the indeterminacies of open systems; prescriptive approaches are an attempt to resolve these issues by closing the system. This involves transposition from the real world of uncertainty to the more limited, but apparently manageable, domain of risk. Principles-based regulation is preferable to prescriptive in this regard; with some thought and careful application, it may accommodate indeterminacy.

“What we observe is not nature itself, but nature exposed to our method of questioning.”

Regulations may and usually do have pronounced effects on the regulated community; they influence and alter behaviour. To quote Edward Fullbrook (2016): “Closed narrative communities typically live in open hostility toward ‘alien’ narratives. … Advocates of closed knowledge narratives often publicly embrace an extreme and primitive form of philosophical idealism, whereby they declare that their conceptual framework rather than offering a point of view on a domain, determines the extent of that domain.” The zealotry exhibited by market-consistency advocates demonstrates exactly this; it has attained the principal trait of an ideology, the refusal to consider other conceptual views.

Paraphrasing Fullbrook: As socially, economically, geopolitically and historically situated individuals, every community of practitioners brings to the narrative enterprise various inclinations and sensibilities, as well as overt purposes, all of which help determine which aspects of the domain the narrative includes, emphasises and ignores. Herding and imitation play a significant role in this bonding and group self-identification, with memes prominent.

The statutory objectives of the Pension Regulator, as well as their subsequent changes, reveal the preferences and sensibilities of the politician legislators when creating them. These objectives begin with the requirement to protect member benefits, the overt purpose, but include the more strangely worded: “to reduce the risk of situations arising which may lead to compensation being payable from the Pension Protection Fund”. It was only much later that a further objective was added: “To minimise any adverse impact on the sustainable growth of an employer (in relation to the exercise of TPR’s functions under Part 3 of the Pensions Act 2004 only)”. The much-qualified, convoluted drafting of this latter objective renders it meaningless, unverifiable and unenforceable. It might serve to justify anything or nothing.

A knowledge narrative may become invert, meaning that instead of being used mainly as an instrument for explaining reality, its focus becomes itself. Turning away from the empirical phenomena that inspired it, it becomes transfixed with its own existence.

The Regulator’s view of risk now dominates, and is far from natural. It has had one major perverse consequence; scheme members may now be more secure but few, if any, companies remain willing to provide DB pensions for their employees. The collective community-wide obsessions with scheme deficits, liability-driven investment and de-risking are additional illustrations.

“Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”

A further caution is necessary: “a social-science conceptual system can alter the objects of its enquiry by becoming part of
the conceptual and belief apparatus, through which humans define themselves, perceive others and make choices.” In the sphere of pensions, closure to new members and future accrual lead directly to higher pension costs and ultimately cash flow deficiencies, reinforcing the view that DB pensions are unaffordable, as does the pursuit of scheme self-sufficiency or buy-out. The ultimate example must be the over-priced cash equivalent transfers of recent times.

The authorities openly and actively recruit disciples and acolytes to their dogma. The transmission dynamics of this induced narrative differ from the contagious and infectious dynamics of epidemics and memes, where chance and susceptibility are important. David Taylor, the general counsel of the Pension Protection Fund, was recently quoted as saying: “We encourage schemes to act …, putting in place risk reduction measures. This can improve security for members and help to reduce bills by limiting the risk to the PPF – something we are keen to encourage.” There is no concern recognised here that risk to the scheme and sponsor is a very different animal from (contingent) risk to the PPF.

When incorporated in regulation, narratives cease to be solely descriptions of the world and become increasingly performative, shaping behaviour by design and intent. The extent of this influence may be judged from the magnitude of the pension sector’s net liability to derivatives hedging discount rates – by 2015, some £300 billion, over 20% of all estimated liabilities.

The case for a plurality of approaches is overwhelming. It is the presence of both competing and complementary narratives that fosters understanding, innovation and development. It is a necessary condition for the ongoing provision of occupational DB pensions, which regulation, with all of its prescriptions and ‘guidance’, has suffocated.

Werner Heisenberg offered a caution that is directly relevant for those who claim that current methods, and only current methods, provide a true, fair, accurate or useful view: “What we observe is not nature itself, but nature exposed to our method of questioning.”

The regulatory narrative for DB pension funding is not the only possible view, many others exist; it is not even the best single view. When a diversity of views is considered, the currently overwhelming narrative of deficits and crisis may be seen as misleading; the trunk or the tail of the elephant, but not the whole picture of an elephant.

All of this said, the prospect for imminent change is limited. As Max Planck noted: “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it”. Whether there will be any occupational DB pension schemes still existing then is an open question.

Biography

Con KeatingCon Keating
After a long professional career, Con Keating has been a board member of a number of educational and charitable foundations, and served as a trustee of several pension schemes. He has published widely in academic and professional circles, and currently sits on the steering committees of several academic research centres, such as the Systemic Research Centre at the London School of Economics and the Financial Econometrics Research Centre. He is a member of the Société Universitaire Européene de Recherches Financières, and chairman of the Bond Commission of the European Federation of Financial Analysts Societies. He serves currently as an advisor on pensions, insurance and capital markets to a number of official institutions, including the ADB, OECD and ASEAN+3.

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