Avoiding the “flaw of averages” in your LGPS actuarial valuation
05 Oct 2021
Jeff Bezos walks into the room…and immediately we all become billionaires on average.
Those last two words are doing all the heavy lifting in that sentence! There’s no denying the arithmetic, but this is an example of what you might call the “flaw of averages”, i.e. where a statistic doesn’t necessarily help us.
The headline numbers in a typical pension scheme valuation report will be perfectly correct and will meet regulatory and professional requirements. However, they cannot be relied upon in isolation to make the best decisions when managing the Fund’s financial risks. They are subject to three variants (it feels strange using this word and not talking about Covid) of the “flaw of averages”.
Flaw 1: “Jeff Bezos walks into the room …”
Big numbers can obscure smaller ones, and in LGPS funding terms this usually means that the whole fund valuation results, in effect, just reflect the councils’ position. However, there will be dozens or hundreds of other employers in varying positions, each of whom needs to “tend its own field” within the fund. And there can be significant variety of employers’ position even within the same sector.
Furthermore, the same liability value change will impact individual employer contribution rates to different degrees depending on the ratio of payroll to obligations.
Lifting the bonnet on a valuation is really important to ensure you consider every employer, not just the big ones.
Flaw 2: “The average family has 2.4 children”
Just as there are families of different sizes, there are employers with very different characteristics, and these variations exist in all LGPS funds already. For example, the same investment return will have a very different impact across the range of employers due to differences in employers’ funding levels, cashflow positions and time horizons.
It may be worth “kicking the tyres” on whether a fund’s single investment strategy is suitable across most employers, or whether additional strategies would serve some groups of employers better and justify the implementation?
And on climate change risk, funds should not place all their bets on a single chosen future outcome. “Stress testing” the investment and funding strategies against different potential outcomes will help ensure robustness to future climate outcomes.
Flaw 3: The “matching DNA” conundrum
There have been a number of miscarriage of justice cases, where people had been convicted on allegedly matching DNA with a crime scene, but were later found to be innocent: the conundrum is how their innocence squares with the “1 in a billion” type probabilities often quoted by prosecuting lawyers in court. The answer is that this tiny probability obscured greater likelihoods that there were (say) process errors in the DNA collection and matching. Ironically, it shows that a small number can obscure bigger ones.
In LGPS funding aspects, the whole fund picture will usually show minimal impacts from the McCloud remedy changes and ill-health early retirement strain costs; however, some employers will be much more affected by these than others. Funds will need to consider how best to engage with such cases, or in the case of ill health strains, explore how the risks and costs could be spread.
Don’t fall foul of the flaws
In summary, headline valuation figures are fine for statutory purposes, but do not present the full level of detail which will allow officers and other stakeholders to see the range of issues and situations facing individual employers. By avoiding such flaws of average, and working with the fund actuary, funds can be assured to make the right decisions arising from the next valuation.
If you would like to find out more, please get in touch.