Had you walked through our office on any given day over the last couple of months you would have seen a copy of Nassim Nicholas Taleb’s Antifragile on someone’s desk. Love him or hate him, his writing certainly spurs debate.
Taleb’s central thesis is startling, easy to grasp and delivered with the straight talking conviction of a man who eats his own cooking. He introduces his abstract theory by stating that we have no accurate antonym for the word fragile. Words such as strong or robust are only half-way houses. To truly be the opposite of fragile, it isn’t sufficient to simply withstand shocks, you also need to benefit, thrive and grow from them – you need to be antifragile.
Why do pension schemes need to be antifragile?
Taleb goes on to explain that nature and other complex systems, such as the economy, are antifragile. But the neurotic obsession of regulators and lawmakers in depriving the economy of volatility and iatrogenic interventionism has introduced fragility into the system (remember Gordon Brown’s failed attempt to “put an end to boom and bust” and where that got us). Shocks no longer occur in dribs and drabs, taking out the weakest for the benefit of the whole. Shocks now hit us like a sledge hammer.
The interdependencies present in today’s globalised economy can produce non-linear chain reactions that decrease, even eliminate, predictability. Instead, Taleb argues we should be focusing on measuring fragility, defined by the following simple heuristic: “anything that has more upside than downside from random events is antifragile” and vice versa.
So are pension schemes fragile, robust or antifragile? And can some of Taleb’s ideas be applied to pension schemes? Fundamentally, pension schemes are arguably the quintessential definition of fragile – the 2008 crisis proved that. Over reliance on static and undiversified asset allocations (primarily consisting of two asset classes), lack of a clear game plan, unrealistic assumptions, reliance on unreliable economic forecasts, a lack of governance that inhibited their ability to take advantage of optionality and focus on a single risk measure (to name but a few!) all contributed to significant deterioration in funding levels in most pension schemes.
Fast forward to 2013 and the pension schemes that survived the turmoil can be divided into two camps: those that didn’t learn from the crisis and remain fragile (think 60/40 allocations!) and those that have moved or are moving towards the robust, even dare I say, venturing into the antifragile.
How are schemes becoming more robust?
Greater diversification (by risk exposure not market values), realistic assumptions (especially for equities), greater emphasis on monitoring key performance indicators such as their funding ratio (not just the FTSE100), hedging out any unrewarded risk such as sensitivity to interest rates and inflation; and they no longer try to call the market or predict the unpredictable (unless you’re Warren Buffet, and you’re not).
Finally, these schemes no longer rely on a single measure of risk. Value-at-Risk is clearly flawed and should not be used in isolation. Deterministic measures allows schemes to measure how fragile they are to, for example, small changes in interest rates, a 40% fall or rise in equity markets, or a repeat of the 2008 financial crisis. Taken together these risk lenses allow schemes to better determine whether they are fragile and allows them to tinker with their portfolio to try and minimise the impact another crisis might have.
“Sensitivity to harm from volatility is tractable, more so than forecasting the event that would cause the harm”, writes Taleb.
So how do schemes shift from being robust to being antifragile?
As for becoming antifragile, that’s not quite as simple. It demands discipline and strict adherence to a framework that will allow for effective decision making and the ability to exploit optionality as and when it presents itself. We’ve assisted a number of our clients to implement their own pension risk management framework that puts them firmly in control of their scheme. It allows them to batten down the hatches when markets become volatile – thereby minimising the downside – and go full sail when the opportunity arises – positioning themselves for the upside.
Being antifragile calls for dynamic asset allocation and the liquidity to do so (or as Taleb puts it, redundancies). Building in this liquidity is a key element of being antifragile, without which you become a super tanker trying to make a u-turn with a storm over the horizon.
Whether you agree with Taleb’s notions or not, there can be no doubt that the world we’re living in is becoming increasingly volatile. Ensuring that you are agile enough take advantage of volatility and accepting that it is impossible to calculate the risks of a Black Swan event, or predict when they might occur, is key to survival.
As Taleb so eloquently puts it, “Not seeing a tsunami or an economic event coming is excusable, building something fragile to them is not."
Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer.