IS ANTIFRAGILE APPLICABLE TO PENSIONS?

(This article first appeared in the May 2013 edition of Investment & Pensions Europe magazine and is reproduced with kind permission)

Had you walked through Redington’s office on any given day over the last few 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 – as fully evidenced by the number of iterations this co-authored article has gone through.

Taleb’s central thesis is startling, easy to grasp and delivered with the straight talking conviction of a man who eats his own cooking. Can some of Taleb’s ideas be applied to pension scheme investing? Are pension schemes fragile, robust or antifragile?

We have made an attempt to map Taleb’s key principles against an underfunded UK pension scheme’s investment strategy and how it is managed (see table) – taking the necessary unapproved artistic licence.
 

Principle Fragile Robust Antifragile
Portfolio construction Large exposure to any one source of risk Diversified by risk exposure  
  No redundancies in expectations (use of “best case” assumptions) Redundancies (prudence) built into expectations  
  Risk just considered by Value at Risk measures Risk also considered by sensitivity and convexity  
  Rebalancing by capital periodically Exposures re-weighted systematically (by risk)  
  No pre-set point where scheme will stop taking risk Clearly defined funding level where the scheme will no longer take risk  
  Over reliance on a forecasted theme or characteristic (e.g. mean reversion in interest rates, or long run outperformance of equities) Plan to achieve objectives is not overly reliant on specific forecasted events  
    Put option protection  
 
Optionality Static strategic market based benchmark   Dynamic, objective-led, strategy
  Perceives sponsor as “back-up” when necessary Assumes sponsor will not provide additional "back up"  
  Low level of liquidity   High level of liquidity
  Inertia caused by other events (e.g. actuarial valuations)   Strategy continues to be monitored and adapted regardless of other events (e.g. actuarial valuations)
 
Rationality Objectives and constraints are not clearly defined Clearly defined objectives and constraints Clearly defined objectives and constraints – and "calls to action" when ahead or behind of plan
  Trustees have a strategy in place they do not fully understand and find it difficult to exercise control Trustees understand the overall strategy Trustees feel in control
  Monitoring focused on potentially distracting secondary metrics (market level, capital weighting, manager performance relative to benchmark)   Monitoring focused on the most relevant primary metrics (funding level, risk exposures, individual strategy performance relative to objectives)
  Agents (consultants/managers) have no skin in the game (their rationality is not your rationality) Agents have “skin in the game” aligned to scheme objectives  
  Review strategy periodically   When ahead of plan, take profits and build in redundancies necessary to then take action when falling behind plan (potentially availing of higher spreads)
 
Execution ability Slow decision making or paralysis   Timely and effective decision making – aligned to objectives
  Trustees infrequently make strategic decisions   Trustees well practiced at tinkering with strategy as conditions change
  Manager mandates do not have a pre-agreed ability to make changes (or potential mandates not already in place)   Manager mandates with pre agreed ability to implement changes (or potential mandates set up in advance)
Taleb 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.
 
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). Shocks no longer occur in dribs and drabs, taking out the weakest for the benefit of the whole. Shocks now hit us like a sledgehammer.
 
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.
 
Taking some of the characteristics he puts forward to identify fragility would imply that an over reliance on static and undiversified asset allocations (primarily consisting of two predominant risk exposures), lack of a clear game plan, unrealistic assumptions, reliance on unreliable economic forecasts, ineffective decision making and a focus on a single risk measure could cause fragility. The 2008-09 “black swan” certainly highlighted that fragility was there, resulting in significant deterioration in funding levels to most pension funds.
 
So how are these schemes becoming more robust? Taleb’s principles suggest that schemes look for greater diversification (by risk exposure not market values), prudent rather than best case assumptions (especially for equities), greater focus on monitoring key performance indicators such as their funding level (not the market level), hedging out large single exposures to risk such as sensitivity to interest rates and inflation; and not trying to call the market or predict the unpredictable (unless you’re Warren Buffet, and there’s only one of him).
 
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.
 
As for becoming anti-fragile, 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 lower the sail when market volatility presents positive outcomes – thereby building reserves against a future downturn – and be decisive enough to 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 put 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 authors' own and do not constitute investment advice.  Click here for full disclaimer]

Author: Patrick O'Sullivan

Patrick is Head of Investment Consulting. He joined Redington in 2012 having held positions at Watson Wyatt and Prisma Capital Partners. Lead consultant to a number of large sophisticated DB schemes with in-house/CIO teams, e.g. TPT, Unilever, L&G, PwC, and BAA. Has a particular focus on setting strategic risk management frameworks and engaging with wider stakeholders to create long-term alignment. CFA charter-holder and Fellow of the Institute of Actuaries.