A summary of part 3 of the IFoA’s Presidential Speaker Series on alternative economic thinking
The third event in the IFoA’s Presidential Speaker Series on alternative economic thinking examined the work of the New Capital Consensus (NCC). NCC is a coalition between think tanks Chatham House and Radix Big Tent, the Financial Systems Thinking Innovation Centre or FinSTIC (part of the IFoA), and the University of Leeds.
Ana Yang is the Executive Director for the Chatham House Sustainability Accelerator.
Ashok Gupta is Chair of FinSTIC, the actuarial profession’s systems thinking group. He is also Chair of Mercer Ltd and NED of Sun Life Financial Inc.
Iain Clacher is Professor of Pensions and Finance, Pro Dean for International at Leeds University Business School, and head of the university’s new Centre for Financial Technology and Innovation.
The webinar’s chair was Peter Scolley, a member of the Managing Committee of FinSTIC and of the IFoA Risk Management Lifelong Learning Committee.
The speakers outlined the NCC’s work, its view on the purpose of the investment system, and the case for systems thinking.
Ana Yang explained that NCC uses a systems approach to:
NCC has a focused two-year programme beginning in April 2023. Fellow panellist Professor Clacher is leading its research, which will be closely linked to engagement with practitioners, politicians, and policymakers.
The coalition aims to build an evidence base to influence institutions to make longer-term investment decisions. This in turn will help to address the challenges of sustainability and inequality.
Ashok Gupta outlined how the NCC takes a broad view of the purpose of the investment system, looking at the roles of various parties. Broadly speaking, asset owners and consultants manufacture capital while investment managers and capital markets distribute capital.
Investor returns are based on the value businesses create through taking risks. In assessing value, we must consider the impact companies have, and potential inequality. The system should enable investors to make acceptable real returns while allowing companies to address problems of people and planet and thrive in the process.
There are different kinds of investment capital: primary equity, long-term debt, bank finance, and secondary trading. Gupta observed that at present the capital manufactured is predominantly debt rather than equity, and mostly secondary rather than primary. In particular there is very little primary equity. He quoted the view of leading economist Sir Paul Collier that the system focuses too much on security, not returns. Lack of investment is a frequent problem across all industries.
Gupta said that actuaries are at the heart of the private investment system and are particularly involved in setting risk appetites and asset allocations.
Iain Clacher made the case for a systems-thinking approach, as opposed to being confined within silos. He gave defined benefit (DB) pensions as an example. The overall DB world contains many ‘systems within systems’ such as legal, regulation, trustees, employees, and more. Understanding DB pensions means having some awareness of all these subsystems. Focusing on each in isolation leads to siloed thinking and systemic risks.
As an example, Clacher mentioned the recent LDI (liability-driven investment) crisis. In his view this could have been predicted. The system already went into a stressed condition some time before the crisis, when interest rates increased late in 2021. Regulators failed to respond adequately because they were taking a siloed approach. In his view we need system custodians, not silo custodians.
Clacher suggested that taking a systems approach to DB pensions could generate useful perspectives. For example, this approach led to an awareness that there wasn’t sufficient capacity in the system to allow for all schemes to buyout. It followed that most DB schemes would continue in their current form, and therefore it was essential to plan for that.
In general, systems thinking creates more resilience, Clacher said. It also enables us to identify leverage points – places to intervene in a system. He noted that the standard government tools for intervention are tax and regulation, although these tend to have minimal leverage or impact in practice.
This second part of the webinar included questions about fair returns for workers, debt capital, and shortcomings of financial models of sustainability.
The first questioner asked if workers receive a fair return for their time and effort, as opposed to the returns investors expect to receive. Gupta framed his response in terms of retirement benefits. Workers are not just employees of companies producing goods and services, they are also pension scheme members, and eventual recipients of pensions.
An audience member suggested that it’s reasonable for companies to use debt capital, which helps them to grow. Gupta accepted that debt has its place but noted that too much debt could lead to companies having excessive leverage, or bubbles in asset classes. Also, too much debt implies too little primary equity, which is needed for greening the economy and addressing inequality.
Clacher added that the hard requirement to pay interest on the debt, or face insolvency, is a constraint on companies’ flexibility. Recent increases in interest rates brought this out more clearly. But he was concerned that the regulatory system is not well-prepared to meet the rising demand from firms wishing to issue primary equity.
There was a question about international comparisons. Clacher argued failure is a normal part of any system, but in the UK there is a lack of suitable mechanisms for dealing with it. This is why UK firms do not take enough risk in his view, and we could learn lessons from other countries.
For example, Canadian insurers benefit from better regulation and risk management. Their approach is more long term: they still offer with-profits products and they invest more in infrastructure.
Clacher said performance metrics tend to be short term. Gupta believed the key factor to measure is the quality of outcomes: consumers are not very interested in short-term volatility.
One questioner highlighted the shortcomings of financial models of sustainability. For example, according to the Bank of England’s Climate Biennial Exploratory Scenario (CBES) a 4°C temperature increase would only reduce pension fund returns by 1%. Clacher commented that an increase on that scale would wipe out the whole pension system. But he thought CBES is useful because it’s a new way for the Bank of England and other central banks to look at climate risks for insurance and banks. In time, the scenarios would become more realistic and more robust.
Yang noted that climate risk had cascading effects on overlapping systems such as food and infrastructure, across many economies. She said it’s inappropriate to squeeze all these impacts into a single model.
Gupta agreed with the questioner’s challenge to current models, adding that these models assume real-world systems behave in a linear manner. They fail to account for the discontinuities in such systems.
The final questioner flagged that individuals can have conflicting needs. For example, as a consumer you want risky business to be funded. But as a saver you don’t want your capital exposed to the risks of such investment.
Clacher said that managing risk on behalf of others is complex. Experts should be managing these risks and delivering outcomes. It’s accepted that a doctor or a car mechanic is an expert managing risks on behalf of patients or customers. But individuals are often expected to take control of managing their own financial risks.
On the IFoA Virtual Learning Environment, you can watch a recording of the webinar.
Read more about the event: New Capital Consensus: the investment system and how actuaries impact it
