Transparent assumption setting

[Gareth]

Hi,

I have some concerns about the section in the core reading on assumption setting, with respect to the bit about optimistic vs. Best estimate vs. cautious.

The strength of an actuarial basis seems to be very hard to determine in practice, as you need to look at every assumption, from discounting, salary growth to mortality and try to judge as a whole if it's weaker or stronger than best estimate.

Here's a contraversal idea: why don't we as a profession become completely transparent about assumptions? Everything could be on a best estimate basis and when we want to be optimistic we could explicitly reduce the liability by x%.

For example, a defined benefit sponsor might tell the trustees and members that on a BE basis the funding rate is 20% but as they have a much better use for capital at the moment they will instead slow the pace of funding to 18% for the next few years?

This might not be an attractive sell, but it's at least totally transparent.

From a professional perspective I think we should ban implicit margins - this means "the needs of the customer" would no longer be a factor in setting assumptions, since there should be only one true BE of the future.

Any views on this?

 

[peter]

It can sometimes make more sense to look at the individual assumptions. For example looking at an assumption for inflation we take the implied inflation as the difference between IL and FI government bonds. As you will know from CA1 the difference between these equals "Expected Inflation plus Inflation Risk Premium".

So a prudent assumption is to use the implied inflation as the difference between the government bonds without knocking off the risk premium (ie to overestimate inflation). A best estimate assumption would be knocking off the risk premium so you are just left with Expected Inflation.

The Inflation Risk Premium in the UK is generally accepted to be somewhere between 0.1% and 0.3% so the difference between the best estimate and prudent assumptions for inflation is often 0.2%.

Similar arguments can be made on the discount rate in relation to Corporate Bond Risk Premium and Equity Risk Premium.

Transparency is important but so is the justification. Often it is not as arbitrary as it may appear.