To be successful, institutional investors, including pension plans, attempt to understand and put a price on the future. But is it possible to accurately forecast future events?
The challenges of financial forecasting have become increasingly evident over the past few years, fueled by the convergence of market forces, government and central bank intervention, and disruptive changes that often impact both investments and the liabilities that the investments are designed to support. Based on the record of failed predictions during the past five years alone, traditional approaches to analyzing markets and forecasting events no longer adequately account for the multitude of possible economic scenarios that could impact institutional investors' accuracy in pricing value and risk.
The variables that impact financial forecasting are not only numerous but rapidly evolving. We could begin with underlying growth fundamentals, global capital flows, shifting yield curves, regulatory and central bank interventions, political uncertainty, and credit and equity risk volatility, and continue from there. Beyond that, correlations and compounding effects are constantly changing. Institutional investors have started to respond with more sophisticated technology in an attempt to develop more robust scenarios. Yet it is still quite difficult to accurately forecast the future. That's because there are a larger number of disruptors impacting today's outcomes — innovative technologies, demographic and social changes, political shifts, emerging business models, regulations and changes in distribution models, to name few.
These disruptors can drastically impact the outcome of forecasts, injecting unexpected inflection points, reversals, jumps and other challenges into the forecasts, upending institutional investors' business planning and strategy. And this can directly impact investments that are designed to support current and future liabilities. Insurance companies and pension plans need solutions that support their liabilities, while optimizing the three dimensions of risk, reward and capital through a range of predictable and unpredictable future conditions.
In order to get paid appropriately for taking risk, institutions need to differentiate between predictions and projections. Institutional investors often utilize forecasts by professionals to predict interest rates and economic growth rates. There is often an implication of “knowns” to these forecasted outputs. Yet professional forecasts often undergo significant revisions as they are overtaken by reality as shown in comparing actual yields with 10-year Treasury forecasts in the Survey of Professional Forecasters, a quarterly survey of macroeconomic forecasts by economists and other analysts and issued by the Federal Reserve Bank of Philadelphia. Even with the insight of these experts, it is best not to bet on a single interest rate forecast, or a single scenario. Odds are, you'll get it wrong. Recent experience shows the error can be very significant.
When thinking in terms of projections (rather than predictions), conventional approaches attempt to develop discrete scenarios that take into consideration the more unpredictable effects of central bank policies and global capital markets. These might be considered “known unknowns.”
Developing useful projections that can help identify value and price risk requires a broad understanding of how the interconnected parts of the economy might behave rather than how they will behave. This can significantly increase the number of scenarios that should be explored, compensating for changes in correlations and causation, risk contagion and black swan events. One should also consider why the cost of bad outcomes is often far worse than expected, and why risk diversification sometimes helps and sometimes doesn't. These stochastic simulations begin to explore the territory of “unknown unknowns.”
So how can insurers and pension plans most effectively plan for the future?
Economic scenario generation software is an emerging tool used by some institutional investors today to generate a broad array of simulated economic scenarios that represent a distribution of possible economic futures. These scenarios incorporate extreme events, similar to what was seen in the 2008 financial crisis.
The ability to assess a range of potential economic outcomes allows institutional investors to effectively prepare their business and investment portfolios to respond to a range of investment environments, good and bad. Investors can begin to understand whether they are being paid for the risks they might take.
A robust and integrated asset allocation, risk management and capital allocation strategy must be carefully designed to meet both tactical and strategic investment goals in today's economic environment. Tactical investment opportunities might emerge that can be more appropriately pursued with a broader view of risk. In addition, a carefully constructed investment strategy can mitigate some of the risks associated with liability risk patterns — including changing liquidity needs, duration considerations and value.
Investors should not shy away from risk. Instead, investors must turn their understanding of risk into an advantage. The challenge is finding opportunities where you can be paid enough to justify taking risks in a range of possible scenarios — not a single forecast clouded by biases and false assumptions.
I believe Yogi Berra was right — it is hard to make predictions, especially about the future. But with the right combination of experience, expertise and technology embedded in the investment planning and management process, insurance companies and pension plans can improve their odds by considering the range of potential outcomes. Mr. Berra also supposedly said, “When you come to a fork in the road, take it.” There will be no shortage of so-called forks in the road for investors going forward; the trick is to evaluate the various paths carefully so we can effectively prepare for risks or grasp opportunities that lie ahead. n
Woody E. Bradford is chairman and CEO, Conning & Co., Hartford, Conn.