Jamie Clark

Jackanory – the life insurers’ bears are reading the wrong story

Jamie Clark

The Liontrust Macro Equity Income Fund’s demographics theme is centered around the identification of corporate beneficiaries of ageing populations.  A large part of the Fund’s thematic exposure currently comprises UK life insurers. We think that these companies have a very lucrative opportunity to exploit the shift in onus and responsibility for savings away from the state and towards the individual. However, in our view the shares of these life insurers are still mispriced and misunderstood due to a bias termed ‘narrative fallacy’ – the tendency to overlay simplistic cause-and-effect explanations onto complex relationships. When applied to demographic change, this has led some investors to the somewhat perverse conclusion that an ageing population will ultimately prove to be a headwind to life insurers. We disagree, and in this blog I seek to clarify the difference between our nuanced assessment of this macro-theme’s impact and the overly simplistic extrapolation being applied by the bears of the life insurance sector.

People love stories. They offer us a way to gather and organize life’s disparate details into a coherent, linear order.

As psychologist Daniel Kahnemann tells us, this tendency arises from our “continuous attempt to make sense of the world”; a motivation that draws us to “simple” and “concrete rather than abstract” accounts [1].

This is no less true of markets and investors. Narratives give each of us a means to cut through the abundance of events and data that can make investing so obscure. They allow us to attribute clear relationships between cause and effect. Stock A has rallied because of event B; stock X has fallen due to Y.

Such mental short cuts, or heuristics, can be useful. They permit clarity in the face of seeming randomness; and equip us to overcome indecision and act purposefully. 

But there’s a snag. If taken too far, our tendency to connect events and facts in seemingly plausible stories, means we risk the impression of understanding. Believing that we have a definitive explanation for the past, can encourage us to view the future with equal certainty. This is a danger to capital and borders on what Nassim Taleb terms ‘narrative fallacy’.

One very prominent story that affects the Liontrust Macro Equity Income Fund is population ageing. We’re all aware that the world is getting older due to a combination of declining fertility (contraception, gender equality) and increased longevity (less poverty, better healthcare).

Statistics abound to this effect. Between 2015 and 2030, it is estimated that the global cohort of over 60 year olds will rise from 901m to more than 1.4bn; a figure exceeding the projected number of children aged 0-9 [2].

Such forecasts are particularly acute for developed nations, where the ageing trend has been in train for many decades. Taking the UK, the percentage of the population aged over 65 years increased from 14.1% to 17.8% between 1975 and 2015; and is projected to grow to nearly 25% by 2045 [3].

As we know, this creates problems. Ageing populations pressure public pension arrangements and threaten the affordability of corporate pension commitments. Naturally enough, governments and businesses have moved to de-risk their obligations, shifting responsibility to the individual citizen and worker.

But this transition also creates opportunity. As individuals save more and corporates pay to remove pension liabilities from balance sheets, we see a very lucrative opportunity for UK life insurers. Whilst this trend can’t be used to forecast quarterly numbers, it gives us confidence in the positive trajectory of sector earnings and explains the Fund’s overweight position; 14% vs 4.7% FTSE All-Share. The Fund owns Legal & General, Aviva, Prudential, Phoenix Group and Chesnara.

For others, however, there is a far more negative conclusion to draw; a conclusion that we think verges on ‘narrative fallacy’. Broadly, the argument is as follows: the global population is ageing and will continue to do so as longevity increases; rising life expectancy pressures economic growth and real interest rates as people save more in anticipation of longer retirements; real interest rates will stay lower for longer, making it harder for life insurers and Companies with defined benefit pension liabilities to meet their obligations.

At first glance, this is a seductive argument. But there are several holes in this narrative, the most intriguing of which is the most recent.

New mortality projections from the UK’s Continuous Mortality Investigation (CMI) suggest that since 2011, the rate at which mortality has improved is far slower than in recent experience [4]. The March released data for 2016, demonstrated that life expectancy for men at age 65 dropped six months from 22.8 years in 2014 to 22.2 years in 2016; and for women, from 24.9 years to 24.1 years.

This is a big deal. CMI estimates are used by many UK insurers and pension schemes as the framework for estimating future changes in mortality. A sharp decline in estimated improvements to life expectancy, means that UK life insurers will pay out less to annuity holders. Significantly, with the exception of Aviva, which recently moved to 2015 CMI assumptions and booked a £153m gain, UK life insurers have not yet adapted to the latest CMI data. This should be of most benefit to annuity writers like Legal & General, which sources almost half of its operating profit from its Retirement division.

The latest CMI data is also a boon to the 5,800 UK private sector companies that sponsor defined-benefit pension schemes. Estimates vary, but data from PwC shows that the trend seen in the latest CMI assumptions, could cut up to £310bn from UK plc’s £530bn aggregate pension deficit [5]. We are optimistic that we will see evidence of this benefit, with this year’s triennial pension reviews from Fund holdings GlaxoSmithKline and BT.

We would add that slowing mortality improvements are not unique to the UK. Similar developments are evident in the US and other parts of Europe. This has far broader, potential implications for the direction of global rates and arguments about the deflationary impact of population ageing (secular stagnation, the global savings glut). In short, the future may see higher rates of economic growth than many have extrapolated. If so, this is profoundly negative for bonds and bond-proxy equities (tobaccos, consumer staples etc); the kind of shares that have rerated in a low rate, low growth setting, by virtue of modest, but consistent earnings growth.

To conclude, stories can be useful in cutting through the complexity of financial markets. With respect to the UK life insurers, population ageing presents a clear, simple multi-decade tailwind to the sector. But if this trend is taken too far, it raises the dangers of ‘narrative fallacy’. Yes, population growth will mean that individuals have to pick up the burden for providing for their old age – providing business for life insurers; no, demographic change will not continue on a constant trajectory which ultimately results in low interest rate, low growth doldrums where annuity costs soar. The recent CMI data serves to demonstrate that real world dynamics are far more nuanced than can be captured in a simple narrative.

---

[1] Kahnemann, Thinking Fast and Slow, pp.199-201

[2] United Nations, World Population Ageing, 2015

[3] ONS, Overview of The UK Population, March 2017

[4] CMI 2016, Institute and Faculty of Actuaries, March 2017

[5] PwC, £310bn could be wiped off UK pension deficit…, May 2017


Disclaimer:

• Past performance is not a guide to future performance. • Do remember that the value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.  Investment in Funds managed by the Macro-Thematic Team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. • The Funds' expenses are charged to capital. This has the effect of increasing dividends while constraining capital appreciation. • The performance of the Liontrust GF Macro Equity Income Fund may differ from the performance of the GF Macro Equity Income Fund and will be lower than its corresponding Master Fund due to additional fees and expenses.

• The information and opinions provided should not be construed as advice for investment in any product or security mentioned.  • Always research your own investments and consult with a regulated investment adviser before investing.

Friday, May 19, 2017, 11:26 AM