Futures Research Project Provides Insight into Tomorrow's Economic Environment
Futures Research Project Provides Insight into Tomorrow's Economic Environment
By Steven W. Easson and Theodore J. Gordon
The legendary investment guru Peter Bernstein commended the SOA in his plenary session at our 2002 annual meeting for having a Futurism Section. But how can our Futurism Section serve the needs of our members? One answer is demonstrating applications of Futures Research techniques. This article reports the results of one such application.
What are some plausible forecasts of the economic environment of the United States two decades into the future? Is it even possible to make judgments about volatile economic variables? What are the rationales and thought processes behind the judgments of a diverse group of experts who make forecasts of economic variables? How can we gather and share these judgments and brainstorm plausible events and discontinuities that could influence the future values of economic variables? Can this be done in such a manner that avoids a "follow the herd mentality," biases inherent in consensus forecasts and weighting past trends too heavily? Are these expert judgments useful in augmenting historical data in setting modeling parameters and assumptions?
The Society of Actuaries answered these questions pertaining to the following four economic variables in the year 2024 in an inaugural in–depth study conducted from August 2004 to September 2005:
- Annual increase in the U.S. Consumer Price Index.
- 10–Year U.S. Treasury yield.
- S&P500 total rate of return.
- Corporate Baa yield.
Designed to focus on the process more than the results, the study obtained rationales and thought processes, identified plausible future developments that could influence the values of these four economic variables and produced a resulting "fan of possibilities" for values of these variables from a diverse group of experts using the Futures Research techniques known as the Delphi method and the Trend Impact Analysis (TIA) method. The group of experts consisted of actuaries, economists, investment managers, futurists, modelers and scientists.
Although numeric forecasts for the economic variables were produced, it was recognized from the outset that it was impossible to forecast such variables with accuracy and confidence over this time period. The main success of this project rests on the educational value it provides to practitioners, specifically the tools that can be used to augment traditional actuarial techniques and practices of forecasting to deal with issues such as strategic planning, setting assumptions and product design among others.
The study's full report contains in–depth descriptions of the Delphi and TIA methods; complete listings of the rationales and thought processes, the plausible future developments that could influence the values of these four economic variables and the resulting "fan of possibilities" for the values of these variables; and a complete listing of the participants and volunteers. It is available at Delphi Study of Economic Variables Report.Methodology
The Delphi method was designed to encourage a true debate, independent of personalities. It is usually administered in the form of anonymous multi–round surveys. The TIA is a forecasting method developed in the late 1970s that permits extrapolations of historical trends to be modified to recognize the effects of plausible future developments. These can include technological, political, social, economic and value oriented changes. The TIA utilizes a Monte Carlo analysis, combining impact and event–probability judgments with the results of a surprise–free extrapolation. This analysis estimates upper and lower quartile limits.
The study used two rounds of a questionnaire. In Rounds 1 and 2 of the Delphi questionnaire, the participants were asked the following:
- Imagine the world in 2024 and provide judgments about the values these variables could plausibly attain in that year. Three estimates were requested:
- Lowest plausible value–that is the value that has a 90 percent chance of being exceeded.
- Expected value–that is the value that is equally likely to exceed or fall below the actual result in 2024.
- Highest plausible value–that is the value that has a 10 percent chance of being exceeded
- Provide the rationales underlying the quantitative estimates. These rationales were presented to participants in Round 2 as background as they reassessed their quantitative forecasts.
- Provide judgments about potential future events that could swing the variables away from past trends (Potential Influential Future Developments). This data was used as input to the TIA model.
- Assess the applicability of these judgmental methods to modeling processes used by actuaries in making forecasts.
The rationales given by the participants for their quantitative estimates were interesting and varied. In both rounds, some viewpoints occurred to many participants and others occurred only to a few. There were many areas of wide differences in approaches and opinions.
- Perceptions of entirely different leadership positions for the United States.
- Models (quantitative as well as qualitative mental models) used by participants.
- Ability of regulators to control inflation and other aspects of the economy.
- Institutional ability to control the economic environment.
- Whether or not severe economic troubles lay ahead.
The rationales from Round 1 were presented to the participants in Round 2. Participants in Round 2 were asked to review them in making their judgments about quantitative forecasts of the four variables. Further, they were again asked to state the rationales for their quantitative judgments. The top rationales that were selected by participants in Round 2 are presented in Table 1.
A Trend Impact Analysis was completed in addition to the Delphi analysis, for all of the variables. The Potential Influential Future Developments* below that had the greatest impact on the TIA numeric results were (*note that the second round of the study was conducted in May 2005, before the spike in oil prices):
- Oil prices rise to over $60/barrel for at least five years.
- U.S. dollar currency collapses versus Euro.
- CPI pressures from growing budget deficits, rising demand for services (e.g., healthcare costs), stable or declining labor force and concomitant growth in retirements.
- New technologies drop costs of production of most products by 10 percent or more.
- Corporate defaults rise significantly (tripling over current rates).
- Confidence in the United States drops; direct foreign investment reaches 50 percent of current levels.
- Global political instability, Iraq–like wars and terrorist activities and threats become the norm.
- New technologies improve productivity in services by more than 10 percent.
- U.S. investment climate proves attractive.
- Globalization lowers labor costs by 10 percent on average.
The following forecasts were produced by the TIA model. For reference, the average judgments from the direct estimate of the Delphi for lowest plausible, expected and highest plausible are also shown. Several approaches were explored in extrapolating the historical data for the TIA–the Baselines illustrated on pages 12 and 13 are simply a linear extension of the 2004 actual value to the average expected value determined by the particpants in the Delphi questionnaire.
The results illustrate that the lowest and highest plausible values are quite wide. There was little shifting from Round 1 to Round 2. The TIA produced narrower ranges and in most cases higher values than the direct estimates made by the participants. The prospective developments used in the TIA moved the expected values higher in all cases except the S&P Total Rate of Return. Taken together, the prospective developments might suggest a more inflationary environment. Another possibility is that participants were more likely to consider negative developments than positive developments.(Click here for Baseline illustrations)
The Applicability of Judgmental Methods to Actuarial Modeling Practices
In examining the applicability of judgmental methods to actuarial modeling, seven specific applications were considered:
- The historical period used to calibrate stochastic models.
- Expected values of variables.
- Identification of potential developments that could affect forecasts.
- Mean reversion assumptions in stochastic models.
- The period over which the current assumption reverts to the mean.
- The volatility assumptions used in stochastic models.
- Validity of outliers that stochastic models may forecast.
Almost everyone answered "yes" to the following:
- Do you think that this study identified potential developments or forecasts that could lead to an increase or decrease in volatility assumptions?
- Do you think that this study provided potential developments and forecasts that could lead to changes in estimates of the expected value of the variables?
Almost everyone answered "no" to the following:
- Do you think that this study provided potential developments and forecasts that could lead to revision of the historical period used in calibration?
- Do you think that this study identified potential developments or forecasts that could lead to a lengthening or shortening of the mean reversion period?
The Delphi and Trend Impact Analysis futures research techniques are effective tools to brainstorm the long–term future. In this study's application of these techniques, judgments were effectively gathered and synthesized from a diverse group of experts about the future long–term economic environment. The study produced rationales for forecasts of values of the economic variables, possible future developments that could disrupt trends and hence change the extrapolation of the values from the past, and, considering these developments, a fan of possibilities for the values.
Financial professionals can strategize, plan and manage the future more effectively by including in their toolkit planning techniques such as those utilized in this study. Engaging a diverse group of experts to identify plausible alternative future states and subsequently developing and implementing plans that consider the potential futures states will increase effective management of potential risks and allow management to take advantage of opportunities that are not otherwise identified.
The only certainty about the future is that it is uncertain. Judging by this study's very wide ranges of plausible values and rationales for the future values of the four economic variables, one could conclude from the results of this particular study that the future is much more uncertain than many of us dare imagine, and hence, managing the future should consider a broad scope of possibilities for the future. As different Delphi panels could produce different insights, the SOA would welcome hearing about the results of your own application of these and other futures research techniques!
Mr. Steven W. Easson, FSA, FCIA, CFA, conceived and created this project and chaired the Society of Actuaries project Oversight Group and Working Group for this study. He is a former chairperson of the Society of Actuaries Futurism Section. He can be contacted at email@example.com.
Theodore J. Gordon is senior research fellow with the Millennium Project of the American Council for the United Nations University. He is a well–known futurist, an inventor of several quantitative methods of forecasting and a co–author of the initial Delphi study produced by RAND in the 1960s. He was the principal consultant to the study team.
The Project Oversight Group consisted of the following members of the Society of Actuaries–Jack Bragg, Mark Bursinger, Sam Cox, Steve Easson (Chair), Doug French, Jack Gibson, John Gould, Phil Heckman, Steve Malerich, Jim Reiskytl, Mark Rowley, and Max Rudolph. The Working Group consisted of Barry Hughes, Kurt Karl and Society of Actuaries' members Eric Thorlacius and Steve Craighead.
Sponsors of the study at the Society of Actuaries were the Futurism Section, Investment Section, Committee on Finance Research and Committee on Knowledge Extension.