A matter of numbers

I have been having a fairly ‘vigorous’ discussion with Brandon Watson here, about fair pricing of financial contracts in general and, more specifically, the practice of making such contracts ‘Sharia compliant’, which, as far as I can see, consists in taking products which have a built-in and unavoidable interest rate cost, and disguising that cost by calling it something else, such as a fee or planning cost or whatever. Brandon has replied with the fairly astonishing claim that “you seem to have the odd idea that fairness in contract is a matter of numbers.”

Fairness is about being is transparent as possible the source of the product costs, and hence the amount of profit. That’s why companies have accountants, and is why, indeed, accountants are called ‘accountants’. Many of the recent problems in the financial area stem precisely from a lack of transparency. 

Most retail banking and investment products are simply cobbled together from products freely available in the wholesale markets, traded at market rates, or are internal products whose risk and price can easily be computed by a financial model of some kind. An annuity, for example. The simplest form of annuity is a product that pays you a fixed and agreed sum of money on a monthly basis from a certain age until you die, in return for a lump sum paid in advance by you. Annuities are the building block of all pensions, of which probably every person in any developed country has at least one. They are a basic, as well as very important financial product. The price of an annuity is also very simple to calculate. You begin with a set of long term government bond rates, which pay a fixed sum far into the future. Then you apply a set of mortality rates which work out the probability of you being alive in any of the years in which you hold the annuity. These allow the provider to work out the fair value ‘spread’ over the government bond yield which it can afford to pay, before the annuitant dies. A fair value annuity is thus one where the mortality-adjusted value of the excess spread exactly balances the profit the provider will receive by owning the bond after the annuitant dies. This fair value can be objectively calculated by using government bond rates – objectively verifiable – and statistical tables, also available from the government. Thus, in this case and most others - pace Brandon - fairness in contract is entirely a matter of numbers.

Of course, the product provider will rarely explain this to you, and will almost certainly hide the fact that standard products like annuities are available almost at cost, if you know where to look. There is little profit in providing such standard pension products. You are more likely to be sold a ‘wrapper’ or pension plan of some kind which combines a standard annuity with other wrinkles such as other forms of insurance, investment plans and early redemption options, all of which are also individually available at a fair cost, plus a whacking great hidden charge, of course. The salesman’s main job will be to emphasise the (geniune) attractiveness of the product, while minimising any hidden risks and hidden charges – one of which will be a handsome fee for ‘advising’ you.

Reform of the financial system involves changing the law to force providers to disclose hidden charges, and to be explicit about the true costs. ‘Sharia-compliant’ products seem like a retrograde step, in my view. They tend to make the raw costs of the product completely opaque to the customer, for the reason that making them explicit would make them immoral, from the customer’s standpoint. How would you construct a Sharia compliant annuity? Impossible, in my view, and the experts seem to agree. Attempts to provide a different product that is not a genuine annuity may lead to risk or harm for the customer – for a sad example see here.

In summary, while other factors must be considered in assessing fairness, correct accounting and transparency about underlying costs are crucial.