Pension Finance Putting the Risks and Costs of Defined Benefit Plans Back Under Your Control

by Waring, M. Barton; Merton, Robert C.

• ISBN13: 9781118106365
• ISBN10: 1118106369
• Edition: 1st
• Format: Hardcover
• Copyright: 2011-11-01
• Publisher: Wiley

Summary

Defined benefit pension plans are in a severe crisis. With nearly a $4 trillion deficit in the U.S. alone, Canada, the UK, Japan, and Holland also suffer from unfunded liabilities. In short, the pension crisis is nearly global in proportion, and there is little likelihood that plan sponsors will be able to come up with the funds to repair the damage. One of the major problems behind the crisis is the approach: pension plans use actuarial science as the basis of assumptions but are subject to the laws of economic finance in terms of their returns. In short, there is a gap between the world presumed by actuaries who determine funding levels and the world as it come to be as determined by market performance and investment outcomes. Waring tackles this thorny issue head on. Well versed in both economic and actuarial science, he walks professionals through the differences and shows why plan sponsors need to focus on the economic account perspective to meaningfully measure present values. Complete coverage of credit risk and the discount rate to determine liability values is examined, contribution levels are then presented based on this revised approach to actuarial accounting. Pension plan sponsors and their employee representatives must face the economics - and adjust their accounting and actuarial view - to gain a true perspective on achieving sustainable benefit levels. Waring is one of the first investment professionals to tackle this controversial topic head on to present realistic solutions to potentially catastrophic problems looming in the very near term.

Author Biography

M. BARTON WARING is a financial economist and lawyer, and an active researcher in pension finance and investing. He retired in 2009 from his role as CIO for investment strategy and policy, emeritus, at Barclays Global Investors. Mr. Waring is well known in the pension industry for his many thoughtful and often prizewinning articles. He serves on the editorial board of the Financial Analysts Journal and as an Associate Editor of the Journal of Portfolio Management.

Table of Contents

List of Figures	p. xiii
List of Propositions	p. xv
Foreword	p. xxi
Preface	p. xxv
Acknowledgments	p. xxxiii
Achieving Long Term Health for Pension Plans Using Improved Managerial Accounting Tools	p. 1
Perspectives on DB Plans	p. 2
What Is Economic or Market Value Accounting?	p. 4
What the Following Chapters Provide	p. 5
Today's Conventional Pension Finance Practices	p. 11
Why Managers Need to Adopt the Economic Accounting Perspective	p. 11
Where Are We Today?	p. 12
The Accounting Always Follows the Economics	p. 17
Historical Context: The Actuaries' Contribution to the Existence of Pensions	p. 21
Conclusion	p. 24
Measuring Meaningful Present Values	p. 27
What Is the Right Discount Rate to Use?	p. 27
The Liability-Matching Portfolio: General Perspective	p. 30
Risk-Free Rate vs. Expected Return on Assets	p. 33
"If We Can Earn 7.5 Percent Per Year Over The Long Term": Happy and Unhappy Asset Return Distributions	p. 35
The Employer's Experience	p. 44
The Discount Rate Is in Fact the Same on Both Sides of the Full Economic Balance Sheet, But That Doesn't Mean That the Liability Changes Its Value with Changes in Investment Strategy!	p. 46
GASB's White Paper and Public Employee Fund Discount Rates	p. 48
Conclusion: Discount Rates	p. 52
Appendix: Are There Market Values for Pension Plans?	p. 53
The Full Economic Liability: The Off-Book Starting Point for Management of Pension Costs	p. 55
The Liability: Inherently an Economic Entity	p. 55
A Newly Formed Pension Plan	p. 58
Multiple Correct Measures of the Accrued Portion of the Liability but Only One PARENT Measure	p. 63
Building a Pension Budget Identity	p. 65
Core Principles of Pension Accounting: The Full Economic Liability Meets Accrual Accounting and Normal Costs	p. 67
Full Economic Normal Cost	p. 68
Enter the Matching Principle: Normal Costs Accruing Over Time	p. 69
Normal Costs and Retirees, Active Employees, and Future Employees	p. 72
Allocating Pension Costs to Current Employees	p. 73
Payment Patterns Other Than Level Payments	p. 82
Illustrating Normal Costs and Accrued and Total Liabilities over Time	p. 86
Comparing Normal Cost Methods	p. 90
Normal Costs and Contributions: Multiple Measures?	p. 92
Normal Cost and Agreed Levels of Benefit Security: An Accrual Method Not Reliant on the Matching Principle	p. 94
Balance Sheet with Accruals of an Economic Measure of Periodic Normal Cost	p. 100
Updating the Beginning-Period Pension Budget Identity	p. 102
Summary of Discussion of Normal Costs	p. 103
Appendix: Computing Level Payment Contributions and Normal Costs with a Handheld Calculator in Order to Gain Understanding of the Nature of the Problem	p. 105
Credit Risk and the Discount Rate	p. 107
Two Useful Views of the Liability's Value	p. 107
Termination and Default Risk	p. 107
Conclusion	p. 114
Paying for the Plan	p. 117
Pension Expense and Contributions	p. 117
Other Components of Pension Expense in Addition to Normal Cost	p. 117
Distinguishing Economic from Conventional Supplemental Costs	p. 119
Strict Economic Pension Expense	p. 120
Economic Pension Expense in an Accrual System	p. 122
Contributions to the Asset Pool, and the Sponsor's Credit Risk	p. 123
Investment Returns on Contributed Assets	p. 124
Benefit Payments	p. 125
The Components of Economically Determined Contributions	p. 126
An Example Immediately Usable in the Boardroom: Analyzing Contributions for the Aggregate Plan with an HP 12c	p. 129
The Volatility Of The Deficit Is Equal To The Volatility of Contributions	p. 133
Conclusion	p. 134
Investment Strategy I: Liability-Relative Optimization	p. 135
Investment Policy and Strategy for Investors with Liabilities	p. 135
The Augmented Balance Sheet: Optimizing on the Combined Risks of the Sponsor and the Plan	p. 139
Brief Review of the Theory of Surplus Return and Surplus Asset Allocation	p. 140
The Elephant in the Strategic Asset Allocation Room	p. 145
Investment Strategy II: Managing Risks to the Plan's Surplus, to Pension Expense, and to Contributions Using the Liability-Matching Asset Portfolio	p. 147
Show Me the Money: Risk Control Through the Liability-Matching Asset Portfolio	p. 148
What Liability Should Be Hedged in the Surplus Asset Allocation Process?: Defining Capital Gains and Losses in the Accrued Liability	p. 151
Hurdles to Adoption of Surplus Asset Allocation and to Holding an LMAP Portfolio: Why Isn't This Easier to Implement?	p. 155
The Shape of Investment Strategy for Pension Plans Using Surplus Optimization and the Two-Fund Theorem	p. 158
Conclusion	p. 160
Appendix: Why Use Dual Durations in the Liability Measures?	p. 162
Investment Strategy III: Risk Tolerance and the Decision to Hold Risky Assets Over and Above the Liability-Matching Asset Portfolio	p. 165
Why Hold Any Equities or Risky Assets?	p. 165
Can the Sponsor Afford the Risk if It Happens? One Part of Identifying the Organization's Tolerance for Risk	p. 168
Visualizing and Comparing Return/Risk Tradeoffs Among Alternative Investment Strategy Choices	p. 171
Controlling Economic Risk to the Surplus Equals Controlling Accounting Risks to the Plan	p. 176
Implementing a RAP in Addition to a Liability-Matching Portfolio	p. 177
Benefits of Surplus Optimization and the LMAP When a RAP Is Held	p. 178
Conclusion	p. 180
Appendix: When Is a Plan Truly in Surplus?	p. 180
Investment Strategy IV: Asset/Liability Studies-The Conventional Approach	p. 183
Traditional Actuarial Asset/Liability Studies	p. 183
Modeling in the Traditional Actuarial Pension Approach	p. 185
Possible False Correlations and Bad Investment Strategy Results	p. 186
Do the Results Prove the Asset/Liability Method?	p. 187
Managing the Present Value of Future Contributions through Investment Strategy	p. 189
Conclusion	p. 191
A Retirement Party for the Required Rate of Return	p. 195
Visualizing the Required Rate of Return	p. 197
The Effect of Investment Risk on Surplus Risk and Contribution Risk Over Time	p. 200
Effect of the Required Rate of Return on Investment Strategy	p. 210
Actuarial Confidence in High Expected Returns	p. 212
Presenting the Gold Watch	p. 214
Postscript	p. 216
The Fully Generalized Pension Budget Identity	p. 217
The Inviolability of the FEL	p. 221
Tough Love: Saving the Underfunded Pension Plan	p. 223
An Action Plan: Something Has to Be Done, but It Isn't Going to Be Easy	p. 224
Accounting and Reporting Policy	p. 226
Contribution Policy and Benefit Policy	p. 229
Investment Policy and Strategy	p. 234
Making These Changes Is Important!	p. 237
Public Policy Suggestions-Revising Accounting and Actuarial Standards for Pensions	p. 239
Only One Accrued Liability, Please!	p. 242
Articulation between Financial Statements	p. 244
Pension Expense	p. 244
Smoothing and Amortizations?	p. 246
Pension Contributions	p. 251
Financial Amortization Rather Than Actuarial Amortization	p. 253
Reconfiguring the Elements of Pension Expense on the Income Statement	p. 253
Should the Pension Trust Be Off the Sponsor's Balance Sheet, or On?	p. 254
Financing the PBGC's Guarantee, or Financing Pension Plans Directly?	p. 256
The IRS and Pension Deductibility	p. 258
Summary of Public Policy Suggestions	p. 259
Beyond Managerial Accounting: Should Accounting and Actuarial Regulatory Frameworks Be Changed?	p. 262
Beyond the Crisis: Making Better Management Decisions and Managing Plans at Lower Risk	p. 265
Mark-to-Market Accounting Is Not a Reason to Terminate the Plan	p. 266
The Intuition Is Already Out There	p. 266
Our Legacy as Pension Advisors	p. 268
Variables and Terms Used in the Book	p. 271
Implicit Options in the Pension Plan	p. 277
Termination or Default Option	p. 278
PBGC Put	p. 281
Participant Call on Economic Surplus	p. 282
Use of Protective Put Options in the Investment Strategy	p. 285
References	p. 287
About the Author	p. 293
Index	p. 295
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