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

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  • Edition: 1st
  • Format: Hardcover
  • Copyright: 2011-11-01
  • Publisher: Wiley
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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 Figuresp. xiii
List of Propositionsp. xv
Forewordp. xxi
Prefacep. xxv
Acknowledgmentsp. xxxiii
Achieving Long Term Health for Pension Plans Using Improved Managerial Accounting Toolsp. 1
Perspectives on DB Plansp. 2
What Is Economic or Market Value Accounting?p. 4
What the Following Chapters Providep. 5
Today's Conventional Pension Finance Practicesp. 11
Why Managers Need to Adopt the Economic Accounting Perspectivep. 11
Where Are We Today?p. 12
The Accounting Always Follows the Economicsp. 17
Historical Context: The Actuaries' Contribution to the Existence of Pensionsp. 21
Conclusionp. 24
Measuring Meaningful Present Valuesp. 27
What Is the Right Discount Rate to Use?p. 27
The Liability-Matching Portfolio: General Perspectivep. 30
Risk-Free Rate vs. Expected Return on Assetsp. 33
"If We Can Earn 7.5 Percent Per Year Over The Long Term": Happy and Unhappy Asset Return Distributionsp. 35
The Employer's Experiencep. 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 Ratesp. 48
Conclusion: Discount Ratesp. 52
Appendix: Are There Market Values for Pension Plans?p. 53
The Full Economic Liability: The Off-Book Starting Point for Management of Pension Costsp. 55
The Liability: Inherently an Economic Entityp. 55
A Newly Formed Pension Planp. 58
Multiple Correct Measures of the Accrued Portion of the Liability but Only One PARENT Measurep. 63
Building a Pension Budget Identityp. 65
Core Principles of Pension Accounting: The Full Economic Liability Meets Accrual Accounting and Normal Costsp. 67
Full Economic Normal Costp. 68
Enter the Matching Principle: Normal Costs Accruing Over Timep. 69
Normal Costs and Retirees, Active Employees, and Future Employeesp. 72
Allocating Pension Costs to Current Employeesp. 73
Payment Patterns Other Than Level Paymentsp. 82
Illustrating Normal Costs and Accrued and Total Liabilities over Timep. 86
Comparing Normal Cost Methodsp. 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 Principlep. 94
Balance Sheet with Accruals of an Economic Measure of Periodic Normal Costp. 100
Updating the Beginning-Period Pension Budget Identityp. 102
Summary of Discussion of Normal Costsp. 103
Appendix: Computing Level Payment Contributions and Normal Costs with a Handheld Calculator in Order to Gain Understanding of the Nature of the Problemp. 105
Credit Risk and the Discount Ratep. 107
Two Useful Views of the Liability's Valuep. 107
Termination and Default Riskp. 107
Conclusionp. 114
Paying for the Planp. 117
Pension Expense and Contributionsp. 117
Other Components of Pension Expense in Addition to Normal Costp. 117
Distinguishing Economic from Conventional Supplemental Costsp. 119
Strict Economic Pension Expensep. 120
Economic Pension Expense in an Accrual Systemp. 122
Contributions to the Asset Pool, and the Sponsor's Credit Riskp. 123
Investment Returns on Contributed Assetsp. 124
Benefit Paymentsp. 125
The Components of Economically Determined Contributionsp. 126
An Example Immediately Usable in the Boardroom: Analyzing Contributions for the Aggregate Plan with an HP 12cp. 129
The Volatility Of The Deficit Is Equal To The Volatility of Contributionsp. 133
Conclusionp. 134
Investment Strategy I: Liability-Relative Optimizationp. 135
Investment Policy and Strategy for Investors with Liabilitiesp. 135
The Augmented Balance Sheet: Optimizing on the Combined Risks of the Sponsor and the Planp. 139
Brief Review of the Theory of Surplus Return and Surplus Asset Allocationp. 140
The Elephant in the Strategic Asset Allocation Roomp. 145
Investment Strategy II: Managing Risks to the Plan's Surplus, to Pension Expense, and to Contributions Using the Liability-Matching Asset Portfoliop. 147
Show Me the Money: Risk Control Through the Liability-Matching Asset Portfoliop. 148
What Liability Should Be Hedged in the Surplus Asset Allocation Process?: Defining Capital Gains and Losses in the Accrued Liabilityp. 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 Theoremp. 158
Conclusionp. 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 Portfoliop. 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 Riskp. 168
Visualizing and Comparing Return/Risk Tradeoffs Among Alternative Investment Strategy Choicesp. 171
Controlling Economic Risk to the Surplus Equals Controlling Accounting Risks to the Planp. 176
Implementing a RAP in Addition to a Liability-Matching Portfoliop. 177
Benefits of Surplus Optimization and the LMAP When a RAP Is Heldp. 178
Conclusionp. 180
Appendix: When Is a Plan Truly in Surplus?p. 180
Investment Strategy IV: Asset/Liability Studies-The Conventional Approachp. 183
Traditional Actuarial Asset/Liability Studiesp. 183
Modeling in the Traditional Actuarial Pension Approachp. 185
Possible False Correlations and Bad Investment Strategy Resultsp. 186
Do the Results Prove the Asset/Liability Method?p. 187
Managing the Present Value of Future Contributions through Investment Strategyp. 189
Conclusionp. 191
A Retirement Party for the Required Rate of Returnp. 195
Visualizing the Required Rate of Returnp. 197
The Effect of Investment Risk on Surplus Risk and Contribution Risk Over Timep. 200
Effect of the Required Rate of Return on Investment Strategyp. 210
Actuarial Confidence in High Expected Returnsp. 212
Presenting the Gold Watchp. 214
Postscriptp. 216
The Fully Generalized Pension Budget Identityp. 217
The Inviolability of the FELp. 221
Tough Love: Saving the Underfunded Pension Planp. 223
An Action Plan: Something Has to Be Done, but It Isn't Going to Be Easyp. 224
Accounting and Reporting Policyp. 226
Contribution Policy and Benefit Policyp. 229
Investment Policy and Strategyp. 234
Making These Changes Is Important!p. 237
Public Policy Suggestions-Revising Accounting and Actuarial Standards for Pensionsp. 239
Only One Accrued Liability, Please!p. 242
Articulation between Financial Statementsp. 244
Pension Expensep. 244
Smoothing and Amortizations?p. 246
Pension Contributionsp. 251
Financial Amortization Rather Than Actuarial Amortizationp. 253
Reconfiguring the Elements of Pension Expense on the Income Statementp. 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 Deductibilityp. 258
Summary of Public Policy Suggestionsp. 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 Riskp. 265
Mark-to-Market Accounting Is Not a Reason to Terminate the Planp. 266
The Intuition Is Already Out Therep. 266
Our Legacy as Pension Advisorsp. 268
Variables and Terms Used in the Bookp. 271
Implicit Options in the Pension Planp. 277
Termination or Default Optionp. 278
PBGC Putp. 281
Participant Call on Economic Surplusp. 282
Use of Protective Put Options in the Investment Strategyp. 285
Referencesp. 287
About the Authorp. 293
Indexp. 295
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