Don’t Kill the Golden Goose

1. Don’t Kill the Golden Goose Pensions and Investments Pension Risk Forum The Harvard Club New York, NY Laurence B. Siegel Director of Research The Ford Foundation l.siegel@fordfound.org

2. The pension funding crisis • Defined benefit pension plans are in danger • Sponsors in U.S. and elsewhere “freezing” plans as fast as they can • Airlines and other financially distressed sponsors using bankruptcy to “dump” plans on PBGC • No one is starting new plans

3. Why is there a pension funding crisis? • Perception is that pension funding risks and costs are unmanageable • Wildly fluctuating asset and liability values (“perfect storm”) • Wildly fluctuating demand for sponsor contributions • Costs seem too high to be sustainable • We do have the tools to sponsor DB plans at manageable levels of risk! So let’s use them But the perception is not correct

4. Account balance at retirement • Annuity value of account balance (stated as annual income) • Mean • $9,243 • $112,000 • Median • $3,631 • $44,000 Will DC participants ever have enough money to retire? We’d better get to work trying to save DB plans!

5. DB vs. DC plans

6. Sharing longevity risk: The key to retirement security and affordability • By annuitizing payout, DB plan spreads longevity risk across a large group • Allows all to have lifetime protection at reduced cost • For DC, need to fund for 105 year possible life. In DB, only need to fund to life expectancy (average) • A male age 65 retiree needs only $1,180,000 contributed to a DB plan to get a $100,000 annual retirement income. In an unannuitized DC plan, he would have to save $1,802,431 • DC participant can annuitize on his own, but at very high cost

7. Root causes of the DB pension crisis Recipe for a perfect storm • Everyone knows stocks can fall 50% and long-term interest rates can fall by 3 percentage points (it could happen again) • Nevertheless, fund long-term liabilities with: • 70% equities • 30% Lehman aggregate fixed income • HELLO…???

8. Why did DB plans adopt this asset mix on average? • Higher expected returns on equities reduce apparent cost of pension (because of accounting convention) • But economic cost is set by the size of the pension promise, not by assets used to fund it • It’s like buying a car for $30,000, with nothing down • If I make the payments with stock market profits at 8% or bond market profits at 5%, the car still costs $30,000 • My accountant would back me up on that • It’s my income, not the car cost, that is affected by the means of funding

9. Managing DB pension funding risksUsing surplus optimization and the economic liability • Three simple steps: • Use an economic model of the liability; that is, identify the market-related risks in the liability • Select a portfolio on the surplus efficient frontier • Revise fixed income weights and durations so that whole portfolio (including equities, etc.) is dual duration hedged Optional: • Add active management

10. What is the economic liability? • Liability is someone else’s asset • All assets (including liability) can be modeled in terms of their market-related risk exposures • Example: Bill Sharpe βi = sensitivity of liability to change in inflation Δi = change in inflation βr = sensitivity of liability to change in real interest rate Δr = change in real interest rate

11. Economic liability: Numerical example • -8 = sensitivity of liability to inflation change = inflation duration of liability • -15 = sensitivity of liability to real interest rate change = real interest rate duration of liability ``

12. Are you surprised that the liability has two durations? • You shouldn’t be • All assets have two durations • Most obvious example is TIPS: inflation duration = 0, real interest rate duration = e.g. 15 • Equities, real estate, pension liabilities, etc. also have two durations • For nominal bonds, the two durations are the same (but they still have two durations)

13. Let’s start building the pension portfolio by “dual duration hedging” the liability • Extreme, fixed income-only position • This will turn out to be the “minimum surplus variance portfolio” (MVP) in surplus optimization • Hold bonds and TIPS with same dollar-duration as liability • Dollar-duration is just an adjustment to duration for plans that are overfunded or fully funded • You’ve eliminated most of the risk of sponsoring a pension plan! • But portfolio return may be too low…what do you do now?

14. What is surplus optimization?First, look at asset-only optimization A stylized view: Small Cap Equity Asset-only frontier International Equity Expected return Large Cap Equity Bonds Cash Expected risk

15. Surplus beta decision: The Risky Asset Portfolio What is surplus optimization? Add in a liability-matching portfolio (beta factors only), decide risk level Surplus Frontier Expected return The Hedging Portfolio Asset only frontier Expected risk Liability How much surplus beta risk?

16. Active risk decision Active frontier Expected alpha Active risk … and how much alpha risk? Liability What is surplus optimization? Consider alpha from active management Expected return Expected risk How much surplus beta risk?

17. Can you be dual duration hedged AND hold risky assets? • Yes • Determine risk-appropriate point on efficient frontier • Determine dual duration hedge for whole portfolio (including equities, etc.) • Once you’ve selected the risky assets, • Modify bond and TIPS weights and durations to produce desired duration exposures for whole portfolio, or, • Achieve exposures through futures and/or swaps markets

18. Asset return distribution “comets”: How to read them 95% 75% Mean Median 25% 5% $10,000 Fixed income $1,000 $10,000 Equities $100 0 5 10 15 20 Years $1,000 Seeking higher returns (steeper slope) means accepting a wider distribution of ending wealth $100 0 5 10 15 20 Years

19. 105% Current policy: 75% Equity-like asset classesFunded ratio (A/L) distributions, over time 250% 95% 75% 50% 25% 5% 260% 200% 176% 150% Expected funding ratio (A/L) 134% 102% 100% 69% 50% 0 2 4 6 8 10 Time (years) Current holdings modestly improve the expected funded ratio over time but imply an unattractive downside scenario This and all other forecasts are focused exclusively on financial risk/return tradeoffs and exclude the impact of future cash flows and all other unhedgeable risks such as mortality risk and other experience risks.

20. Impact of extending duration, changing stock-bond mixImproved funded ratio (A/L) distributions over time 260% 250 200 150 100 50 95% 75% 50% 25% 5% 193% 176% 152% Expected funding ratio (A/L) 134% 129% 105% 110% 102% 87% 69% 0 2 4 6 8 10 Time (years) (Current policy in background) Expected return is slightly lower, but downside risk is MUCH less

21. How much tolerance for investment risk?The integrated corporate balance sheet Corporate “T-Account” Debt Operating assets Pension Liability Pension assets Shareholder Equity The weighted avg. beta of the assets = weighted avg. beta of the liabilities If the pension assets are a large part of the total assets, beta risk from the risky asset exposure will have a large effect on shareholder equity beta risk So, bad investment experience in the plan may compound an otherwise bad period for the company .

22. Risk Tolerance: How much equity?What does bad investment experience mean to you? • More equity  Higher expected or average return, but also higher cumulative probability of very bad returns over long periods of time • Equivalently, contributions and expense can be expected on average to be smaller, but the probability that they will be larger goes up • Can you afford greater contributions and expense when markets (including possibly your company) are generally depressed? • Enterprise view: • Today’s 75% equity allocations are probably going to come down

23. “But the DB plan is just too expensive!” • Economic cost is set by PV of promised benefits, not by anything else (asset allocation, accounting conventions, etc.) • “Pension budget identity”: contributions and periodic normal costs have present values equal to that of the liability (ab initio): • Thus, a plan’s periodic normal cost is controlled solely by the economic cost, i.e., by the total PV of the benefit level, not by the accounting! • How could it be otherwise? • To control costs, control the benefit level • To control benefit level, both management and labor need good valuations, transparency

24. Conclusions • Use core concepts of modern finance to control pension risks and costs • Pension funding risks are manageable, with 3 tools: • Economic model of the liability (what are its market-related risk exposures?) • Dual-duration hedging: Managing both types of interest rate risks (real interest rate, and inflation) • Surplus optimization: Taking additional risk rationally, to improve returns • Costs can be managed if benefit levels are negotiated using economic measures of the liability • If costs are controlled, then contributions and expense are also controlled • DB plans are a much better use of a given employee benefit dollar than DC plans. Don’t kill the golden goose!