2006 General Meeting, Chicago Illinois IP-33: ERM & The Pension Actuary Emily Kessler

1. Canadian Institute of Actuaries L’Institut canadien des actuaires 2006 General Meeting, Chicago Illinois IP-33: ERM & The Pension Actuary Emily Kessler

2. ERM for Pension Plans • What is ERM? • Why is ERM important? Why is ERM important for pension plans? • Using ERM • To improve ALM • To design next generation plans • Appendices

3. Fundamental ERM tenets • Corporations exist to create value • ERM processes help companies identify and manage risks to maximize value creation • ERM can be thought of on three levels: Operational, Strategic and Catastrophic

4. Operational • Objective: Controlrisk, by keeping risks within enterprise limits on an ongoing basis • Identify, monitor, limit, offset and transfer all potential significant losses to a firm

5. Strategic • Objective: Promote risk taking to maximize risk adjusted returns • Integrate risk into pricing, planning and performance evaluation, using economic capital in pricing, capital budgeting and risk adjusted performance measurement

6. Catastrophic • Objective: Protect limits or reduces the risk of firm failure • Identify and prepare for potential catastrophic events that could threaten the success of the enterprise • Through trend analysis, stress testing, contingency planning and catastrophic risk transfer/offset

7. Why is ERM important? • ERM is a framework to understand the risks to your enterprise and manage them • If you don’t manage risk, it will manage you • Crisis management • Not feasible to do in global economy (can be catastrophic) • Real value: if you manage risk well, you can do a better job of growing your business

8. Why is ERM important for pension plans? • The pension plan is not part of the core business, but represents a financial risk for corporation • Long-tailed liability • Owe benefits to employees long since terminated or retired • Sticky liability • Easier to dump a business than unwind a pension plan • Call on cash • Mostly due to risks taken with plan investments

9. The fallacy of ongoing plan • Plans have been viewed as having an infinite lifespan • In theory, they can infinitely take on risk • Problem: plan doesn’t exist outside of plan sponsor • Plan must have source of cash: plan sponsor • Plan can only take as much risk as the enterprise can support

10. Lifecycle concept • One way to think about risk management & pension plans is as a lifecycle issue • Lifecycle of plan  lifecycle of business • Ability of sponsor to absorb plan risk varies over lifecycle • This framework helps you understand • Why current statutory framework is failing • Why managing to accounting doesn’t work • Why we have hedge funds that own a few airplanes

11. A simplistic business lifecycle experiences difficulties in maturity reaches maturity merger/ acquisition grows and reaches a turning point A business is born bankruptcy (fast decline) slow decline

12. A simplistic plan lifecycle and reaches a turning point Plan matures with business grows A plan is established termination Freeze the plan

13. Business matures; Plan cost still growing core business not growing Business matures; Plan cost still growing core business declining ? Plan matures; cost grows core business grows faster A plan is born; negligible cost core business growing rapidly Plan and business cycle

14. How is plan generated risk viewed relative to core business risk? ? None/ negligible Moderate/ acceptable Difficult: why do we have a plan? Unacceptable

15. The lifecycle challenge • Plan and core business have antithetical lifecycles • Plan grows initially more slowly than business • Plan improvements granted during this period magnify future difficulties • Plan matures after core business peaks • Plan continues to mature as core business declines

16. The lifecycle challenge • Position in lifecycle considers size, stage, industry • Size • Market capitalization (not ratio of actives to retirees) • Stage • Growth, maturity, retooling (e.g. Eastman Kodak in the age of digital cameras) • Industry • Globalization • Other industry specific, e.g. deregulation

17. Risk management, financial economics & lifecycle • Risk management can tie together financial economics & lifecycle issues • Financial economics gives you the answer to “how do shareholders perceive the risk, and what’s the best way to mitigate risk from plan” • Lifecycle can help you understand level of acceptable risk • Risk management helps sponsor make decisions about whether to accept, mitigate or avoid risk

18. Investment Strategy & ERM • Consider ALM consulting from ERM POV • Goal: evaluate plan investment strategy relative to how well the enterprise can sustain the effects of those risks

19. ERM ALM Framework • Risk mitigation baseline (100% government bonds) • Aggressive investments could drive down cost of plan, allowing company to create value in core business (move into equities) • Can company take the downside risk – the 99th percentile event – should the investment strategy fail without core business suffering?

20. Letting the tail wag the dog • Traditional ALM: Sponsor’s decision based on whether asset mix allows it to use a discount rate/expected return on asset assumption that is competitive with peer group • Accounting standard (reporting) drives investment strategy (risk) • Accounting, by its nature, is backward looking • Risk monitoring not risk management • Can’t drive looking backwards

21. Letting the dog wag its tail • ERM ALM: Use knowledge of pension finance to drive a risk management discussion • The perfect hedge strategy, to indemnify shareholders, is 100% bonds • But, can your shareholders take additional risk? • Where are you on the lifecycle? • What is the size of your plan relative to your market capitalization? • Where is your business today? • What specific issues is your industry facing or are just down the road?

22. Letting the dog wag its tail • The answer may be that 70% equities/30% bonds is OK because the corporation can sustain the investment risk without hurting core business • It probably wouldn’t be for most large, established companies • Caveat: From a pension finance point of view there are still issues around which generation of shareholders pays and benefits, and tax arbitrage issues

23. Letting the dog wag its tail • Statutory framework puts everyone into same risk paradigm • That may not be the right place for this plan sponsor • Risk management means evolving thinking • Failed risk management: hedge fund that owns a few airplanes • Successful risk management: airline with a very large but secure pension fund.

24. ERM & the Pension Practitioner • Today, ERM is a state of mind • ALM study example: letting the dog wag its tail (ERM frame of mind) • Considering plan within the core business • Financial economics (immunizing risk) • DB plans under fire presents opportunities to design new retirement systems • That better meeting economic, demographic needs of 21st century • That incorporate ERM principles

25. ERM & Pension Practitioner • Benefits of ERM frame of mind • Thinking differently about how we do our jobs today • Using the lessons of risk management and DB failure to design better systems for 21st century

26. Thinking differently about risk today • Many plans, industries are mature: catastrophic risk is real • What is the risk of the plan to the business? • What is the risk of the business to the plan? • Manage the plan dynamically • Beyond the statutory/accounting framework • Consider how the plan and company may grow (and may grow at different rates)

27. Thinking differently about risk today • Consider the risk the plan puts on the enterprise • Size of plan relative to market capitalization • How close is the plan to fully funded? (more variation at the edge of full funding) • What happens when market shocks? Interest rate shocks? Demographic shocks?

28. Thinking differently about risk today • Look forward, not backward • Help your clients talk to shareholders about plan costs and risks going forward • Percent of payroll, variation in percent of payroll • How you’ve considered the investment strategy and how that’s projected to benefit shareholders • Does your plan design best manage risk? • Consider eliminating options that add risk to plan

29. Thinking differently about risk today • All plans aren’t infinite • Companies have a beginning, middle and end, and so do their pension plans • Plan for the end, but don’t dwell on it • Long-lived liabilities will have extreme events • Can the plan sustain a 99th percentile event? • Long-tail liabilities will have a 99th percentile event: there will always be a perfect storm • September 2004, Pension Section News, “Defined Benefit Plans are More Successful with Bonds,” Mark Ruloff

30. Using ERM to Answer 21st Century Challenges • Pension Systems under stress, in US, Canada and other countries • Use ERM to design better systems • Transparent, hedgable risks • Risk pooling versus risk transfer • Understanding needs, risks and roles • SOA Pension Section’s Retirement 20/20 effort • www.retirement2020.soa.org

31. Using ERM to Answer 21st Century Challenges • Don’t be afraid to understand why DB broke • DB met 20th century needs for retirement system • DB clearly doesn’t meet 21st century needs for retirement system • If we understand why, we can design better systems …

32. Learning from DB Failure • NY Times interview of Dr. Henry Petroski, engineer: • “From [Dr. Petroski’s] vantage point, failures in design and construction present perfect teaching opportunities. They are object lessons in the history and practice and beauty of engineering. ‘Failure is central to engineering … [e]very single calculation that an engineer makes is a failure calculation. Successful engineering is all about understanding how things break or fail.’” NY Times, 02 May 2006 “Engineering a Safer, More Beautiful World, One Failure at a Time” emphasis added

33. Learning from DB Failure • “Successful engineering is all about understanding how things break or fail.” • Break: operational risk, fail: catastrophic risk • What can we learn about DB plan risk management from the perceived “brokenness” and “failure” of DB plans?

34. “Success masks failure. The more a thing operates successfully, the more confidence we have in it. So we dismiss little failures … as trivial annoyances rather than preludes to catastrophe” DB risk taking in 70s/80s/90s masked risk in plans Risk grew but strategies to mitigate it didn’t Individual years of bad performance were dismissed Learning from DB Failure NY Times, 02 May 2006 “Engineering a Safer, More Beautiful World, One Failure at a Time”

35. “Systems that require error-free performance are doomed to failure” Error-free performance Ongoing plan Company’s ability to provide cash to plan Lifecycle model Plan will grow relative to size of company Company always fails/ shrinks before plan Learning from DB Failure NY Times, 02 May 2006 “Engineering a Safer, More Beautiful World, One Failure at a Time”

36. “Computer simulations and other methods of predicting whether components will fail are themselves vulnerable to failure.” ALM studies based on assumptions Limit on long bonds Ignore lifecycle, change in company over time In our presentations, do we consider 99th percentile events Learning from DB Failure NY Times, 02 May 2006 “Engineering a Safer, More Beautiful World, One Failure at a Time”

37. “Devices can be made foolproof, but not damn-fool-proof …” Agency issues “DB plans are for adults only” Lifecycle Benefit levels may not always be sustainable Risk tolerance may change over time Learning from DB Failure NY Times, 02 May 2006 “Engineering a Safer, More Beautiful World, One Failure at a Time”

38. “Today’s successful design is tomorrow’s failure, in that expectations for technology are continually on the rise.” Global competition Increasing shareholder expectations Not interested in long term Learning from DB Failure NY Times, 02 May 2006 “Engineering a Safer, More Beautiful World, One Failure at a Time”

39. “A device designed for one purpose may fail when put to another use. (Is it fair to call that a failure? Dr. Petroski smiled. ’Good question,’ he said.)” DB plans are wholly-owned block of annuities Been treated like investment trusts (generating income) DB plans won’t fail if risk is managed Learning from DB Failure NY Times, 02 May 2006 “Engineering a Safer, More Beautiful World, One Failure at a Time”

40. Appendices • Appendix I: Objectives of Risk Management • Appendix II: Failure of Statutory systems/Understanding DB under fire • Appendix III: ERM in a DB/DC Consulting Framework • Appendix IV: Resources

41. Appendix I: Objectives of Risk Management • Compliance • Knowledge • Culture • Value added

42. Appendix I: Objectives of Risk Management • Compliance • E.g. Sarbanes-Oxley • Limitations • Risk monitoring is not risk management • Can become bureaucratic • Knowledge • Culture • Value added

43. Appendix I: Objectives of Risk Management • Compliance • Knowledge • Understand the risks taken (transparency) • Risk • Accept risk when there is a competitive advantage • Mitigate (e.g., hedging, reinsurance) • Avoid • Culture • Value added

44. Appendix I: Objectives of Risk Management • Compliance • Knowledge • Culture • Developing a risk management culture • Value added • Determine risk appetite/tolerances • Prioritize risks and optimize risk/return profile • Provide incentives to take risk where it adds marginal value

45. Appendix II: Failure of Statutory Framework • Statutory framework: Accounting standards, funding standards • Today’s statutory framework fails, for most plans, the risk management goal • Risk management goal: Manage to the appropriate level of risk based on position in lifecycle • Current statutory/accounting standards work against this goal for majority of large plans

46. Appendix II: Failure of Statutory Framework • Current statutory/accounting standards developed when most plans in “growth/ maturity” stage • Plan risk relative to core business was smaller • A risk-taking model worked, at least in short-term • Problem: didn’t encourage evolution of risk-taking to account for shifting size of risk • Stopped evolution of thinking around risk • Result: many companies taking risks they ought not to be taking

47. Appendix II: Understanding DB Under Fire • Statutory framework encourages one-size-fits-all risk taking. Results: • All DB plans have been taking the same level of risk • In some critical industries, this is too much risk (e.g. airlines, steel, auto) • As these industries fail, so do their DB plans • Markets now view all DB plans are viewed as too costly and too risky

48. Appendix II: Understanding DB Under Fire • We can understand the failure of DB plans if we consider objectives of ERM • Compliance • Knowledge • Understand the risks taken (transparency) • Risk • Accept risk when there is a competitive advantage • Mitigate (e.g., hedging, reinsurance) • Avoid • Culture • Value added

49. Appendix II: Understanding DB Under Fire • Lack of transparency is driving much of the discussion about pension plans • FAS 87/CICA 3461 type standard not adequate for mature plans • “Traditional” funding rules spreading losses not sufficiently transparent or secure for mature plans and declining industries • ERM says eliminate risks that aren’t transparent • Mitigate or avoid • Observation: in an ERM framework, transparent standards are in the best interest of DB plans

50. Appendix II: Understanding DB Under Fire • Mitigate • Hedge, reinsure through bond, annuity purchase • Mitigation strategy has little attraction today • FAS 87 EROA • Hedging might be more attractive under FRS 17 style standard • Problem: transition • Changes the cost I thought I understood; no one wants to pay more for the same thing • Avoid: get out of DB