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SOA 08 Annual Meeting

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  • 1. SOA 08 Annual Meeting & Exhibit October 19-22, 2008 Session 17, Bringing "Equity" to the Issue of Equity Investments in Pension Plans Moderator Thomas M. Sablak, FSA, MAAA, EA, FCA Authors Paul Bosse Chad Aaron Hueffmeier, FSA, MAAA, EA Dimitry D. Mindlin, ASA, MAAA
  • 2. Equities in Pension Portfolios Paul Bosse, CFA Principal, Investment Strategy Group October 19, 2008 For Institutional Investor Use Only. Not For Public Distribution. A changing paradigm for pension investing Old paradigm New paradigm Legislation ERISA (1974) PPA (2006): funding cost impact Regulation FAS 87 (1985) FAS 158 (2006): balance sheet impact Shortfall (long run) Risk Shortfall Volatility (short run) Return Total return Cost vs. volatility Volatility Smoothed Recognized annually Process Asset allocation Asset liability studies are key Prepared by Vanguard Institutional Advisory Services™ >2 1
  • 3. Paradigm shift: Liability-driven investing (LDI) • PPA & FASB adds volatility to funding requirements and the balance sheet • Asset liability management (ALM): a new efficient frontier – Long-duration bonds, are the new low-risk asset • What doesn’t change: Equities is still the way to increase return Absolute return efficient frontier Liability efficient factor 12 6 Return versus liability 10 Equities Equities 4 8 Return 6 Bonds 2 Long bonds 4 Cash 0 Long Bonds 2 bonds Cash 0 -2 0 5 10 15 20 25 0 5 10 15 20 Risk versus liability Risk Vanguard estimates. Absolute volatility based on standard deviations of portfolio returns. Surplus volatility based on how >3 closely pension plan assets track plan liabilities; this is the risk that the PPA 2006 and FASB ruling are addressing. LDI: should DB plans dump equities? For a long investment horizon, equities still make sense - Lowers plan costs: maintain asset return assumption - Raises funding volatility: can client accept this? Total Return: Stocks, Bonds Cash 1926-2007 10,000 10 .5% 1,000 Log Scale 5 .5% 100 10 3 .9% 1 1925 1935 1945 1955 1965 1975 1985 1995 2005 >4 2
  • 4. How about diversifying with high return alternatives? (Private equity, private real estate, hedge funds) Sure, if you can meet the requirements of doing it well – Do you have the access and size to effectively invest in alternatives? • Large investors fare better in alternative investments • Manager selection is critical – Can you tolerate the low liquidity/transparency? • Alternatives require more manager confidence & supervision – Can you achieve sufficient diversification within the asset class? • Returns from a small sample of the average is more volatile than the average • Fund of Fund managers offer diversification, but at a cost – Can you overcome the cost? >5 Can LDI happen without adding more bonds? Industry Survey*: 62% plan sponsors want to reduce funded ratio volatility… while maintaining portfolio return Physical investments • Buy longer duration bonds - Easy to understand, explain, execute, monitor - Can lower return, increasing plan cost Swap arrangements • Obtain long duration return stream through a swap - Maintains return, keeping costs lower - Complicated: best for large/sophisticated plans *Industry Global Quick Poll, 2008 >6 3
  • 5. Doing LDI by adjusting the bond mix A recipe page Expected Outcome: Rates flat Equities +10% Negative Outcome: Rates -1% Equities -10% Positive Outcome: Rates +1% Equities +20% % Scenarios: Fixed Income Allocation Liability Funding Equity Le Agg Long Extended Hedged Expected A/L Ratio Expected Negative Positive Ratio Bond Bond Duration Bonds Return Volatility Outcome Outcome Outcome 50% 100% 0% 0% 20% 7.4% 8.0% 105 85 120 50% 0% 100% 0% 50% 7.3% 7.1% 105 89 116 50% 50% 0% 50% 60% 7.5% 7.2% 105 90 115 50% 25% 0% 75% 80% 7.5% 7.2% 105 93 112 60% 100% 0% 0% 16% 7.9% 9.2% 106 84 122 60% 0% 100% 0% 40% 7.7% 8.5% 106 87 119 60% 50% 0% 50% 48% 7.9% 8.5% 106 88 118 60% 25% 0% 75% 64% 7.9% 8.4% 106 90 116 60% 0% 0% 100% 80% 7.9% 8.5% 106 92 114 70% 100% 0% 0% 12% 8.4% 10.5% 107 82 125 70% 0% 100% 0% 30% 8.3% 10.0% 107 85 122 70% 50% 0% 50% 36% 8.4% 10.0% 107 85 122 70% 25% 0% 75% 48% 8.4% 9.9% 107 87 120 70% 0% 0% 100% 60% 8.4% 9.8% 107 88 119 >7 Once the allocation is set, is the equity position static? As the funded ratio changes, so do plan objectives and the asset mix Primary funding objective: Primary funding objective: Improve funding status Maintain funding status Primary asset objective: Primary asset objective: High returns Manage volatility relative to liabilities Primary risk: Solvency risk Primary risk: Funded ratio volatility 80% funded 100% funded 120% funded Stocks Bonds Extended Bonds >8 4
  • 6. Company specifics key the equity allocation process An incomplete laundry list Plan Objective: what is the fund mission? - Case study Drivers: Funded level – drives portfolio aggressiveness Financial strength – higher strength allows more risk taking Company’s sensitivity to economic cycle – can reduce risk taking Fund profile (closed/open, participant age) – open plan requires more return Return on corporate capital - high ROC pushes for lower contribution One that shouldn’t be here: - peer tracking >9 Bottom line: How much into Equities? It depends… > 10 5
  • 7. Bringing “Equity” to the Issue of Equity Investments in Pension Plans For Institutional Investor Use Only And May Not Be Used With The General Public Page 1 Risk Budget is Built Around the Liability Benchmark ABO cash flows should be used for risk management • Future salary increases should Current Spot Curve Projected Benefit Payments reflect their impact on pension increases (i.e., total compensation should be managed) • Uncertainty of future cash flows should be considered during the risk budgeting process Years • Customized liability benchmark should be used – Based on projected cash flow and treasury or swap curve – Customization is important for tight risk controls – Note that a long duration fixed income index (as a proxy) could be easier to communicate • Risk budget is based on liability benchmark – Liability Tracking Error (LTE) = Volatility [Asset Return − Liability Return] – Surplus at Risk (SaR) 1. Assuming duration of liabilities of 12. Page 2 1
  • 8. Identifying the Best Interests of Participants Participants only lose when a plan • Beneficiaries can lose “value” if the plan sponsor claims bankruptcy and the plan is sponsor with an underfunded plan goes bankrupt under-funded Participants have limited downside (PBGC put) and limited upside (do not own surplus) Beneficiary Value Poorly Fully funded Fully funded funded PBGC liability termination liability • Consequently, beneficiaries’ risk appetite changes as the funded status changes Beneficiary Risk Appetite Poorly Fully funded Fully funded funded PBGC liability termination liability Graphs shown are for illustration purposes only. Page 3 Shareholder Interests Are Well Aligned Decision-making framework Well Status: A/L Matched Funded Status: A/L Matched • Take low level, tax-efficient, dynamic risk to • Take moderate level, tax-efficient, dynamic risk develop usable surplus to develop usable surplus • Negative investment performance could trigger bankruptcy Risk taking should be dynamic, changing with funded status, corporate credit, expected growth and other conditions and avoids large beta risk Weak Strong “Dynamically de-risk” Status: Materially Underfunded Status: Partially Funded • Sponsors should take risk to try to improve • Unfunded pension liabilities treated as a hard funded status debt • May not be possible to avoid bankruptcy • Companies should fund the plan to take without taking risk advantage of the tax arbitrage between the corporation and the pension plan Poorly Funded “PBGC end of game’’ Graphs shown are for illustration purposes only. Page 4 2
  • 9. Integrated Pension Solutions (IPS) Risk Allocation Liability Hedge synthetic Enhanced Cash Enterprise Explicit Risk Budget Risk Risk synthetic Management Management (Beta Tilt) Portfolio Integrated Cash & Long Pension Duration Solutions Treasuries Tail Risk Protection Performance Portfolio Diversified Alpha Sources Page 5 Is a Short Negative Interest Rate Position a Good Use of the Risk Budget? • Market Expectation Theory suggests longer rates simply reflect expectations of future rates, not risk premiums • If there is a risk premium, the consensus believes the premiums would be positive • Tactical short positions should be judged against other risks that weren’t taken • Enterprise Risk Management (ERM) should be considered but also the limitations of having the gains in the pension should be evaluated • Correlation with other asset classes are not stable – Average correlation between S&P 500 return and Moody’s AA Bonds is 0.2353 – 90% of correlations fall between 0.0047 and 0.3727 Correlation of S&P 500 Return and Moody's AA Bond Return 0.70 0.60 0.50 0.6-0.7 0.5-0.6 0.40 0.4-0.5 0.30 0.3-0.4 0.2-0.3 0.20 0.1-0.2 0.10 0-0.1 0.00 -0.1-0 -0.10 -0.2--0.1 -0.3--0.2 -0.20 -0.4--0.3 -0.30 -0.5--0.4 -0.40 -0.6--0.5 12/31/1952 -0.7--0.6 -0.50 12/31/1963 -0.60 12/31/1974 -0.70 12/31/1985 End Date 11/30/2007 12/31/2003 12/31/1999 12/31/1996 12/31/1995 12/31/1991 12/31/1987 12/31/1983 12/31/1979 12/31/1975 12/31/1971 12/31/1967 11/30/2007 12/31/1963 12/31/1959 12/31/1955 12/31/1951 12/31/1947 Start Date Page 6 3
  • 10. Everyone Believes in Risk Premiums… • Capital Asset Pricing Model (CAPM) • Arbitrage Pricing Theory (APT) • Building Block Approaches EROA = rf + weighted average risk premium + α Page 7 …but Ignore the Same Arguments When Evaluating the Impact on Stockholders • How is risk deflected in market prices? – Discounted prices! – $1bn of bonds = $1bn of equities – Value ≠ future risk profile • Investors pay less for assets containing risk – For example, the price (value) is higher for a treasury bond than a corporate bond with the same coupons and maturity • If a plan sponsor chooses to take more risk to increase or sustain expected returns, what impact should it have on stock price? Page 8 4
  • 11. Paying Lower Taxes on Highly-Taxed Assets Should be Attractive to Stockholders • Returns in pension plans directly impact stock price • Equity returns to shareholders receive capital gains treatment in most countries • In the U.S., capital gains taxes are approximately 20% lower than taxes on highly taxed assets • Transferring highly-taxed assets to the pension plan allows shareholders to increase their after-tax returns Individual Pension plan Individual Core Pension plan Core Shareholder containing highly Shareholder Business containing equities Business Portfolio taxed assets Portfolio Highly Stock Stock Price Taxed Price Equities Assets Shift highly taxed High taxes asset exposure Capital Gains Capital Gains Capital Gains into pension plan Shareholder Shareholder After-tax After-tax Return Return Present value of tax savings is approximately 13% - 15% of the equities currently held in the Graphs shown are for illustration purposes only. pension plan. Page 9 What Should be Considered When Managing Risk? • Investment exposures in pensions directly impact the risk to stockholders or taxpayers • Dynamic risk management is beneficial to both participants and shareholders • Reducing the correlation between pension and business performance is generally beneficial to participants and shareholders – Reduces risk of underfunding at the same time as bankruptcy – Reduces risk of bankruptcy which should be penalized by markets • Limit risk taking to “core competencies” and/or “competitive advantages” – Optimal capital structure maximizes stock price while minimizing risk – Passive risks should be penalized by the market because it does not create value but increases risk of bankruptcy Page 10 5
  • 12. Bringing "Equity" to the Issue of Equity  Investments in Pension Plans  Dimitry Mindlin, ASA, MAAA, PhD President CDI Advisors LLC October 19, 2008 Asset Allocation •Objectives must be perfectly clear •Ask a question, then look for an answer •State a problem, then look for a solution CDI Advisors LLC 2
  • 13. Stakeholders and Objectives •Plan Participants: benefit security •Shareholders/taxpayers: cost of providing benefits CDI Advisors LLC 3 Optimization •Plan Participants: maximize safety given cost •Shareholders/taxpayers: minimize cost given risk •What’s your objective? CDI Advisors LLC 4
  • 14. Commitments and Assets •$100 in 10 years •$100 in 35 years •Market Value of Assets $70.00 CDI Advisors LLC 5 “Marked‐to‐Market” Accounting •Treasury 10 year rate 4% •“Marked‐to‐market” PV of $100 in 10 years is $67.56 •Treasury long‐term rate 5% •“Marked‐to‐market” PV of $100 in 35 years is $19.95 •“Marked‐to‐market” PV of total Commitment is $87.51 $87.51 CDI Advisors LLC 6
  • 15. The Funding Problem •Policy portfolio? •(Partially) matching bond portfolio? •Additional contributions? CDI Advisors LLC 7 Cost‐Risk Frontiers Cost‐Risk Efficient Frontiers with and w/o Matching Bonds 45 40 35 30 25 COST 20 15 100/0 10 100/0 100/0 52/48 5 89/11 100/0 0 40% 35% 30% 25% 20% 15% 10% 5% 0% SHORTFALL PROBABILITY w Matching Bond w/o Matching Bond Source: CDI Advisors CDI Advisors LLC 8
  • 16. Optimal Portfolios Optimal Policy Portfolios ‐ No Matching Bond 100% 80% 60% US Stocks Int Stocks 40% Bonds 20% 0% SHORTFALL PROBABILITY Optimal Policy Portfolios ‐ Matching Bond 100% 80% 60% US Stocks Int Stocks 40% Bonds 20% 0% SHORTFALL PROBABILITY Source: CDI Advisors CDI Advisors LLC 9 Example: “Fully Funded” Plan No Matching Bond Matching Bond MVA $87.51 $87.51 Policy Portfolio US Stocks 14% 39% Int Stocks 22% 29% Bonds 64% 32% Return Geom 6.49% 7.53% Return Arithm 6.73% 8.12% St Deviation 7.11% 11.29 Shortfall Prob 8.7% 9.7% Shortfall Size 9.7 6.8 Surplus Size 23.9 9.6 CDI Advisors LLC 10
  • 17. Conclusion Some allocation to equities may be necessary Ask the right questions! CDI Advisors LLC 11

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