soa 08 annual meeting
TRANSCRIPT
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
1
For Institutional Investor Use Only. Not For Public Distribution.
Equities in Pension Portfolios
Paul Bosse, CFAPrincipal, Investment Strategy GroupOctober 19, 2008
> 2
A changing paradigm for pension investing
Asset liability studies are key Asset allocationProcess
Recognized annuallySmoothedVolatility
Cost vs. volatilityTotal returnReturn
Shortfall (long run) Volatility (short run)ShortfallRisk
FAS 158 (2006): balance sheet impactFAS 87 (1985)Regulation
PPA (2006): funding cost impactERISA (1974)Legislation
New paradigmOld paradigm
Prepared by Vanguard Institutional Advisory Services™
2
> 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
0
2
4
6
8
10
12
0 5 10 15 20 25
Risk
Retu
rn
CashLong bonds
Equities
Bonds
Vanguard estimates. Absolute volatility based on standard deviations of portfolio returns. Surplus volatility based on how closely pension plan assets track plan liabilities; this is the risk that the PPA 2006 and FASB ruling are addressing.
Liability efficient factor
-2
0
2
4
6
0 5 10 15 20Risk versus liability
Ret
urn
vers
us li
abili
ty
CashBondsLong
bonds
Equities
> 4
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 Cash1926-2007
1
10
100
1,000
10,000
1925 1935 1945 1955 1965 1975 1985 1995 2005
Log
Sca
le
10 .5%
5 .5%
3 .9%
3
> 5
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?
> 6
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
4
> 7
Doing LDI by adjusting the bond mix A recipe page
119 88 107 9.8%8.4%60%100%0%0%70%
120 87 107 9.9%8.4%48%75%0%25%70%
122 85 107 10.0%8.4%36%50%0%50%70%
122 85 107 10.0%8.3%30%0%100%0%70%
125 82 107 10.5%8.4%12%0%0%100%70%
114 92 106 8.5%7.9%80%100%0%0%60%
116 90 106 8.4%7.9%64%75%0%25%60%
118 88 106 8.5%7.9%48%50%0%50%60%
119 87 106 8.5%7.7%40%0%100%0%60%
122 84 106 9.2%7.9%16%0%0%100%60%
112 93 105 7.2%7.5%80%75%0%25%50%
115 90 105 7.2%7.5%60%50%0%50%50%
116 89 105 7.1%7.3%50%0%100%0%50%
120 85 105 8.0%7.4%20%0%0%100%50%
OutcomeOutcomeOutcomeVolatilityReturnBondsDurationBondBondRatio
PositiveNegativeExpectedA/L RatioExpectedHedgedExtendedLongLe AggEquity
Scenarios: Funding
% LiabilityFixed Income Allocation
Expected Outcome: Rates flat Equities +10%Negative Outcome: Rates -1% Equities -10%Positive Outcome: Rates +1% Equities +20%
> 8
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: Improve funding status
Primary asset objective:High returns
Primary risk:Solvency risk
Primary funding objective:Maintain funding status
Primary asset objective:Manage volatility relative to liabilities
Primary risk:Funded ratio volatility
Stocks Bonds Extended Bonds
120% funded100% funded80% funded
5
> 9
Company specifics key the equity allocation processAn incomplete laundry list
Plan Objective: what is the fund mission?- Case study
Drivers:Funded level
– drives portfolio aggressivenessFinancial strength
– higher strength allows more risk takingCompany’s sensitivity to economic cycle
– can reduce risk takingFund profile (closed/open, participant age)
– open plan requires more returnReturn on corporate capital
- high ROC pushes for lower contributionOne that shouldn’t be here:
- peer tracking
> 10
Bottom line: How much into Equities?
It depends…
1
1PageFor Institutional Investor Use Only And May Not Be Used With The General Public
Bringing “Equity” to the Issue of Equity Investments in Pension Plans
2Page
Risk Budget is Built Around the Liability Benchmark
• 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.
Years
Pro
ject
ed B
enef
it P
aym
ents Current Spot Curve
ABO cash flows should be used for risk management
• Future salary increases should 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
2
3Page
• Beneficiaries can lose “value” if the plan sponsor claims bankruptcy and the plan is under-funded
• Consequently, beneficiaries’ risk appetite changes as the funded status changes
Identifying the Best Interests of Participants
Participants only lose when a plan sponsor with an underfunded plan goes bankrupt
Participants have limited downside (PBGC put) and limited upside (do not own surplus)
Poorly funded
Fully funded PBGC liability
Fully funded termination liability
Beneficiary Value
Graphs shown are for illustration purposes only.
Poorly funded
Fully funded PBGC liability
Fully funded termination liability
Beneficiary Risk Appetite
4Page
Risk taking should be dynamic, changing with funded status, corporate credit, expected growth and other conditions and avoids large beta risk
WellFunded
Strong
PoorlyFunded
Weak
Status: A/L Matched
• Take moderate level, tax-efficient, dynamic risk to develop usable surplus
Status: A/L Matched
• Take low level, tax-efficient, dynamic risk to develop usable surplus
• Negative investment performance could trigger bankruptcy
Status: Materially Underfunded
• Sponsors should take risk to try to improve funded status
• May not be possible to avoid bankruptcy without taking risk
Status: Partially Funded
• Unfunded pension liabilities treated as a hard debt
• Companies should fund the plan to take advantage of the tax arbitrage between the corporation and the pension plan
“Dynamically de-risk”
“PBGC end of game’’
Shareholder Interests Are Well AlignedDecision-making framework
Graphs shown are for illustration purposes only.
3
5Page
Integrated Pension Solutions (IPS)
Enterprise Risk
Management (Beta Tilt)
Integrated Pension
Solutions
EnhancedCash
synthetic
Diversified Alpha
Sources
PerformancePortfolio
Explicit Risk Budget
Liability Hedge
EnhancedCash
Risk Management
Portfolio
synthetic
Risk Allocation
Tail Risk Protection
Cash & Long Duration
Treasuries
6Page
11/3
0/20
0712
/31/
2003
12/3
1/19
9912
/31/
1995
12/3
1/19
9112
/31/
1987
12/3
1/19
83
12/3
1/19
79
12/3
1/19
75
12/3
1/19
71
12/3
1/19
67
12/3
1/19
63
12/3
1/19
59
12/3
1/19
55
12/3
1/19
51
12/3
1/19
47
11/30/2007
12/31/1996
12/31/1985
12/31/197412/31/1963
12/31/1952
-0.70
-0.60
-0.50
-0.40
-0.30
-0.20
-0.10
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
Correlation of S&P 500 Return and Moody's AA Bond Return
0.6-0.70.5-0.60.4-0.50.3-0.40.2-0.30.1-0.20-0.1-0.1-0-0.2--0.1-0.3--0.2-0.4--0.3-0.5--0.4-0.6--0.5-0.7--0.6
Start Date
End Date
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
4
7Page
Everyone Believes in Risk Premiums…
• Capital Asset Pricing Model (CAPM)• Arbitrage Pricing Theory (APT)• Building Block Approaches
EROA = rf + weighted average risk premium + α
8Page
…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?
5
9Page
Paying Lower Taxes on Highly-Taxed Assets Should be Attractive to Stockholders
Graphs shown are for illustration purposes only.
• 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
Core Business
Pension plan containing equities
Stock Price
Highly Taxed Assets
Shareholder After-tax Return
Capital GainsCapital Gains High taxesHigh taxes
Core Business
Pension plan containing highly
taxed assets
Stock Price Equities
Shareholder After-tax Return
Capital GainsCapital Gains Capital GainsCapital Gains
Present value of tax savings is approximately 13% - 15% of the equities currently held in the pension plan.
Individual Shareholder
Portfolio
Individual Shareholder
Portfolio
Shift highly taxed asset exposure into pension plan
10Page
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
Bringing "Equity" to the Issue of Equity Investments in Pension Plans
Dimitry Mindlin, ASA, MAAA, PhDPresident
CDI Advisors LLCOctober 19, 2008
Asset Allocation
2CDI Advisors LLC
•Objectives must be perfectly clear
•Ask a question, then look for an answer
•State a problem, then look for a solution
Stakeholders and Objectives
3CDI Advisors LLC
•Plan Participants: benefit security
•Shareholders/taxpayers: cost of providing benefits
Optimization
4CDI Advisors LLC
•Plan Participants: maximize safety given cost
•Shareholders/taxpayers: minimize cost given risk
•What’s your objective?
Commitments and Assets
5CDI Advisors LLC
•$100 in 10 years
•$100 in 35 years
•Market Value of Assets $70.00
“Marked‐to‐Market” Accounting
6CDI Advisors LLC
•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
The Funding Problem
7CDI Advisors LLC
•Policy portfolio?
•(Partially) matching bond portfolio?
•Additional contributions?
Cost‐Risk Frontiers
8CDI Advisors LLC
Source: CDI Advisors
0
5
10
15
20
25
30
35
40
45
0%5%10%15%20%25%30%35%40%
COST
SHORTFALL PROBABILITY
Cost‐Risk Efficient Frontiers with and w/o Matching Bonds
w Matching Bond w/o Matching Bond
100/0
100/0
52/48
100/0
89/11
100/0
Optimal Portfolios
9CDI Advisors LLCSource: CDI Advisors
0%
20%
40%
60%
80%
100%
SHORTFALL PROBABILITY
Optimal Policy Portfolios ‐No Matching Bond
US Stocks
Int Stocks
Bonds
0%
20%
40%
60%
80%
100%
SHORTFALL PROBABILITY
Optimal Policy Portfolios ‐Matching Bond
US Stocks
Int Stocks
Bonds
Example: “Fully Funded” Plan
10CDI Advisors LLC
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
Conclusion
11CDI Advisors LLC
Some allocation to equities may be necessary
Ask the right questions!