SOA 08 Annual Meeting

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

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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™

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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

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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

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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?

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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

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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%

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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

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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

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Bottom line: How much into Equities?

It depends…

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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

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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

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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.

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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

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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

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…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?

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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!