Transcript The Defined Benefit Dilemma The Underfunding Crisis

Asset/Liability Management
Pensions and Other Post Employment Benefits
State Association of County Retirement Systems (SACRS)
February 6, 2007
Navigating Public Pensions & OPEB
with Liability Driven Investments
Ryan Labs (www.ryanlabs.com)
Sean McShea
Chris Adair
Jason Johnson
Ryan Labs Asset Management
[email protected]
[email protected]
[email protected]
1
Asset/Liability Management
Pension & OPEB:
Problems
Problems:
1.
Under Funding
2.
Higher Net Costs (Accrued Liabilities)
3.
Higher Contributions
4.
Compounding in reverse (Negative Leverage)
5.
CPI & COLA inflation < Medical inflation
6.
Demographics
7.
Mortality tables
8.
Sunset communities vs. Sunrise communities
Ryan Labs Asset Management
2
Asset/Liability Management
Pension & OPEB:
Crisis In Public Plans
Causes:
1. Silo effect (optimization in isolation)
2. Agency problem (no one in charge)
3. Morality issues (wealth transfer)
4. Asset Only Framework (mean variance models)
5. Actuarial Smoothing (No economic content)
6. Pro forma Accounting Return Assumptions
7. Lack of Financial Economics in pension practices
8. Peer Group (Beauty Contest)
Ryan Labs Asset Management
3
Asset/Liability Management
Solution Framework
Objectives
Fund liabilities at lowest relative cost
Fund liabilities at lowest relative risk
Enhance Financial Statements
Enhance Credit Rating
Rules
GASB 25, GASB 45
Teams
Assets v. Liabilities
Playing field
Present Value
Time
Annual Financial Statements
Scoreboard
Custom Liability Index
Ryan Labs Asset Management
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Asset/Liability Management
Client Objectives:
Public Funds
Client
Corporation
Nuclear
Decommissioning
Hospitals
Endowment/
Foundation
Pensions
Medical
Liabilities
Plan
Terminations
Custom
Distribution
Custom
Grant
States &
Municipalities
Insurance
Endowment
Pensions
General
Accounts
Medical
Liabilities
Life
Construction
Projects
Workers
Compensation
Defeasance
Programs
Self
Insurance
Property &
Casualty
Taft-Hartley
Incurred
Liabilities
General
Accounts
Pensions
Medical
Construction Liabilities
Pension
OPEB Medical
Lottery
Prepaid Tuition
Defeasance
Worker’s Compensation
Ryan Labs Asset Management
5
Asset/Liability Management
Public Plans:
Assumptions
Government will not default on it promise
Prefunding ensures intergenerational fairness
Current stakeholder pays fair share current cost
Future stakeholder pays only for future cost
Minimize current costs by capturing equity risk premium
Protect the municipal bond rating and bonding capacity
Participants exchange direct for deferred compensation
Stakeholders own the pro rata share of balance sheet
Ryan Labs Asset Management
6
Asset/Liability Management
Public Plans:
Three Key Levers
1. Benefit Management
Current benefits, Benefit enhancements
2. Contribution strategy
% of active payroll
Constrained by budget
3. Asset Allocation
Capture equity risk premium (Reduce cost)
Avoid risk
Ryan Labs Asset Management
7
Asset/Liability Management
Teams:
Asset/Liability Watch (December 2006)
2006: Good year !!
Ryan Labs Asset Management
8
Asset/Liability Management
Assets vs. Liabilities
Funding Volatility (December 2006)
Ryan Labs Asset Management
9
Asset/Liability Management
Risk:
Risk is Based on the Objective
Risk is best defined as NOT meeting the client objective:
No Risk
=
Assets Match Liabilities
High Risk
=
Assets Don’t Match Liabilities
(Surplus Volatility)
Low Risk
=
Assets Behave Like Liabilities
New Sharpe Ratio
=
Return of Portfolio – Return of Objective
STD (Portfolio Return – Objective Return)
Ryan Labs Asset Management
10
Asset/Liability Management
GASB 25 versus FASB 87/158
(Difference between Public & Private)
Private versus Public
Authority
FASB (Norwalk, CT)
GASB (Norwalk, CT)
Inception
1973
1984
Mission
Financial reporting
Output
Useful, transparent information
Ongoing
Focus
Point in time snapshots
Bankruptcy
Settlement focus
Remote
Solvency
Increased focus
Not reported
Users
Shareholders
Stakeholders
Ryan Labs Asset Management
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View in perpetuity
Asset/Liability Management
Public Pension Plan
Funding Policy v. Investment Policy
Funding Policy (Actuary) v. Investment Policy (Risk Manager)
Finance
Domain
Actuary
Framework
Actuarial cost methods
Policy Issue
Objective
Assumptions
Asset Management
Short Long bonds
Hedging, risk
How to allocate plan
assets
How much to contribute
When
Smooth, predictable
contributions
Economic, prudent
Finance
Actuary
Asset Management
Smoothed, amortized
Scorekeeping
Mark to market
Actuarial gains/(losses)
Contributions as % of active
payroll
Ryan Labs Asset Management
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Financial statements
Rating agency
Asset/Liability Management
Time: Annual Financial Statements
(Private vs. Public)
Annual Reporting Requirements
Pension contribution annually
Based on present value of assets and liabilities
Private/Corporate America
Pension Expense
Pension Contribution
Surplus or Deficit
Public/State or City
Revenue & Expense
Funding Cost
Surplus or Deficit
Ryan Labs Asset Management
(Income Statement)
(Cash flow Statement)
(Balance Sheet)
(Municipal rating)
(Current tax rates)
(Generational or resident equity)
13
Asset/Liability Management
Rules: GASB 43 & 45
(Non Pension Related Liabilities)
OPEB
Other post employment benefits
GASB 43
Financial Reporting for Post Employment
Benefit Plans Other Than pension plans
Requires accrual of liabilities
Replaces pay-as-you go basis
GASB 45
Requires accrual of OPEB expense
Ryan Labs Asset Management
14
Asset/Liability Management
Playing Field: Time Frame
Long Term Horizon v. Solvency
Public Plans : Horizon (10 to 20 year horizons)
Prevailing Pension practice
Smoothing Assets (5, 10, 15 years)
Amortization of Liabilities (15 to 30 years)
Fully funding (assumes asset allocation return of 8%)
Assumes Sponsorship Longevity
Private : Economic Solvency
Best Practice methodology
Fair Value of Assets and Liabilities (Basel II)
No smoothing
100% interest rate driven
Mark to Mark Valuation on Assets vs. Liabilities
Ryan Labs Asset Management
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Asset/Liability Management
Playing Field:
Solvency / Present Value $
Future value (Projected benefit payments)
Inflation, COLAS, Mortality
Labor costs/demographics
Plan design
Don't know the future value of assets
Present value
Determines funding adequacy
Required by SEC/FASB/PPA 2006
100% interest rate driven
Priced using yield curve
Ryan Labs Asset Management
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Asset/Liability Management
Public Fund Risk:
Unpleasant Issues
Public Pension & OPEB Plans
Bankruptcy
Taxpayer will pay
Stakeholders
Taxpayers may escape deficits
Intergenerational risk sharing
Long Term Focus LT focus captures rewards without
commensurate risks
Risk (Traditional)
Annual contributions as a percent of
active payroll or tax revenue
Smoothing
Smoothing masks risk
Ryan Labs Asset Management
17
Asset/Liability Management
Problem: Investment Process
Prevailing Practice vs. Best Practice
Current Actuarial Models and Methods
Current practice is not best practice
Financial Economic models expose flaws in standard modes
Calls for revision of actuarial training and practice
Financial Economics and Actuarial Practice
Tony Day
Presented at The Great Controversy: Current Pension Actuarial Practice in Light of Financial
Economics Symposium
Sponsored by the Society of Actuaries
Vancouver
June 2003
Ryan Labs Asset Management
18
Asset/Liability Management
Problem: Pro Forma Returns
Risk Premium Review
Starting Dividend Yield
Growth in Real Dividends
Change in Valuation Levels*
Cumulative Real Return
Less Starting Bond Real Yield
Less Bond Valuation
Change**
75 Years,
Starting Dec.
1925
5.40% (a)
1.00%
1.70%
8.10%
Prospects
January
2006
1.94%
1.00%
?????
2.94%±
3.70% (b)
2.10% (c)
Cumulative Risk Premium
-0.40%
?????
4.70%
0.84%
(a) Dividend Yield of S&P 500 Index
(b) 3.7% yield, less an assumed 1926 inflation expectation of zero
(c) The yield on US government inflation-indexed bonds
Based on Ibbotson data and First Quadrant research
Ryan Labs Asset Management
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Asset/Liability Management
Problem: Stakeholder
Current vs. Future
Generational Equality (Fair share of costs)
Pro Forma mechanism transfers risk ($1 equity > $1 bonds)
Reward is captured today, risk is transferred to the future
Smoothing feels good but contains no “economic” content
Current practice favors current management, taxpayers, plan
participants, politicians, at the expense of future
shareholders and stakeholders (taxpayers).
Source:
Risk Transfer in Public Pension Plans, Jeremy Gold, PRC WP 2002-18, 2002, Pension Research Council
The Wharton School, University of Pennsylvania
Ryan Labs Asset Management
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Asset/Liability Management
Problem for Stakeholders
Expected Returns
Sub Optimal Decision Making
Benefit leakage (wage / pension negotiation)
Asset Allocation focused on asset only framework
Granting of valuable options (DROPS, skim funds)
Costly financing options (i.e. Pension Obligation Bonds)
Wealth transfer devices (i.e. Infrastructure Securitization)
Source:
Risk Transfer in Public Pension Plans, Jeremy Gold, PRC WP 2002-18, 2002, Pension Research Council
The Wharton School, University of Pennsylvania
Ryan Labs Asset Management
21
Asset/Liability Management
Problem: Actuarial Valuations
(Mispricing Liabilities)
Actuarial Flaw: (Benefit Management & Funding)
Single Discount Rate
(Assumes “horizontal” term structure)
Not fully determined by market interest rates
(Usually 100 to 400 plus basis points too high)
Present Value calculation performed annually
(Usually the month plus delinquent)
Liability Term Structure not visible
(Short, Intermediate, Long, Very Long)
Ryan Labs Asset Management
22
Asset/Liability Management
Problem: Disclosure
A New York City Pension Story
Robert North, Chief Actuary of New York City
Actuarial methods based on actuarial interest rate (AIR)
Ignores financial economics
North ratio: NYCRS 70% Funded ($14 B deficit)
2005 CAFR : NYCRS 99% Funded (No deficit)
Source: Life & Pensions magazine, March 2006
Ryan Labs Asset Management
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Asset/Liability Management
Problem : Generic Indexes
(Mean Variance Models)
Mean Variance Models based on Generic Indexes
Represent the market (Lehman Aggregate, S&P 500)
(Subjective methodology)
(Potential bias = Investment Banking, Trading)
NOT based on client liability schedule
(Unique to each client)
Does NOT represent clients’ true objective
Ryan Labs Asset Management
24
Asset/Liability Management
Scoreboard:
Custom Liability Index
Goal
Measure growth, size, shape of liabilities
Features
Market value, yield, duration, returns
Return
Total return, index levels
Performance Money management index
Quantifies asset allocation
Ryan Labs Asset Management
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Asset/Liability Management
Solutions:
Adopt Liability Benchmark
Ryan Labs Asset Management
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Asset/Liability Management
Structure Difference
Liabilities vs. LB Aggregate
Total Lives
Duration Cell
SHORT (0.00 - 0.50)
0.5 - 1.5
1.51 - 2.5
2.51 - 3.5
3.51 - 4.5
4.51 - 5.5
LMTD (0.51 - 5.50)
5.51
6.51
7.51
8.51
9.51
-
6.5
7.5
8.5
9.5
10.5
INTER (5.51 - 10.50)
10.51
11.51
12.51
13.51
14.51
15.51
16.51
17.51
18.51
19.51
-
11.5
12.5
13.5
14.5
15.5
16.5
17.5
18.5
19.5
20.5
LONG (10.51 - 20.50)
20.51
21.51
22.51
23.51
24.51
25.51
26.51
27.51
28.51
29.51
-
21.5
22.5
23.5
24.5
25.5
26.5
27.5
28.5
29.5
30.5
VLONG (20.51 - 30.50)
ULTRA (30.51+)
TOTAL
Note:
Port (%)
YTW
1.8
5.0
4.3
4.4
4.4
4.5
4.5
22.0
4.4
4.4
4.3
4.3
4.2
21.6
4.0
3.9
3.7
3.6
3.4
3.3
3.1
3.0
2.8
2.7
33.5
4.9
4.7
4.6
4.5
4.4
4.6
4.5
4.6
4.6
4.7
4.7
4.6
4.7
4.8
4.8
4.9
4.9
4.9
4.9
4.9
4.9
4.9
4.8
MDUR
0.2
0.9
1.9
2.9
3.9
4.9
2.9
5.8
6.8
7.8
8.8
9.7
7.7
10.7
11.7
12.6
13.6
14.6
15.6
16.5
17.5
18.5
19.5
14.7
Lehman Aggregate
Port (%)
YTW
0.4
2.3
7.4
10.9
9.1
19.1
18.8
65.3
15.1
5.5
2.5
1.9
1.2
26.3
1.5
2.5
2.2
1.2
0.2
0.3
0.0
0.0
0.0
0.0
8.0
5.1
4.9
5.0
5.2
5.5
5.2
5.3
5.1
5.0
5.0
5.1
5.2
5.4
5.6
5.4
5.5
5.6
4.9
0.0
5.1
0.0
0.0
5.4
MDUR
0.3
1.2
1.9
2.9
4.0
5.0
3.5
5.8
6.9
7.6
8.8
9.6
6.6
10.7
11.7
12.7
13.5
14.4
15.8
0.0
17.6
0.0
0.0
12.3
Difference
Port (%)
YTW
1.3
2.6
-3.1
-6.5
-4.7
-14.6
-14.3
-43.2
-10.7
-1.1
1.8
2.3
2.9
-4.7
2.5
1.4
1.5
2.4
3.2
3.0
3.1
3.0
2.8
2.7
25.5
-0.2
-0.2
-0.4
-0.7
-1.1
-0.6
-0.8
-0.5
-0.4
-0.4
-0.4
-0.6
-0.6
-0.8
-0.5
-0.6
-0.7
0.0
4.9
-0.2
4.9
4.9
-0.6
MDUR
0.0
-0.2
0.0
-0.1
-0.1
-0.2
-0.6
0.0
-0.1
0.1
0.0
0.1
1.1
0.0
0.0
0.0
0.1
0.2
-0.2
16.5
-0.1
18.5
19.5
2.4
2.5
2.4
2.3
2.1
2.0
1.8
1.7
1.6
0.8
0.5
4.8
4.8
4.8
4.8
4.8
4.8
4.7
4.7
4.7
4.7
20.5
21.4
22.4
23.4
24.4
25.3
26.3
27.3
28.2
29.3
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
2.5
2.4
2.3
2.1
2.0
1.8
1.7
1.6
0.8
0.5
4.8
4.8
4.8
4.8
4.8
4.8
4.7
4.7
4.7
4.7
20.5
21.4
22.4
23.4
24.4
25.3
26.3
27.3
28.2
29.3
17.6
3.5
100.0
4.8
4.7
4.7
23.9
36.2
12.7
0.0
0.0
100.0
0.0
0.0
5.2
0.0
0.0
5.0
17.6
3.5
0.0
4.8
4.7
-0.5
23.9
36.2
7.7
YTW = Yield To Worst
Mdur = Modified Duration
Ryan Labs Asset Management
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Asset/Liability Management
Solution:
First Steps
Reduce Risk, Protect Expected ROA
Ryan Labs Asset Management
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Asset/Liability Management
Solutions:
Strategy Results
Strategy
Annualized
Returns
Interest
Rate
Hedge
Annualized Correlation
Tracking
to
Error
Liabilities
% Bonds
1
Current Strategy (LB Agg)
8.37%
5%
16.73
-9%
40%
2
Liability Duration Strategy
9.70%
23%
12.17
36%
40%
3
Dollar Duration Strategy
10.51%
39%
10.96
52%
40%
Bonds
Estimated Economic Dollar
Surplus Gain/Loss
Strategy
-100
0
100
Interest
Rate
Hedge
0
Current Strategy (LB Agg)
(83,838,242)
0
83,838,242
5%
40%
1
Liability Duration Strategy
(57,754,236)
0
57,754,236
23%
40%
2
Dollar Duration Strategy
(38,444,879)
0
38,444,879
39%
40%
Ryan Labs Asset Management
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Asset/Liability Management
Scoreboard:
Custom Liability Index
Goal
Measure growth, size, shape of liabilities
Features
Market value, yield, duration, returns
Return
Total return, index levels
Performance Money management index
Quantifies asset allocation
Ryan Labs Asset Management
30
Asset/Liability Management
Solution: Custom Liability Index
Benefits
Represents client objective (funding target)
Supports strategic & tactical asset allocation
Benchmark for asset management
Benchmark for performance measurement
Benchmark for risk management control
Foundation for risk budgeting
Ryan Labs Asset Management
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Asset/Liability Management
Solution: Asset Allocation
Liability Driven Allocation
Asset allocation based on two portfolios:
Beta Portfolio
= Liability Portfolio
Bonds to outgrow liabilities
Interest rate hedge
Bonds, Futures, Swaps
Alpha portfolio
= Performance Portfolio
Non Bonds
Without liability constraints
Rebalancing
= Success is rebalanced back to Beta
Harvest gains
Ryan Labs Asset Management
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Asset/Liability Management
Objective:
Understand the Liabilities
Ryan Labs Asset Management
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Asset/Liability Management
Problem:
Negative Leverage
Ryan Labs Asset Management
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Asset/Liability Management
Solution: New Approach
(New methodologies)
Transparency
Fair Value Accounting
Asset/Liability Management
Focus on Asset Allocation (Strategic/Tactical)
Alternative Asset Classes (Low correlation)
Ryan Labs Asset Management
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Asset/Liability Management
Solution: New Approach
(New methodologies)
Traditional Approach
LDI Approach
Liability Risk
Asset Mix Risk
Active Risk
Source: Leo de Bever, Ontario Teachers' Pension
Ryan Labs Asset Management
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Asset/Liability Management
Solution: Move Away From
Single Focused Strategies
Source: First Quadrant/Research Affiliates
Ryan Labs Asset Management
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Asset/Liability Management
Assets vs. Liabilities Monitor
(Last 20 years ending 2005)
Ryan Labs:Assets vs. Liabilities Monitor
Annualized
Return
Annualized
Return
Twenty Year Returns - Period ending 12/31/05
16%
16%
Ryan Labs Liability
Index is represented by
the Treasury STRIP
curve (1 thru 25 years)
14%
Wilshire Large
Cap Value
12.15%
• • •• • •
•
12%
•
•Liability
Labs
• • Ryan
P&I Asset
10.61%
10%
Merrill Lynch
Yankee
8.63%
Ryan Labs
3yr. GIC
6.75%
•
6%
Ryan Labs
6 mo. Bill
5.24%
•
•
•
•
•
• •
•• •
••
•
•
•
•
•
• Ryan Labs
•
• • • • • Wilshire Small
Russell 2000
11.17%
•
12%
Cap Growth
12.00%
•
MSCI EAFE
10.00%
•
11.07%
10%
30yr. Treasury
8.79%
•
Ryan Labs
10yr. Treasury
7.58%
FInancial Times
Equity Pacific
7.30%
8%
•
Ryan Labs
5yr. Treasury
6.95%
6%
Ryan Labs
2yr. Treasury
6.16%
Short
0
Merrill Lynch
High Yield
9.26%
Lehman
Aggregate
7.88%
8%
•
S&P 500
11.93%
14%
Intermediate
2
4
6
Very Long
Long
8
10
12
14
16
18
20
22
24
Volatility of Total Return (STD)
Sources: Ryan Labs, Inc.- Standard & Poor's Corporation - Lehman Brothers - Merrill Lynch - Morgan Stanley Capital International - Frank Russell Company - Financial Times - Wilshire Asset Management - Crandall, Pierce & Company
The information presented herein was compiled from sources believed to be reliable. It is intended for illustrative purposes only, and is furnished without responsibility for completeness or accuracy.
Ryan Labs Asset Management
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Past performance does not guarantee future results.
Asset/Liability Management
Asset/Liability Return Difference
And Tracking Error (Last 20 years)
Asset/Liability Return Difference
2%
0%
4%
Ryan Labs Liability
Index is a proxy
for pension plans
Ryan Labs
Liability Index
n
-2%
• • • •• •
•
••
•••
• •
•
Lehman
GC Long
•
Ryan Labs
•• •
Merrill Lynch
30yr. Treasury
Yankee
•
•
•
•
Ryan Labs
•
10yr. Treasury
••
•
-4%
Ryan Labs
5yr. Treasury
2%
Wilshire Large
Cap Value
•
S&P 500
•
Wilshire Large
Cap Growth
•
0%
P&I Asset
n
•
•
•
•
Ryan Labs
2yr. Treasury
•
•
•
Merrill Lynch
Convertible
Merrill Lynch
High Yield
Lehman
Aggregate
Russell 2000
•
Ryan Labs
3yr. GIC
-4%
•
•
•
FInancial Times
Equity Pacific
Ryan Labs
6 mo. Bill
-6%
0
2
4
6
8
10
-2%
MSCI EAFE
12
14
16
18
20
22
24
•
-6%
Annualized Excess Returns vs. Ryan Labs Liability Index (%)
Annualized Excess Returns vs. Ryan Labs Liability Index (%)
4%
26
Annualized Tracking Error (TE) vs. Ryan Labs Liability Index (%)
Ryan Labs Asset Management
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Asset/Liability Management
Solution:
Equity Correlation to Liabilities
Equity Correlations to Liabilities
Time Horizon
Annualized
Return on S&P
500
Annualized
Return on
Liabilities (1)
Correlation
(S&P v. Liabilities)
1950 to 1960
16.16
1.54
(0.20)
1960 to 1970
8.18
1.47
0.21
1970 to 1980
8.44
4.73
0.25
1980 to 1990
13.94
13.69
0.40
1990 to 2000
17.44
11.24
0.26
2000 to 2002
(17.12)
10.71
(0.60)
2002 to 2004
19.45
6.17
0.02
2004 to 2006
10.21
5.95
(0.19)
(1) RL Treasury Long Index from 1949 to 1990, RL Liability Index from1991 to 2006,
Ryan Labs Asset Management
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Asset/Liability Management
Solution: Next Steps
1.
Adopt Liability Driven Investment strategy
2.
Design Custom Liability Index
3.
Document economic solvency
4.
Document cash flow budgeting
5.
Segregate Liability portfolio
6.
Segregate performance portfolio
7.
Reduce deficit, harvest gains back to liabilities
8.
Grow surplus
9.
Monitor risk
10. Document, Document, Document
Ryan Labs Asset Management
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Asset/Liability Management
Solution:
Small Steps
1.
Move from prevailing practice to best practice
2.
Create economic and actuarial reporting
3.
Replace Policy benchmark with Liability benchmark
4.
Understand limitations of peer group analysis
5.
Structure fixed income to liabilities
6.
Segregate Surplus (performance portfolio)
7.
Positive story to trustees and rating agencies
8.
Protect defined benefit pension plans
Ryan Labs Asset Management
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Asset/Liability Management