Pension Finance: Putting the Risks and Costs of Your Defined Benefit
Plan Back Under Your Control, by Barton Waring, is now available from all
the usual book vendors. It’s a CFA Institute book, published by Wiley.
This important book offers a
window into the inner workings of the DB pension plan, and by looking through
that window the reader learns how to bring the plan under control. As anyone
reading this knows, it has been difficult or impossible for the non-actuary to
have any idea of what is going on inside the plan, and they have had to
surrender nearly complete control to the actuaries as a result.
And the results have been disappointing
to say the least. Sponsors have experienced a continuous flow of negative
surprises in pension contribution requirements and in pension expense accruals.
They’ve experienced a completely illogical and unexplained swing from perfect
health in the 1980s and 1990s to a continuous disaster of bad health throughout
the first decade of the new century. Funded ratios are well below parity in
both corporate and governmental plans, representing real current debt owed by
the sponsor.
Managing the pension plan should
not be all that hard. After all, the pension plan is just a big bond, an
aggregate pile of deferred life annuities and present life annuities. There are
complexities, of course, but no more so than for many other bonds and
securities actually found in the markets. To finance such an obligation should
not be a mystery, and by using modern finance tools instead of traditional
actuarial finance tools, the mystery is immediately removed.
To fix these plans and bring
them back under control, we need management accounting treatments that
transparently get this financing problem right. The book is a complete re-write
of pension actuarial finance into market value terms, of course getting the
discount rate right (many of us have done this before) but going far beyond
that point to cover many critically important points never made before. The
finance itself isn’t particularly ground breaking—but it doesn’t need to be.
But applying solid basic finance to the pension finance problem we learn many
important new things about pensions and their behavior that have previously been
obscured in the arcana of the traditional actuarial approach:
·
The book shows how amortizations and smoothings increase
risk, rather than reducing it.
·
The book shows the economic nature of the
several liabilities that are important—the full economic liability, the present
value of future benefit payments, the accrued liability, etc, and the important
ways in which they relate to each other.
·
The book shows that normal cost is just an
amortizing payment—like a mortgage amortization payment—of the difference
between a larger liability measure, the present value of all future benefit
payments, and the accrued liability. Similarly, the makeup contribution is just
the difference between the accrued liability and the actual assets on hand.
This latter difference should be paid immediately, but one can demonstrate
amortizations for it as well. These are financing concepts no more complex than
paying off a mortgage, or saving for the kids’ college. People think that the
actuarial numbers are not comprehensible by non-actuaries, but in fact they are
completely comprehensible when reduced to such economic basics.
·
Importantly, with simple simulations the book
shows that the continued used of the traditional expected return assumption
nearly guarantees eventual failure of the pension plan—if not in this
generation then likely in the next. And after 11+ years of roughly zero returns
where the actuaries were expecting not the 4% or so of the risk-free rate, but
instead 8% or so for public plans and 6% or so for corporate plans, the assets
are far less than what they “should” have been (half, for public plans, and
about ¾ for corporate plans). No wonder pensions are in a quandary and near
failure today, as there has been far too much faith and reliance put into the
false notion that a long term investor will get the expected return over time.
The only correct discount rate for payments that have to be made without risk
is not the expected return on assets or the risky high quality corporate credit
rate, of course, but rather the risk-free rate.
·
And best of all, the book shows how with market
value numbers one can see a path that nearly completely removes risk from the
plan simply by hedging appropriately (think LDI, but not the ad hoc version
seen today, a more complete version based on solid finance theory). And by
removing risk, the book means removing volatility of surplus, volatility of
pension expense, and volatility of contributions. This would make pensions much
more user friendly to plan sponsors, who are tired of the seemingly endless
stream of negative surprises brought to them by their pension plan using the
traditional actuarial finance methods.
·
The book shows the misleading duration of the
accrued liability as it is conventionally computed today. It actually has no
duration of its own, but instead its duration is derived from the difference
between the duration of the present value of benefits and the present value of
future contributions. Traditional duration measures presume that the accrued
liability is freestanding. If hedged using that traditional duration, the hedge
won’t remove risk from contributions or pension expense.
The biggest point is one of
salvation, however. The path to solvency and health for pension plans is
through market value management. There is no other way to rationalize the
employees’ demand for benefits with the ability of the employer to pay for
benefits. The DB plan is one of the best vehicles ever designed for taking a
portion of one’s working life income and setting it aside for one’s retired
life income. We want them to survive. The book shows the path. There is pain
involved, of course, as the traditional actuarial models doled out generous
benefits and told the employer and the employees that they cost only about half
of what they really cost. But there is also a path to success. The book has a
section devoted to the tough love process of getting from where we are today,
back to a healthy pension system.
This book will prove compelling
to anyone that has struggled to peer through the actuarial mist and figure out
what is really happening, “under the hood” of the DB plan, and who wonders why
these plans have to feel so risky to the sponsor. The answer is, they don’t
have to feel so risky. I think it is fair to say that this book presents a
dramatic new set of insights into pension plan risk and cost management, and is
the leading work—perhaps the only economically sound work—on the topic in its
fullness.
While its first use is as a tool
for pension management accounting, it is of course as blueprint for where our
GAAP accounting requirements need also to go, at all levels including the IASB,
FASB, and GASB.
The book is exceedingly well
reviewed, with a foreword by Robert C. Merton of MIT and positive reviews by
(among many others) Brad Belt (former PBGC head), Guus Bonder (lead pension
guru in Holland), Frank Fabozzi (editor, Journal of Portfolio Management),
Richard Grinold (former CIO of Barclays Global Investors), Roger Ibbotson
(Yale; Ibbotson Associates), Marty Leibowitz (Morgan Stanley), Lionel
Martellini (Princeton), Olivia Mitchell (Wharton), Dallas Salisbury (Employee
Benefits Research Institute), and Noboru Terada (leading pension thinker in
Japan).
While the book is widely available, one oft-used source is Amazon.com: http://www.amazon.com/s/ref=nb_sb_ss_i_2_15?url=search-alias%3Daps&field-keywords=pension+finance+waring&sprefix=pension+finance.
