MANAGING LIABILITIES: THE TRUE PENSION OBJECTIVE Thomas M. White and Geraldine Michalik, Ph.D. The objective ofa pension fund is: 1) to pay or fund the pension lia- bility; 2) at the lowest cost to the plan sponsor; 3) subject to sensible risk. Historically, pension plans have traditionally focused on the performance of assets with slight or no regard for the performance of a plan’s liabilities. Plan sponsors, their advisors, and other stake- holders are now beginning to rec~ ognize that significant attention must also be teristics and performance of plan liabilities, Such an economic anal- ysis will reduce cost and risk and therefore increase the likelihood that pension plans will satisfy their objective of being able to fulfill their benefit obligations as. they become due. Moreover, asset/lia- ven to the charac Thomas White isa partner in the Employ- ee Benefits and Executive Compensation _gvoup at final services law firm Chap ‘man and Cutler LLP in Chicago, He ro tinely advises corporate and. public sector dents on benefit administration issues. Geraldine Michalik, Ph.D., serves as Chief Operating Officer and. Director of Credit Research at Ryan Labs, where she versees corporate ancl agency credit review process and sector analysts bility management, or Liability Driven Investment (LID), isan ap- propriate tool whether a pension plan is over- or under-funded and can be utilized by both private see— tor and governmental plans. Several factors have resulted in this increased interest in LDI. The Financial Accounting Standards Board’s (FASB) new standards for reporting liabilities (FAS 158) will require public companies to recog nize the funded status of their pen~ sion and other postretirement ben efit plans on their balance sheets FAS 158 represents the first phase of FASB's two-phase postretirement benefit accounting reassessment. The Pension Protection Act of 2006 (PPA), signed into law by President Bush in August, reformed the rules for measuring pension lia- bilities and established new mini- mum finding standards for defined benefit plans. There will be conse- quences if employers fail to achieve funding benchmarks, This new re- gime will require plan sponsors to better assess the impact of potential balance sheet changes and consider the appropriateness of mitigating funding volatility. In addition, litigation risk may be mitigated through utilization of an LDI strategy. Currently, some plan sponsors seck to maximize their plan’s investment returns by allocating fiands to those asset classes with the highest anticipated returns while others allocate assets based on generic investment targets, for ex ample investing 60% in equities, 35% in bonds, and 5% in cash. In both cases, there has been little analysis of when the benefit pay- ments that have accrued will be paid. For example, if a lange per- centage of plan assets will be paid in the near term, a large investment in more volatile asset plan with insufficient assets to pay accrued claims if those asset classes classes may leave have diminished in value at the time large distributions have to be made. This situation may result in litigation by plan participants whose benefits may be reduced or by the PBGC or Department of Labor, which may find faule with the plan’s This li gation risk may be mitigated if plan investments were coordinated with it schedule, In that case, short-term li- investment managem the particular plans habilty/bemabilities would be matched with short-term assets, mid-term liabili- ties would be matched with mi term assets, and so on. Thus the v ue of both assets and liabilities would move in tandem, and vole- tility and the risk that benefits could not be paid—the major cause of lit igation—would be diminished. Moreover, plan investment fiducia ries would be able to defend their course of action by specific refer- ence to their plan’s unique charac~ teristics and to the investment ap- proach which was taken into ac- count with regard to the plan’s an- ticipated distribution requirements, ‘The new FASB requirement to mark-to-market pension could result in huge swings on fi- nancial statements, Increased rec~ cognition of fimding volatility has become, for some, an additional reason to terminate pension plans. Volatility and resulting contribu- tion increases may be minimized when anticipated benefit distribu- tions drive asset allocation deci- sions. Consequently, the new legal and accounting environments are sparking a renewed interest in LDI for pension plans, with pension obligations driving the asset alloca tion decision. assets ‘An LDI strategy may pass muster under ERISA’s fiduciary standards, The Department of Labor (DOL) recently ruled in Advisory Opinion 2006-08A that a plan fiduciary may consid er the volatility of plan liability obligations when creating an i vestment strategy for a pension plan, notwithstanding the fact that the plan sponsor would also benefit by a reduction in the vol- atility of the plan's contribution evel. The DOL decided that it would not violate ERISA’s fidu- ciary standards to develop an in- vestment strategy that attempts to prevent an increase in under~ funding levels. The agency noted that plan fiduciaries have broad discretion in defining investment strategies appropriate for their plans. In this regard, the DOL stated that there is nothing in ERISA or the regulations that would limit a plan fiduciary’s ability to take into account the risks associated with benefit fa- bilities or how those risks relate to the portfolio management in designing an investment strategy. For. these DOL, found that a fiduciary would not violate its fiduciary duties under ERISA solely because the fidu- ciary implements an investment strategy for a plan that takes into account the liability obligations of the plan and the risks associat ed with such liabilities and results in reduced volatility in the plan’s funding requirements, reasons, the Ideally, investment returns on pension assets should be the prima- ry source to fund liabilities, rather than pension contributions com- ing from either the employer, the employees, or in the case of public funds, current or future taxpayers. For many plan sponsors, pen~ sion liabilities are one of their larg- est liabilities. Traditionally, most pension asset managers are given a generic index as their benchmark, which may have no similarity to the behavior pattern of their unique stream of liabilities. Fur thermore, actuaries often price lia~ bilities differently than either the market does or the Financial Ac- counting Standards Board (FASB) would confirm as proper, Indeed, it has become common practice for actuaries to price alll the same interest rate regardless of their maturity or payment due date. Too offen, this discount rate is much higher than the rate that bilities at might be obtained in the market for obligations with identical ma- turities, causing a reduced valua~ tion of liabilities. Moreover, liabil- ities are analyzed annually, with the data only available after a lag in time. Given all this confusion, it is difficult, if not impossible, for the asset side co “understand” the lia~ bility side. By losing sight of the true pension objective, several problems may develop. FIRST DILEMMA: GENERIC OR IDENTICAL ASSET ALLOCATION The goal of traditional asset allo~ cation is to create the optimal ab- solute retum, As a result, stocks are favored and plan sponsors are avidly exploring the introduction of additional asset classes with ant~ ticipated higher returns. Howev- er, the tue objective of asset allo~ cation should be to create the op- timal relative return versus liabili- ties. Each plan has a unique liability term structure based on the plan's demographics, ec nomic assumptions, and design. Similar to snowflakes, no two pension liability schedules are identical. FASB 87, Paragraph 199, recognizes this difference:' A plan covering only retired employees would be expected to have significantly different dis- count rates from one covering a work force of 30-year-olds. Logically, therefore, the liability term structure should dictate the shape of the asset allocation. Un- fortunately, most asset allocation models have no input for a plan's liability characteristics, They only analyze historical generic market indices. Without an application of plan's liability structure to its asset mix, all plans could be invested in a nearly identical manner. 32EXHIBIT Plan (Weare) Let's take, for example Plan A Plan A is a mature company which has a complement of rela- tively old active employees and retirees, with pension liabilities heavily skewed to current retir- ees. Thus Plan A has a duration’ of only 9.6 years with 58% of its liabilities coming due in the near These shorter liabilities should be in- vested in Treasury bills or bonds swith a duration similar to those of to intermediate term. the maturing liabilities so that the funds are readily available to meet payouts and the plan does not have to liquidate assets at a loss to cover known distributions, Only 42 percent of its liabilities are long liabilities, suggesting an allo- cation of 42 percent to long as~ sets, unless there is an unusual deficit/sumplus situation. 14.5 years Plan B has a very young participant group with few retirees. Its liability duration is 14.5 years, Over 57 percent of Plan B’s liabilities are greater than 10 years su allocation of 57 percent to long as- sets, unless there is an unusual def icit/surplus situation. Again, the 43% of its liabilities that are due in the near to intermediate term should be invested in Treasury bills esting an or bonds with a duration similar to those of the maturing liabilities ‘The assets of these two plans should not be invested in the same way. Rather, in order to prevent a funding mismatch of assets versus the liabilities, the term structure of each pension fiability payout schedule should become the base for asset allocation, or LDI. Asset allocation should be tailored to each plan’s unique liabiliey situa tion and not based on generic models which may indiseriminate~ ly assign the same percentage of as~ set classes to plans with entirely different liability schedules. | SECOND DILEMMA: INAPPROPRIATE PERFORMANCE MEASUREMENT Historically, asset performance has been measured against generic in- dices (e-g., S&P 500). Performance is measured by comparing the total return ofan asset class (e.g., stocks, bonds) to the generic market index | for chat asset class, Money manag ers are hired and fired based on their performance versus an as ed generic asset index. ‘An important reason why this situation persists is that pension li- abilities are traditionally calculae- ed annually and reported months after the fact. Significantly, the present value pricing of liabilities is done in a way that the asset side does not understand (assuming the use of non-market rates) how the liabilities are moving, It is ex- tremely difficult, if not impossi- ble, for an asset manger to manage against such an objective, What is needed is a liability in— dex system that correctly prices plan liabilities (in conformicy with the FASB) as a tangible, frequent (Le., daily) system for investment ‘management. ‘The asset side must know the liability growth rate and the liability term structure. Perfor- mance measurement can then be properly assessed as the growth rate of assets versus the growth rate of liabilities that each asset class is funding (i.e. short assets vs, short liabilities, long assets vs. long liabil- ities, ete.) Frequently, plan sponsors and their actuaries and investment ad- visors do not recognize that their plans may be losing ground despite experiencing good investment re~ tums in excess of those assumed in their actuary’s projections. ‘The following exhibit is based ona hy- pothetical plan's asset allocation and assumes the plan was fully funded in the base year 1997. The table illustrates how, over time, a plan's assets could lose ground to the liabilities because of the mis- match of assets to the duration of the liabilities. Over the ten-year period illustrated, the fanding level decreased from more than 100% to only 88.6% with significant fluctu- ations in the interim. Note that in 2004 this hypo- thetical plan eamed 8.93% on its assets. Most plans assume that plan investments will earn between 7% and 8% per year. In 2004, a typical plan sponsor would have focused on the investment returns and have been satisfied because the in- vestment return exceeded the plan’s ROA assumption. Howev- et, liabilities increased by 10.25% that year and the plan was less wellcorrect Incorrect single] rity cate. | weld pifterence {AV2"@9® Liabilty] Present Value Discount Rate | ability weld Ovfference Hoy sation (vears}| Difference T50% Z50 is ST SO Note: Present Value Difference Yield Difference x Duration finded at the end of the year. This would have come as a shock to most plan sponsors which diste- gard the performance of their plan’s liabilities THIRD DILEMMA: PRICING ‘ALL LIABILITIES IDENTICALLY The Financial Accounting Sta dards Board (FASB) specifies the financial statement reporting of pension liabilities for private sector businesses and has become the that all pension should follow. FASB requires that the market value of assets be com- pared to the present value of fiabil- ities marked to current market rates. In addition, the FASB re- quires that the present v: bilities be calculated (priced) using individual discount rates for each liabiliey payment date rather chan on some “blended” basis. FASB 87, paragraph 44 reads model fonds ue of li Assumed discount sates shall re flece the rites at which the per sion benefits could be effectively settled ,.. In making those st mates, employers may. look 10 rates of tetuins ot high quality Fixed income invesnients ur rently available and expected 10 be available during the period ro maturity ofthe pension beni FASB 87, p graph 199 continues: Interest rates vary depending on duration of investments; for ex ample, Treasury Bills, 7-year bonds’ and 30-year bonds have liffevent interest rates. The dis closures required by this State- tment regarding components of the pension obligation will be more representationally fehl i individal discount rates applica- ‘nl ro various benefit deferral pe= Fiods are selected According to FASB 106, Para- graph 186: The obligation would equal che ‘current market value of a porta Tio of high-qualcy zero coupon Thonds whene maturity dates and amounts would be the same a the timing and amounts of the ex pected faeare benele payrents Under FASB rules, pension lia- bilities should be priced like a high-quality zero-coupon bond portfolio whose par values match the liability payment amount and whose maturities match the liabili- ty payment dates. However, most plans use a sin- gle discount rate to price al liabil- ities. This single discount rate is normally around 100 basis points or more higher than the market rate. To convert this yield differ ence to a present value difference (8), multiply the yield differe: by the average duration of the plan’s abilities EXAMPLE OF CONVERSION OF DISCOUNT RATE DIFFERENCE INTO PRESENT VALUE DIFFERENCE According to the above exhibit, if Hiabilities were priced 250 basis points aboye the market (yield), this would translate into a 37.50% lower valuation, i.e., mispricing, of the liabilities. Shorter duration pension plans (skewed to retirees or “new” cash balance plans) may experience even higher disparities, as the weighted average discount rate could be lower in a “novinal” upwanlly-sloped yield curve envi- ronment, This undervaluation is critical if it results in lower plan contributions in the short term, which will consequently require: higher future contributions; higher investment returns than historical dlata suggest; and/or diminution of future benefit accruals, FOURTH DILEMMA: INAPPROPRIATE BENCHMARKS ‘The appropriate benchmark for pension assets is a custom liability index that properly represents the present value growth of the plan sponsor's unique liability schedule, Generic indices that measure asset classes (¢-y., S&P 500) are inappro- priate measurements of liability growth. Only a liability index that mnatehes the plan sponsor's unique benefit payment schedule cam ac- curately reflect the plan’s future obligations. Particular attention should be paid to the liability schedule, and appropriate, timely changes should be made to it ifthe plan sponsor’s circumstances det riorate or if actuarial assumptions are out-of-date significant reduction in the work~ force might result in larger distri- butions in the near term than had been previously anticipated, Simi- larly an increase in longevity may necessitate an increase in liabilities. In these cases, the distribution schedule should be updated and the investment mix reevaluated to reflect Moreover, might prove to be lower than had been anticipated in that situation. It is important for the assumptions For example, a the new circumstances. foture contributions a4EXHIBITS Ryan Labs, Ine ‘Asset / Liability Return Difference and Tracking Error nt Yor aed ee used to fimnd the plan to be exam- ined. periodically and more fre~ quently as circumstances warrant, and the results should be transmit- ted to the plan’s sponsor and those responsible for making investment decisions, Liability indices should con- form to FASB standards. As the Asset/Liability Watch illustrates (Gee Exhibit 3), using g ket indices for asset objectives, in- stead of a liability index, results in significant asset/liability: volatility In that example, the hypothetical pln was significantly overfanded in 1999 and significantly under funded in 2002. In one of the greatest bull markets in American history, assets lost ground to liabil- ities in five of the last 10 calendar years—50% of the time! And through the end of December 2006, assets have underperformed liabilities by about ~10.8% (refer page 8). The great absolute investment returns of the last se eral years turned out to be poor relative returns versus liabilities. By not having a correct measure of a plan's liabilities. and investing. ac ence cordingly, the plan sponsor has lost the opportunity to maintain full fanding levels in the plan and ben- fit from the tax deductibility of pension contributions and the tax~ free growth of: plan, ultimately increasing the cost of paying plan liabilities. Im the ex- ample, the plan could have taken all risk for funding accrued liabili- fF the table” when the hypo~ thetical plan was fully funded. By adheri sneric_ investment sets in the pension ties © guidelines, the sponsor unneces- sarily increased its cost of main- taining its plan, Traditional market indices are poor proxies for labil ties and should not be the objec- tive of the assets SOLUTIONS: LDI IN CONJUNCTION WITH CUSTOM LIABILITY INDICES It is critical that each plan's distibu- tion requirements be properly mea sured and its investment methodolo- gy correhted to those streams of benefit distributions. A custom lia- bility index should be tailored to ac- curately calculate liability present value, present value growth, and term structure so that the plan spon sor can have an accurate measure ment of plan liabilities. A custom bt ability index is a table showing month by month anticipated distri- butions. An appropriate asset alloca~ tion (including stocks, bonds, and nents) is dependent on the liability term structure, Different other inv asset classes have different character istics and different time horizons. Segment They Are Meant to Fund The chart’ on the next page illus. trates the risk and return character- istics of various asset classes versus the liabilities, As with traditional risk/reward graphs, return is me: sured on the Y axis and risk is me, sured on the X axis, and move~ ment toward the Northwest repre- sents higher return with lower risk. However, unlike traditional mea- surements, this graph defines re~ tum as return above that of liabili- ties and risk as trackiny liability returns. The solid, curved line represents the excess return and tracking error of I~ to 25-year ‘Treasury STRIPS. Non-correlat- ced assets, stuch ay domestic and i ternational equities, representa substantial amount of relative risk (toward the right of the graph), which has gone largely uncom: pensated over the past 20 years (or virtually any other time period) Of particular note, the graph illus- tw es that, over the past 20 yea &P 500 offered a mere 0.5 excess return (reward) over liabili- ties. This 0.5% achieved at the cost of significant volatility (risk), with 18 degrees of tracking error the return was Performance measurement is dependent on such a liability index to accurately assess asset growthEXHIBIT 4 Asset / Liability Watch Total Retuone a nooreite ne aa ws 4 aM 20 an [= ee versus the liability growth these as- sets are funding. Thus, the perfor- mance of each asset class should be measured against the segment of li- abilities itis meant to fund. Solution Il: Fun ties by Matching the Asset Class to the Liabilities Short assets, such as cash, should bbe matched against short liabilities with a similar duration. Treasury and corporate bonds are more suitable for intermediate liabili- ties, For investors willing to tole ate the additional volatility: risk, investments in equities, interna~ tional assets, real estate, and other alternatives may be included in the portfolio as a hedge against Jong and very long liabilities For asset managers and plan con- sultants to fianetion effectively, a li- ability index should be updated fre- ‘quently. The index should conform to FASB pricing requirements. As- set allocation and performance measurement can best be under- stood once the weight and growth rate of each lability maturity sector (term structure) is calculated. Term structure precision is a critical cal culation. Without accurate liability term structure definitions and mea- surements, plan sponsors fice am= biguous asset allocation and perfor ‘mance measurements Pension plans do not have infi- nite duration, as the large number of recent plan terminations dem- onstrate. Plan sponsors, particular ly those in declining businesses, should therefore seek to analyze their plans’ funding statuses based on valid economic assumptions and data rather than on conven tional factors which have small re- lationship to their plans. asset managers can better un- derstand the risk/reward behavior pattern of the liability opponent, they can better strategize how to outperform such an opponent. If consultants can understand the term structure of liabilities, they can build proper assets allocations for each term structure area (c.g. long assets versus long liabilities). CONCLUSION Without accurate liability term structure measurements, — plan sponsors face the greatest risk there is: Le., having insufficient assets to fund liabilities when the sponsor does not have the capacity to con tinue the plan. ‘The Sal. crisis is too vivid an example of what can happen with mismatched term structure exposure. In conclusion, different asset classes are correlated with different risk and reward characteristics Without accurate liability term measurements, plan sponsors and their advisors are limited in their ability to properly match their assets to their pension and other postem- ployment liabilities. This, in turn, prevents them ftom satisfying their objective of finding benefit obliga tions when they come due at rea- sonable expense and minimal risk, NOTES: 1 The citation 4 FASE stands ive not bon amended by the new FAS 138 whic explains how employers ate requied to 3c ‘count for pemion and other postemploy ment bene. 2 The duration ofany scunty or seis of se— cutis provides a micsave of thers with Which the sensitivity of bonds oF bond Portas interest ate chang ca bec Tima. The calculation is based on the svsighid average present vals fr all exh flows in the porto. Ir represents the weighted average length oF ae hat a plan sw py Bene to an average participant [8.1% merease (or decrease) de interest, rate acconlingly produces 4 percentage Gill {or rms) in she price i proportion to d duration, fs the above example ite do sation (dscounted present valve) of Plan AN fibiies 9.6 year and che antes rate deops by 1%, ee pce of Plan A's bilies wl ners by approximately 9.0%. nal nd Pierce epics upped by Cs