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Wayne H. Wagner SERVICES PROVIDED TO

Chief Investment Officer Institutional Invesf ors
Edward C. Story Investment Managers
Client Communication Institutional Traders
LarryJ. Cuneo Plan Sponsors
Portfolio Researchand
Operations
THE BLINDMEN AND THE ELEPHANT

MONTHLY COMMENTARY #19

October 1988

(Summarized from a speech by Wayne at the Institute for Quantitative

Research in Finance in San Diego, October 2-5, 1988.)

Each of the proverbial blindmen who touched a dissimilar part of the elephant
envisioned a different treast. Likewise, the various interested parties who view
the pension plan develop different perspectives. The actuary, the accountant,
the employee benefits administrator and the pension investment administrator
all have different perspectives, but is any of these more correct?

Historically, it was the view of the actuary that
dominated the management of the pension plan.
Operating under the imprimatur of the profes-
sion, he discounted the accumulated earned
benefits back to the present. The discount rate
was a conservative, stable rate which more or
less assured pension payments under all but the
worst conceivable circumstances. It
also created
a substantial margin of safety incase the
assumptions didn't work out . real risks of falling well short of expectations.
Out of necessity, other parties responsible for
other aspects of the pension plan developed
their own independent views.
The pension investment administrator found
little reality in the actuary's assumptions, and
dealt with the world as he saw it. Usually the
game was defined as a devil-take-the-hindmost
horserace, restrained only by a fear of the very

The actuary's view was accurate from where he
stood, yet it failed to recognize several key
factors:
1. The conservatively stated discount rate'gave
little useful guidance to the manager charged
with implementing the investment program.
2. The assumption of a fixed rate gave little
acknowledgement to the implications of vari-
abiliry in asset values.
3. The use of earned benefits ignored the
predictable stream of changes in pension pro)
mises in response to company and economic
growth.
The employee benefits administrator generally
ignored the views of both the acfuary and the
pension investment administrator, and focused
on the benefits and the beneficiaries.
ENTER THE ACCOUNTANT
FASB 87 brought forth a new view of the
pension plan: that of the accountant. The
accountant's new view was to valte both the
liabilities and the assets at market (not actu-
arially assumed) rates. The net result was a
far more realistic view of the pension funding
process. The view shifted toward a comprehen-
sive and inclusive view of both sides of the
assetfliability equation. The focal point became
the difference between the asset valuation and
the liability valuation: What private plans usually
call surplus and public plans call shortfall.
Certainly, the accountant's view provided many
useful insights. Most importantly, it reduced the
isolation of the pension investment administrator
and made him or her rethink the nature of the
investment activity in the context of the liability
side of the equation.
Unfortunately, FASB 87 also invited a con-
siderable narrowing of the range of investment
alternatives thought to be suitable to the fund.
Here's how this happened: Bond prices vary
with interest rates. If the present value of a
liability also varies with interest rates, then a
liability is an anti-bond which can be neutralized
by locking it in with a bond of similar interest
rate response. The natural outcome of this
thought process is that bonds appear to be the
ideal vehicles for funding pension liabili$
streams.
Hidden behind this seemingly simple and ele-
gant solution is a serious flaw: The accounting
rules have taken precedence over the strategic
objectives. The best solution to the accounting
problem (minimizing the pension plan's effects
on the balance sheet and income statement) is
not the same solution which would derive from
a thoughtful analysis of the plan's strategic
objectives.
A short term horizon has been interposed over
a long term problem. From this narrow view,
the most important variable in the management
of the pension plan becomes the December 31st
insurance company new money rate, which is
the rate typically used to price the liabilities.
This view has many faults. First, bonds are not
the Fixed Income vehicles they once were:
inflation, interest rate volatility, and creative
covenants have radically altered the nature of
the tlpical bond.
Secondly, a very short horizon was imposed on
the pension plan: the December 31 valuation
date. Risk has been equated to variabilif"in
short term interest rates. Yet in realify, a
pension fund is a continuing economic entity
with a horizon usually stretching into decades.
The most relevant risk is that of falling behind
2
on pension payments years into the future, a
risk which has little to do with December 31st
interest rate quotes.
Finally, and most importantly, bonds do not
participate in the productive energy of the
economy. In Monthly Commentary #5, we
identified The Pension Promise as an adequate
standard of living paid for by the ultimate
pension payments. Comparable standards of
living, and thus the eventual pension payments,
are strongly influenced by economic productivity
growth. A heavy fixed income orientation
dooms pension plans into falling further behind
the rising benefits. Pension investment is not as
simple and one-dimensional as the advocates of
FASB 8? would have us believe. Pension risks
have many important dimensions beyond short
term interest rate fluctuations.
OFFSETTING THE REAL RISKS
In this section, we will illustrate in a slightly
different context how some of dimensions of
risk can be offset through a policy which would
at first glance appear more riskY.
Medical benefits for retirees is one of those
topics that no one seems eager to discuss. The
big bugaboo for health plans is the rapidly
expanding use of new and very expensive medi-
cal technology. Whatever current assumptions
are made for financing future levels of health
payments, they are likely to fall far short.
There is no good way to make estimates,
because it is impossible to predict the timing
and cost of new medical technological break-
throughs.
Any funding strategy based on the present value
of assumed future payments is tikely to fall very
short.
Yet there is good news: the financial hazards of
productivity gains in medical technology can be
partially offset by a well conceived investment
policy. The financial beneficiaries of medical
breakthroughs will be the equity owners of the
companies which produce the breakthroughs.
The obvious hedge for a health benefit plan,
then, is to invest in medical technology stocks.
Asset values then rise in response to the same
events that raise medical costs.
The same thoughts apply to the pension plan:
a well conceived investment strategy should
favor assets which will benefit from gains in
productivity; namely equities.
OUR NEW HERO
The actuary's view has been shown to be insuf-
ficient, the accountant's view is short sighted,
the investment administrator is sometimes
caught up in the romance of the asset side of
the pension world.
Curiously then,it is the view of the employee
benefits specialist which provides the best
insights into the optimal investment stratery. Of
all the pension blindmen, the employee benefits
administrator knows whv the pension plan
exists: To fulfill the employees' expectation of
a decent standard of living throughout retire-
ment.
In earlier times it was the view of the actuary
which had to be resisted in order to establish
rational pension investment policy. Now, the
viewpoint of the accountant must also be
resisted.
It is from the viewpoint of the employee bene-
fits administrator that bonds are revealed as not
being the end-all solution to pension funding.
It is by observing the process by which pension
obligations grow over time that we gain a better
understanding of the nafure of pension risk.
This understanding leads to a better perspective
on the relative merits of different classes of
assets. Equity returns not only relate best to
productivitygains, they also have higher expecta-
tions which should lead to higher benefits, lower
contributions and/or greater assurity of pay-
ment. This is achieved, of course, at a cost of
higher short term variability. Variability, unfor-
tunately, is likely to create FASB 87 problems
for the pension investment administrator.
A conflict of views is almost inevitable. and the
logic behind the investment strategy must be
well thought out ahead of time. Strategy must
be built on a clear understandins of the nature
of the pension plan:
1. Pension funds exist to pay retirement bene-
fits. Accordingly, the asset policy must be
related to the benefits policy.
2. The actual pension benefits that will be paid
in the future will reflect the then-contemporary
comparable standard of living. As a result,
pension benefits will probably grow beyond
current expectations due to productivity in-
creases in the economy.
3. The only way to hedge those long term risks
is to invest in assets which participate in the
benefits of productivity gains: equity issues.
4. Equity markets are volatile and will rise and
fall several times before the assets are cashed
in to pay pension benefits. This does not
create a long term problem.
Risky assets will cause variations in year-end
surplus valuations, with possible balance sheet
and income statement effects on the corpora-
tion. A rational long-term pension investment
strategy surely must take cognizance of these
effects. but cannot allow itself to be dominated
by them.