Dr.

Norman Ehrentreich

The Asset Return - Funding Cost Paradox

The Case for Liability Driven Investment

“My message is simple: Almost every corporate pension

fund should be entirely in fixed dollar investments.”
Fischer Black, Financial Analysts Journal 1980

16 November, 2009
Overview

¾ The Current State of DB Pension Plans and the Return –

Volatility Trade-Off of LDI Strategies
¾ The Asset Return – Funding Cost Paradox
¾ Proof of its Existence: A Simple Example
¾ Why can the Asset Return – Funding Cost Paradox arise?
¾ The Step from Possibility to Reality – Why is it likely to arise?
¾ Can we Quantify the Effects?
¾ Volatility Risk
¾ Return Risk
Initial Poll

¾ Is it possible that a higher returning equity strategy leads to higher

funding costs for a DB pension plan than a lower returning LDI
strategy?
Do You Think that Higher Returns in a Given Period Automatically
Translate into Lower Funding Costs?
PLANSPONSOR / RiverSource Investments study (August 2008)
(21 questions to 4,090 DB plan sponsors, responses from 98 corporate plans and 52 non-corporate plans)

Corporate Defined Non-Corporate Defined

Benefit Plans Benefit Plans
7%
15%
24%
30%

55% 69%

Yes No Don't know Yes No Don't know

/ RiverSource Investments
Initial Poll

¾ Is it possible that a higher returning equity strategy leads to higher

funding costs for a DB pension plan than a lower returning LDI
strategy?

¾ Is it likely?

¾ Can a fully funded DB Pension Plan that earns, on average, its

discounting rate over a certain investment period, be bankrupt at the
end of that period?
Pension Fund Objectives

¾ To fund the pension liability

¾ At the lowest cost to the plan sponsor
¾ Subject to reasonable risk

To achieve these objectives, asset returns should

be the primary source to fund these liabilities, not
contributions to the pension fund.
The Current State of DB Pension Plans

¾ Lowest-ever funding levels of U.S. corporate pension

plans (Watson Wyatt, January 2009)
¾ An asset plunge of $445 billion in 2008 for the 450 DB plans of
the Fortune 1000 companies
¾ A $78 billion aggregate surplus turned into a $366 billion deficit
¾ For 2008, about 61% of pension plans will have funding levels
between 50% and 70% (only 5% of plans were in that range a
year earlier)
¾ Similar, if not worse, for public pension plans
¾ Underfunded Pension Benefit Guarantee Corporation
¾ Underfunded by $11.2 billion (fiscal year 2008, ended in Sep ‘08)
¾ Social Security (???)
Why Not more LDI? The Volatility-Return Trade-Off

¾ Pros: LDI strategies

¾ avoid large funding shortfalls,
¾ reduce funding status volatility, and hence
¾ balance sheet volatility (FAS 158),
¾ and contribution volatility (PPA of 2006).

¾ Cons:
¾ Supposed to lock-in an eventual funding deficit
¾ Interest rates are at historic lows
¾ Pure LDI solutions are fixed income based and thus have lower
expected returns than equity
¾ Lower expected returns are supposed to lead to higher
funding costs
“Heard on the Street” − Opinions from Plan Sponsors,
Managers, and Investment Analysts

¾ “Not sure plans will be able to stomach performance of LDI in a

rising rate environment.”
¾ “Why would a plan adopt an LDI strategy when equities are
expected to outperform over long periods of time. It's a strategy
that's "too safe" for most plans.”
¾ “The best hedge against future liabilities is a strong record of
portfolio total return.”
¾ “… politicians will care much more about maximizing return and
minimizing contribution rates than short term swings in funding
status.”
¾ “LDI raises the cost of the DB plan in the low rate environment we
are in.”
¾ “We are in for the long term.”
¾ “A 3% difference in expected return would increase the cost of a
defined benefit plan to employers by 30% over ten years.”
The Asset Return – Funding Cost Paradox
I have yet to see any problem, however complicated, which, when
you look at it in the right way, did not become more complicated.”
Poul W. Anderson

¾ It is possible for a lower yielding bond portfolio to require

lower average contribution payments than a higher
returning equity portfolio.
¾ Higher average asset returns do not automatically translate
into lower average funding costs for DB pension plans
since the requirements to convert an eventual equity risk
premium into lower funding costs are regularly violated in
practice.

The asset weighted average returns of fully funded

LDI strategies tend to beat asset weighted average
returns of traditional asset allocation strategies.
Funding Cost Scenarios for a Simple DB Pension Plan

Liabilities of a Simple DB Pension Plan

The “Traditional” View
Liability End of year End of year 100
Year Return
payment asset value funding status
Bonds: 6% annualized rate of return
Scenario 1: Return sequence 6%, 6%, and 6%
0 133.58 100.0 % 75
1 6% 25.00 116.59 100.0 %
2 6% 100.00 23.58 100.0 %

Liabilities
3 6% 25.00 0.00 N/A
Stocks: 8% annualized rate of return 50
Scenario 2: Return sequence 8%, 8%, and 8%
0 128.73 100.0 %
1 8% 25.00 114.03 100.0 %
2 8% 100.00 23.15 100.0 % 25
3 8% 25.00 0.00 N/A

0
1 2 3
Period
Funding Cost Scenarios for a Simple DB Pension Plan

The “Traditional” View What Else Could Happen?

Liability End of year End of year Liability End of year End of year
Year Return Year Return
payment asset value funding status payment asset value funding status
Bonds: 6% annualized rate of return Stocks: 8% annualized rates of return
Scenario 1: Return sequence 6%, 6%, and 6% Scenario 3: Return sequence of 10%, 10%, and 4%
0 133.58 100.0 % 0 128.73 100.0 %
1 6% 25.00 116.59 100.0 % 1 10 % 25.00 116.60 102.3 %
2 6% 100.00 23.58 100.0 % 2 10 % 100.00 28.26 122.1 %
3 6% 25.00 0.00 N/A 3 10 % 25.00 +4.39 N/A
Stocks: 8% annualized rate of return
Scenario 2: Return sequence 8%, 8%, and 8%
0 128.73 100.0 %
1 8% 25.00 114.03 100.0 %
2 8% 100.00 23.15 100.0 %
3 8% 25.00 0.00 N/A
Funding Cost Scenarios for a Simple DB Pension Plan

The “Traditional” View What Else Could Happen?

Liability End of year End of year Liability End of year End of year
Year Return Year Return
payment asset value funding status payment asset value funding status
Bonds: 6% annualized rate of return Stocks: 8% annualized rates of return
Scenario 1: Return sequence 6%, 6%, and 6% Scenario 3: Return sequence of 10%, 10%, and 4%
0 133.58 100.0 % 0 128.73 100.0 %
1 6% 25.00 116.59 100.0 % 1 10 % 25.00 116.60 102.3 %
2 6% 100.00 23.58 100.0 % 2 10 % 100.00 28.26 122.1 %
3 6% 25.00 0.00 N/A 3 10 % 25.00 +4.39 N/A
Stocks: 8% annualized rate of return Scenario 4a: Return sequence of 4%, 4%, and 16%
Scenario 2: Return sequence 8%, 8%, and 8% 0 128.73 100.0 %
0 128.73 100.0 % 1 4% 25.00 108.88 95.5 %
1 8% 25.00 114.03 100.0 % 2 4% 100.00 13.23 57.2 %
2 8% 100.00 23.15 100.0 % 3 16 % 25.00 – 9.59 N/A
3 8% 25.00 0.00 N/A
Funding Cost Scenarios for a Simple DB Pension Plan

The “Traditional” View What Else Could Happen?

Liability End of year End of year Liability End of year End of year
Year Return Year Return
payment asset value funding status payment asset value funding status
Bonds: 6% annualized rate of return Stocks: 8% annualized rates of return
Scenario 1: Return sequence 6%, 6%, and 6% Scenario 3: Return sequence of 10%, 10%, and 4%
0 133.58 100.0 % 0 128.73 100.0 %
1 6% 25.00 116.59 100.0 % 1 10 % 25.00 116.60 102.3 %
2 6% 100.00 23.58 100.0 % 2 10 % 100.00 28.26 122.1 %
3 6% 25.00 0.00 N/A 3 10 % 25.00 +4.39 N/A
Stocks: 8% annualized rate of return Scenario 4a: Return sequence of 4%, 4%, and 16%
Scenario 2: Return sequence 8%, 8%, and 8% 0 128.73 100.0 %
0 128.73 100.0 % 1 4% 25.00 108.88 95.5 %
1 8% 25.00 114.03 100.0 % 2 4% 100.00 13.23 57.2 %
2 8% 100.00 23.15 100.0 % 3 16 % 25.00 – 9.59 N/A
3 8% 25.00 0.00 N/A Scenario 4b: Return sequence of 4%, 4%, and 16%
0 133.58 103.8 %
1 4% 25.00 113.92 99.9 %
“… there is no way to reduce the ex ante 2 4% 100.00 18.47 79.8 %
cost by taking risk. Taking risk can only 3 16 % 25.00 – 3.57 N/A
change future outcomes, not the present
value of costs.”
Zvi Bodie (2005)
Funding Cost Scenarios for a Simple DB Pension Plan

The “Traditional” View What Else Could Happen?

Liability End of year End of year Liability End of year End of year
Year Return Year Return
payment asset value funding status payment asset value funding status
Bonds: 6% annualized rate of return Stocks: 8% annualized rates of return
Scenario 1: Return sequence 6%, 6%, and 6% Scenario 3: Return sequence of 10%, 10%, and 4%
0 DW-ARR: 6.00% 133.58 100.0 % 0 DW-ARR: 9.45% 128.73 100.0 %
1 6% 25.00 116.59 100.0 % 1 10 % 25.00 116.60 102.3 %
2 6% 100.00 23.58 100.0 % 2 10 % 100.00 28.26 122.1 %
3 6% 25.00 0.00 N/A 3 10 % 25.00 +4.39 N/A
Stocks: 8% annualized rate of return Scenario 4a: Return sequence of 4%, 4%, and 16%
Scenario 2: Return sequence 8%, 8%, and 8% 0 DW-ARR: 4.62% 128.73 100.0 %
0 DW-ARR: 8.00% 128.73 100.0 % 1 4% 25.00 108.88 95.5 %
1 8% 25.00 114.03 100.0 % 2 4% 100.00 13.23 57.2 %
2 8% 100.00 23.15 100.0 % 3 16 % 25.00 – 9.59 N/A
3 8% 25.00 0.00 N/A Scenario 4b: Return sequence of 4%, 4%, and 16%
0 DW-ARR: 4.78% 133.58 103.8 %
1 4% 25.00 113.92 99.9 %
What matters are dollar-weighted rates of 2 4% 100.00 18.47 79.8 %
return and not average asset returns. 3 16 % 25.00 – 3.57 N/A
 Intermediate Results

¾ The Asset Return – Funding Cost Paradox arises because of

¾ volatile asset returns
¾ current benefit payments (Intra-period cash flows, in particular
benefit payments, break the link between average returns and
average funding costs, reverse dollar cost averaging)
¾ Funding costs for DB pension plans are path dependent on
the sequence of asset returns.
¾ To compare competing investment strategies, one needs to
look at dollar weighted rates of return
¾ To convert an eventual equity risk premium into lower
funding cost, DB pensions plans need to be, on average,
fully funded.
The Asset Return – Funding Cost Paradox: How Likely Is It?

In reality, DB pension plans tend to be, on average, underfunded.

Therefore, they are not in a position to profit from an eventual
equity risk premium.

40%
Average Funding Levels over the last 10 Years

36%
Corporate Non-Corporate

30%
25%
30%

20%

18%

18%
20%
13%

13%

12%
10%

5%
6%
3%
1%
1%

0%
<=60% <=70% <=80% <=90% <=100% <=110% >110%
/ RiverSource Investments
Reasons for Persistent Underfunding
¾ Inability to close arising funding gaps
¾ Through above-average asset returns following an
asset slump (reverse dollar cost averaging)
Liability Profiles of Seven DB Pension Plans
(normalized to $100 million present value of liabilities at 6%)
18
Millions

16
14
Liability Payments / Year  in

12
10
8
6
4
2
0
0 10 20 30 40 50 60 70
Years from Now
Plan A (Duration 8.9) B (12.2) C (10.0) D (8.0) E (22.7) F (14.0) G (16.9)
 S&P-500 (TRI) vs. S&P-500 Investment Strategies
160%

140%
Funding Status / S&P-500

120%

100%

80%

60%

40%

20%

0%
00

02

03

04

05

07

09
99

01

06

08
1/

1/

1/
1/

1/

1/

1/

1/
1/

1/

1/
1/

1/
1/

1/

1/

1/

1/

1/
1/

1/

1/

S&P500 (TRI) E (21.1) B (11.7) C (9.7) D (6.8)

Required Asset Returns to Maintain Funding Status

Pension Fund’s Asset Value = Present Value of Liabilities x Funding Status

AVt = PV(Liab t ) FSt AVt +1 = PV(Liab t +1 ) FSt +1

Case 1: Benefit Payments at the End of the Period

AVt +1 = AVt (1 + i) − BPt

PV(Liab t +1 ) FS + BPt
i= −1
PV(Liab t ) FS

Case 2: Benefit Payments at the Beginning of the Period

AVt +1 = (AVt − BPt ) (1 + i)

PV(Liab t +1 ) FS
i= −1
PV(Liab t ) FS − BPt
Required Asset Returns to Maintain Funding Status

22.00%

20.00%
Required Return to Maintain Funding Status

18.00%

16.00%

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%
150% 140% 130% 120% 110% 100% 90% 80% 70% 60% 50%
Funding Status

Plan A (7.8) Plan B (10.7) Plan C (8.7) Plan D (7.0) Plan F (20.2) Plan E (12.7)
Reasons for Persistent Underfunding (continued)
¾ Inability to close arising funding gaps
¾ Through above-average asset returns following an
asset slump (reverse dollar cost averaging)
¾ Through additional contributions
¾Large funding gaps usually arise under adverse business
conditions
¾Pension Relief Bill (WRERA 2008)
¾Asset and Liability Smoothing
A Note on Asset and Liability Smoothing

¾ mask the true economic funding status of a pension plan.

¾ needed to minimize balance sheet & contribution
volatility (i.e., to defer necessary contributions)
¾ Introduce a wedge between “accounting” and “economic”
funding levels
¾ Huge differences between reported funding levels and
funding levels on a termination basis
¾ Bethlehem Steel 2002: 84% vs. 45%
¾ US Airways 2003: 94% vs. 35%

¾ Not needed for LDI strategies as funding gaps are

usually small and not systematically correlated with the
business cycle.
Have You Smoothed Asset and Liability Values?

Corporate Defined Non-Corporate Defined

Benefit Plans Benefit Plans

18%

48%
52%

82%

Yes No Yes No

/ RiverSource Investments
Reasons for Persistent Underfunding (continued)
¾ Inability to close arising funding gaps
¾ Through above-average asset returns following an
asset slump (reverse dollar cost averaging)
¾ Through additional contributions
¾Large funding gaps usually arise under adverse business
conditions
¾Pension Relief Bill (WRERA 2008)
¾Asset and Liability Smoothing
¾ Funding cushions to prevent new shortfalls are
not acquired during good economic times
¾ Minimum funding policies (Mercer 2008)
¾ contribution holidays
¾ Benefit bargaining
¾ Tax treatment
Reversion Tax on Excess Pension Assets

¾ Intended to prevent corporate takeover / raiding / plan

terminations of overfunded plans in the early 1980ies
¾ 1985: 15%, 50% in 1990
¾ Changed the property rights to excess pension assets
¾ Led to a fall in average funding status (Ippolito 2002)
through
¾ contribution holidays
¾ and minimum funding policies (Mercer Sep. 2008)
¾ Disfavors DB Plans by increasing their after-tax costs in
comparison to cash balance & DC plans

¾ “It is hard to imagine a public policy that has engendered a

result so contrary to its original intent.” (Ippolito 2002)
Quantifying the Effects of Volatile Asset Returns

Monte Carlo Simulation

¾ Our seven DB pension plans (A to G), hard frozen, no contributions

¾ Generate random monthly return paths with a given annualized total
rate of return

− Simulation structure:
For all plans and all return paths
Initialize plans with xx% of the PV(Liabilities)
For i = 1 to 120 months
Earn return
Pay out benefit
Next i
Analyze terminal funding levels
Identifying the Components of Risky Asset Returns

Return Risk: The range of investment outcomes

stemming solely from differences in non-
volatile asset returns.

Volatility Risk: For any given average rate of return over

a specific investment period, volatility risk
is the range of investment outcomes (e.g.,
final funding levels for DB pension plans)
stemming solely from intra-period return
volatility.
Volatility Risk: Uncertainty about the Path towards the 
(Realized) Expected Return

75 random asset price paths (annual rate of return =8%, sigma=4.2%)

2.4

2.2

1.8

1.6
Stock Prices

1.4

1.2

0.8

0.6

0.4
0 1 2 3 4 5 6 7 8 9 10
Years
Volatility Risk: Uncertainty about the Path towards the 
(Realized) Expected Return
Volatility Risk: Uncertainty about the Path towards the 
(Realized) Expected Return
Return Risk: Uncertainty about the Realized Rate of Return at 
the Investment Horizon
100 random asset price paths with no intra‐period volatility. The realized average 
returns are normally distributed around the expected return.
Return Risk
Distribution of Fundig Levels when the Realized (No-Volatility) Returns are Normally Distributed Around Their Expected Returns
(i.e., "Return Risk" for 70/30 S&P-500/Barclays Agg Strategies)

Plan D, Duration 6.8 Plan C, Duration 9.7 Plan F, Duration 13.3

2500 2500 2500

2000 2000 2000

1500 1500 1500

1000 1000 1000

500 500 500

0 0 0
0 0.5 1 1.5 2 0.5 1 1.5 0.5 1 1.5

Distribution of Final Funding Levels When Plans Earn, on Average, Their Discounting Rate
(i.e., "Volatility Risk" for 70/30 S&P-500/Barclays Agg Strategies, monthly asset return volatility = 3%)

Plan D, Duration 6.8 Plan C, Duration 9.7 Plan F, Duration 13.3

2500 5000 10000

2000 4000 8000

1500 3000 6000

1000 2000 4000

500 1000 2000

0 0 0
0 0.5 1 1.5 2 0.5 1 1.5 0.5 1 1.5
Return Risk versus Volatility Risk
Distribution of Fundig Levels when the Realized (No-Volatility) Returns are Normally Distributed Around Their Expected Returns
(i.e., "Return Risk" for 70/30 S&P-500/Barclays Agg Strategies)

Plan D, Duration 6.8 Plan C, Duration 9.7 Plan F, Duration 13.3

2500 2500 2500

2000 2000 2000

1500 1500 1500

1000 1000 1000

500 500 500

0 0 0
0 0.5 1 1.5 2 0.5 1 1.5 0.5 1 1.5

Distribution of Final Funding Levels When Plans Earn, on Average, Their Discounting Rate
(i.e., "Volatility Risk" for 70/30 S&P-500/Barclays Agg Strategies, monthly asset return volatility = 3%)

Plan D, Duration 6.8 Plan C, Duration 9.7 Plan F, Duration 13.3

2500 5000 10000

2000 4000 8000

1500 3000 6000

1000 2000 4000

500 1000 2000

0 0 0
0 0.5 1 1.5 2 0.5 1 1.5 0.5 1 1.5
Conclusions
¾ The Asset Return – Funding Cost Paradox is real. Low duration
plans are more likely to experience it.
¾ LDI strategies minimize the risk of creating large funding deficits
from which it is hard to recover.
¾ Funding costs are a function of asset returns and funding levels.
¾ By continuing to use unmatched strategies, underfunded plans have
a slight chance of improving their funding status, yet run the risk of
failing even earlier (Russian roulette).
¾ Even if average return expectations materialize, non-LDI plans have
a positive risk of failing if no further contributions are made.
¾ The volatility risk due to volatile asset returns is not sufficiently
compensated in today’s market place
¾ In my opinion, plans have no viable alternative to LDI in terms of
risk management and funding costs.
Exit Poll

¾ Is it possible that a higher returning equity strategy leads to higher

funding costs for a DB pension plan than a lower returning LDI
strategy?

¾ Is it likely?

¾ Can a fully funded DB Pension Plan that earns, on average, its

discounting rate over a certain investment period, be bankrupt at the
end of that period?
Cited Sources and Additional Materials
¾ Allen J. (2008): “Do You Have a Funding Policy? … And Is It Working?”,
Mercer US Retirement Perspective (September).
¾ Bodie, Z. (2005): “On the Time Dimension of Investing”, Boston University
School of Management Working Paper No. 2005-28.
¾ Black, F. (1980): “The Tax Consequences of Long-Run Pension Policy”,
Financial Analysts Journal 36(4), p. 21-28.
¾ Ippolito, R.A. (2002): “The Reversion Tax’s Perverse Results”, Securities
and Investments, 25(1), p. 46-53.
¾ Watson Wyatt (2008): “Dramatic Drops in Interest Rates Forecast Much
Lower DB Plan Funding Status on Accounting Basis for 2008”, Insider
February 2009.
¾ Plansponser/RiverSource (2008): “The Funding Cost Paradox – Higher
returns don’t always result in better funding outcomes”, Plansponsor,
August 2008, p. 18 – 20.

¾ For questions or comments contact Dr. Norman Ehrentreich

¾ Norman.Ehrentreich@yahoo.com, 612-706-7819