Pension finance : putting the risks and costs of defined benefit plans back under your control PDF
Preview Pension finance : putting the risks and costs of defined benefit plans back under your control
PENSION FINANCE Putting the Risks and Costs of Defined Benefit Plans Back Under Your Control M. Barton Waring P1:TIX/XYZ P2:ABC JWBT542-praise JWBT542-Waring September3,2011 4:1 Printer:CourierWestford P1:TIX/XYZ P2:ABC JWBT542-praise JWBT542-Waring September3,2011 4:1 Printer:CourierWestford Praisefor Pension Finance “PensionFinanceseemsexactlyrightandwilllikelyprovecontroversialonlybecause thetruthisuncomfortable.Therearepeoplewholiketoimagineunderfundingwill magicallyfixitselfthroughabullmarketordramaticchangeinhumannature;then therearethosewhothinkalldefinedbenefitplansaredoomedtodisaster.Neither group will be pleased with the message that defined benefit plans are workable and fixable, but that the fixes require sacrifice, hard work, and honest appraisal rightnow.” —CliffAsness,Ph.D.,Managing&FoundingPrincipal, AQRCapitalManagement “Pension Finance is now the seminal work on the subject and should be required readingforpolicymakers,practitioners,andplanfiduciaries.Waringmakesacom- pelling and persuasive case that the only way to ensure the long-term viability of defined benefit plans is to accurately measure the true costs and risks of providing thebenefitsandprovisioningaccordingly.” —BradleyD.Belt,formerDirector,PensionBenefitGuaranty Corporation,andSeniorManagingDirector,MilkenInstitute “There’s a problem hidden inside the nation’s biggest corporations and public in- stitutions:Themassive,systemicunderestimationofpensionobligations.Notvery sexy,youmightsay,andyetitrepresentsnothinglessthanatickingtimebombat the core of our society. Pension Finance lays bare the heart of the issue and sets outinclear,concisemathematicsandproseitssolution.Itisdestinedtobecomethe standardreferencesourceonpensionmanagementforactuaries,financeacademics, pensionofficers,andpublicpolicymakers.” —WilliamBernstein,AuthorofTheInvestor’sManifesto,TheBirthof Plenty,ASplendidExchange,andTheIntelligentAssetAllocator “Descartesfruitfullyintegratedgeometryandalgebra.PensionFinanceprovidesan excellentintegrationoftheactuarialdisciplineandfinancialeconomics.Alsoforthe Netherlands,whereweseekaworthyalternativeforunconditionaldefinedbenefit systems,thebookcontainscrucialfundamentals.” —GuusBoender,boardmemberOrtecFinance,andALMprofessorat TheFreeUniversityAmsterdam “Pensionsarebyfarthelargestobligationsowedbystateandlocalgovernments,yet theyarenotaccountedforinatruthfulmanner.Asaresult,neitherlegislatorsnor thecitizenswhosufferalltheconsequencesknowthetruesizeofthoseobligations orthegrowingsharesofgovernmentbudgetsthatmustbededicatedtotheirservice. a P1:TIX/XYZ P2:ABC JWBT542-praise JWBT542-Waring September3,2011 4:1 Printer:CourierWestford This book sheds new light on an important subject that for far too long has been kepthiddenintheshadows.” —DavidCrane,lectureratStanfordUniversity,amemberofthe UniversityofCaliforniaBoardofRegents,andaformerboard memberoftheCaliforniaStateTeachersRetirementSystem “PensionFinanceexposestheaccountant’sandtheactuary’sviewsofproperpension planmeasurementtothedisciplineandinsightofconsistenteconomicmeasurement. Thejuxtapositionisnotcomplimentary,butoverdue.Existingmeasurementortho- doxyhasproducedthecomfortofnamesandnumbers,hasprovidedlicensetothose unwillingtolookbeyondthenamesandnumbers,andhasbeenawillingaccomplice to systematic distortion of the economic reality of today’s defined benefit pension plans. Intelligent pension management requires consistent economic measurement. Waringpointstheway.” —JoelDemski,FrederickE.FisherEminentScholarofAccounting, FisherSchoolofAccounting,UniversityofFlorida “ThevalueofPensionFinanceisnotinpropoundinganynewornovelfinanceideas, butinsystematicallyexplainingthegutsoftheactuarialprocess,andthenrestating the process in sound terms. After reading this book, those involved in the pension arenawillunderstandthecausesofthepensioncrisisandappreciatehoweasythe ‘rightanswers’areoncethosecausesareunderstood.” —FrankFabozzi,ProfessorofFinance,EDHECBusinessSchooland Editor,JournalofPortfolioManagement “BartonWaring’sideas,basedonsolideconomicandaccountingtheory,areoriginal andverymuchhisown.Heknowshisstuffand,bestofall,hisexpositioniscrystal clear.Everyseriousstudentofpensionfinanceshouldreadthisbook.” —JeremyGold,FSA,Ph.D.,JeremyGoldPensions “PensionFinanceisessentialreadingforanyoneconcernedwiththefutureofdefined benefitplansandtheimpactofthoseplansoncorporatebalancesheetsandonpub- licbodiesincludinggovernmentsatalllevelsandpublicemployeefunds.Waring’s drivinginsightistousemarketvaluationsofliabilitiesandassets.Ashestatesem- phatically,thecurrentactuarialpracticeofusingassumedratesofreturntodiscount and value defined benefit plans is not used to value ‘anything else, anywhere else.’ Ratherthanrelyoncurrentpractice,Waringdevelopsproceduresstronglygrounded in financial economics that offer the possibility of keeping defined benefit plans as animportantpartoftheretirementmix.” —RichardGrinold,GlobalDirectorofResearch, BarclaysGlobalInvestors,retired “PensionFinanceredirectsdefinedbenefitactuariesandaccountantsbacktotheun- derlyingeconomics,andalongthewayrefocusesdecisionmakingtowardtheissues b P1:TIX/XYZ P2:ABC JWBT542-praise JWBT542-Waring September3,2011 4:1 Printer:CourierWestford thatreallymatter.Aneconomicunderstandingofpensionrealitycanleadtobetter investmentpolicies,morerealisticestimatesofliabilitiesandfundingrequirements, andtopensionpromisestobeneficiariesthataremorelikelytobemetbecausetheir true costs are better understood. This is an industry that badly needs reform, and thisbookprovidestheconceptualframework.” —RogerG.Ibbotson,ProfessorinthePracticeofFinance, YaleUniversity “Definedbenefitplans,aneffectiveretirementvehicleformillions,areadyingbreed. Theirlaudablefeaturesofhighsavings,lowcost,andpredictablelifelongincomeare sadly giving way to a [defined contribution] DC system that, so far, has generally failed to deliver these same advantages. Waring’s bold call for the application of transparentmarketvalueapproachesandsoundfinancialprinciplestothemanage- mentofDBplansiswelcomeandifbroadlyadopted,wouldputourpensionsystem onmuchsounderfootingandhelpsecureitslongtermsurvival.” —ColinJ.Kerwin,Fortune500Pensionexecutive “Thisbookisamajoradvanceintheliteratureofpensionfinance,breakingmuchnew groundinthemarketvalueapproachtopensionfinance.Thoroughandhard-hitting, Waringwarnsthatmanywillconsiderhisbluntviewstobe‘controversial’oreven ‘heretical.’ But his approach sheds a much-needed bright light on the fundamental natureofthepensionliability.Therearealsomanyvaluablesuggestionsabouthow tostructureanassetportfoliothataddressthesenowmoreclearlydefinedliabilities, given a specific fund’s risk tolerance, contingent reserves, back-up resources, and paymentschedule.” —MartinLeibowitz,ManagingDirector,MorganStanley “Pension Finance is a welcome attempt to apply modern financial economics to pensionfundmanagement.Itcoversawiderangeofissues,includingpensionvalua- tionandassetallocationdecisionsbypensionplans.Itprovidestheoreticallysound andpracticallyrelevantinsightsintohowpensionassetsshouldbemanaged,which should be of interest to pension fund managers, as well as asset managers, invest- ment bankers, and policy makers involved in the field. Given the current state of underfunding of pension schemes around the world, this book, which is likely to becomeareferenceinpensioninvestment,isahighlytimelyinitiative.” —LionelMartellini,ProfessorofFinance,EDHECBusinessSchooland ScientificDirector,EDHECRiskInstitute “Pension Finance draws cross-disciplinary lessons learned the hard way to set in motionamuch-neededoverhauloftheU.S.defined-benefitpensionsystem.Waring’s risk-management approach will help guide corporate and public plan sponsors to bettermeasure,payfor,andmanagetheirpensionassetsandliabilitiesusingmodern financial principles. Chock full of examples and sometimes sad lessons from the pension trenches, this book will set the terms of debate for corporate boards and c P1:TIX/XYZ P2:ABC JWBT542-praise JWBT542-Waring September3,2011 4:1 Printer:CourierWestford public plan trustees, consultants and actuaries, unions and financial advisers, and mostofall,policymakersseekingtoreturntheU.S.retirementsystemtohealth.” —OliviaS.Mitchell,ProfessorofInsurance&RiskManagement/ Business&PublicPolicy,TheWhartonSchoolofthe UniversityofPennsylvania “Amustreadforthosethatwouldliketopreservedefinedbenefitpensionplansina worldmovingtomarktomarketaccountingandfinancialanalyst/CFOdominance inplansponsordecisionmaking.” —DallasL.Salisbury,PresidentandCEO, EmployeeBenefitResearchInstitute “BartonWaring’writings,fiveofwhichhavewonbestarticleawardsfromquality investment journals, have always been thought provoking with theoretical rigor- ousness and practical insights. This book lucidly demonstrates the excellence of economicaccountingbasedonfinancialeconomicsascomparedwithconventional accounting and actuarial rules—which reduces the volatility of surplus, expense, and contribution of a [defined benefit] DB plan and subsequently enhances its manageability.” —NoboruTerada,FormerChiefInvestmentOfficer,Government PensionInvestmentFund(Japan) “BartonWaringisprobablytheworld’sleadingthinkerattheintersectionoffinance, economics, actuarial science, and pension policy. If his prescriptions are followed, retireeswillbeabletorelyonasecurepensionincome.Ifnot,theywillmostlyhave to save and invest for themselves. The first outcome is vastly better, and Waring describesinbeautifuldetailhowtoachieveit.” —LaurenceB.Siegel,FormerDirectorofResearch,TheFord Foundation,andDirectorofResearchfortheResearch FoundationoftheCFAInstitute d P1:TIX/XYZ P2:ABC JWBT542-fm JWBT542-Waring August9,2011 20:9 Printer:CourierWestford Pension Finance i P1:TIX/XYZ P2:ABC JWBT542-fm JWBT542-Waring August9,2011 20:9 Printer:CourierWestford Founded in 1807, John Wiley & Sons is the oldest independent publishing companyintheUnitedStates.WithofficesinNorthAmerica,Europe,Aus- tralia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional andpersonalknowledgeandunderstanding. TheWileyFinanceseriescontainsbookswrittenspecificallyforfinance and investment professionals as well as sophisticated individual investors andtheirfinancialadvisors.Booktopicsrangefromportfoliomanagement to e-commerce, risk management, financial engineering, valuation and fi- nancialinstrumentanalysis,aswellasmuchmore. For a list of available titles, visit our web site at www.WileyFinance.com. ii P1:TIX/XYZ P2:ABC JWBT542-fm JWBT542-Waring August9,2011 20:9 Printer:CourierWestford Pension Finance Putting the Risks and Costs of Defined Benefit Plans Back under Your Control M. BARTON WARING John Wiley & Sons, Inc. iii P1:TIX/XYZ P2:ABC JWBT542-fm JWBT542-Waring August9,2011 20:9 Printer:CourierWestford Copyright(cid:2)c 2012byResearchFoundationofCFAInstitute.Allrightsreserved. PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey. PublishedsimultaneouslyinCanada. 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LimitofLiability/DisclaimerofWarranty:Whilethepublisherandauthorhaveusedtheir besteffortsinpreparingthisbook,theymakenorepresentationsorwarrantieswithrespectto theaccuracyorcompletenessofthecontentsofthisbookandspecificallydisclaimanyimplied warrantiesofmerchantabilityorfitnessforaparticularpurpose.Nowarrantymaybecreated orextendedbysalesrepresentativesorwrittensalesmaterials.Theadviceandstrategies containedhereinmaynotbesuitableforyoursituation.Youshouldconsultwitha professionalwhereappropriate.Neitherthepublishernorauthorshallbeliableforanylossof profitoranyothercommercialdamages,includingbutnotlimitedtospecial,incidental, consequential,orotherdamages. Forgeneralinformationonourotherproductsandservicesorfortechnicalsupport,please contactourCustomerCareDepartmentwithintheUnitedStatesat(800)762-2974,outside theUnitedStatesat(317)572-3993orfax(317)572-4002. Wileyalsopublishesitsbooksinavarietyofelectronicformats.Somecontentthatappearsin printmaynotbeavailableinelectronicbooks.FormoreinformationaboutWileyproducts, visit our web site at www.wiley.com. LibraryofCongressCataloging-in-PublicationData: Waring,M.Barton. Pensionfinance:puttingtherisksandcostsofdefinedbenefitplansbackunderyour control/M.BartonWaring.–1 p.cm.–(Wileyfinanceseries;708) Includesbibliographicalreferencesandindex. ISBN978-1-118-10636-5(hardback);ISBN978-1-118-13836-6(ebk); ISBN978-1-118-13833-5(ebk);ISBN978-1-118-13834-2(ebk) 1.Pensions–Finance. 2.Pensionsmanagement. 3.Pensiontrusts–Management. I.Title. HD7091.W272011 331.25(cid:3)24–dc23 2011018496 ISBN978-1-118-10637-2 PrintedintheUnitedStatesofAmerica. 10 9 8 7 6 5 4 3 2 1 iv
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