Pension finance : putting the risks and costs of defined benefit plans back under your control

338 Pages·2011·2.82 MB·English

by  M. Barton Waring

PENSION
FINANCE
Putting the Risks and Costs of Defined
Benefit Plans Back Under Your Control
M. Barton Waring
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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
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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
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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
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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
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Pension Finance
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Pension Finance
Putting the Risks and Costs of
Defined Benefit Plans Back
under Your Control
M. BARTON WARING
John Wiley & Sons, Inc.
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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
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