FPPTA Trustees School - Financial Economics

1. FPPTA Trustees School - Financial Economics October 6, 2009 Jose Fernandez

2. Nomenclature • FE – Financial Economics • MVL – Market Value Liability • LDI – Liability Driven Investments • Mark – to – Market

3. Why Do We Need To Know About FE? • Dramatic Impact On • Taxpayers • Plan Sponsors • Bond Ratings • Plan Members • Prompt calls to replace defined benefit plans with defined contribution plans

4. Why Do We Need To Know About FE? • Financial Economics compares pension • Market Value of Liabilities (MVL) based on short-term fixed income interest rates to • Market value of assets (No asset smoothing) • Mark-to-market – ignores very long time horizon of pension plans and eliminates smoothing process.

5. Why Do We Need To Know About FE? • Actuarial organizations and bond investors promoting FE for pension plans. • Applying FE to public pension plans would • Reduce funded status 30% to 50% • Double or triple contribution rates

6. Sample FE Impact

7. What Is Financial Economics? • Branch of microeconomics concerned with the workings of financial (capital) markets • Concentrates on money transactions • One aspect is how markets determine current values of transactions involving a stream of future cash payments

8. What Is Financial Economics? • Two well known cash flow transactions are stocks and bonds – stocks generate dividends and/or earnings growth, and bonds generate future interest and principal payments. • Both trade on the open market and therefore determining their “market” value is straightforward. • Some cash flow transactions, like pension payments, do not trade openly so determining a “market” value is more difficult.

9. What Is Financial Economics? • FE considers pension payments to be a form of corporate (government?) debt and the assets held in trust to be corporate (government?) assets. • The plan sponsor is the borrower of the debt and the plan participants are the lenders. • Economists argue that employee debt is inefficient and therefore sponsors should borrow money elsewhere.

10. What Is Financial Economics? • FE views pension plans as pass-through entities, not stand-alone entities. • A pension plan is a means for shareholders (taxpayers?) to compensate employees for their services. • FE does not support the concept that a pension plan is a long-term enterprise nor that pension plans can take a long-term view of risk and reward.

11. What Is Financial Economics? • FE concludes, for most pension plans, that all assets should be held in bonds. • When recognizing the tax treatment of pension trusts, FE argues that shareholders (taxpayers?) are better off on an after-tax basis if the plan holds higher-taxed investments (like bonds) and shareholders (taxpayers?) hold lower-taxed investments (like stocks) in their individual portfolios.

12. How Is It Being Applied To Pensions? • Ideal investment for full funding should be risk-free bonds because of tax-arbitrage and cash flow match. • Value of the obligation (the pension) is independent of the choice of assets used to secure it. • Failure to invest 100% in bonds is due to opaque accounting rules and will change when more transparency is mandated.

13. How Is It Being Applied To Pensions? • FE argues the “market” value of the promised pension benefits is the expected payment stream for benefits earned to the valuation date (based on service and salary to that date) discounted by a risk-free interest rate. • In a perfect world this “market” value would be 100% funded with a duration matching portfolio consisting of risk-free bonds, and each year’s pension cost would be the increase in this liability from the previous year. • Moving to a 100% fixed income portfolio “locks in” higher costs than would potentially be the case with a diversified portfolio. This is a great scenario for defined contribution plan proponents.

14. Issues With MVL Calculation • There are many assumptions used to develop the expected benefit payment stream. Why eliminate risk in only the discount rate? Should we assume everyone lives to 120? Everyone retires when first eligible? No one terminates before retirement? We use expectations for all these risks, why not investment return? • The use of a risk free discount rate ignores the higher expected return from stocks. Public plans have a very long time horizon and can take advantage of the smoothing process. • If greater returns cannot be anticipated, then why would anyone want to invest in equities? Surely there are some investors who can accept the risk – those with very long time horizons and low demand for current cash – i.e., public DB plans. • If a risk free bond portfolio is the correct investment allocation for DB plans, where are the instruments going to be found? Who will buy all the equities that plans now hold?

15. Private vs. Public Plans • FE has a role in private plan administration for a number of reasons: • Sponsors of private plans are in business to add economic value for their shareholders and need a “market” value for their pensions in order to allocate resources efficiently. • Private plan sponsors can go bankrupt which will then require a “market” value of plan liabilities. • Private plans can be terminated so the “market” value of the benefits accrued to a specific date can provide useful information. • These issues do not apply to the public sector.

16. Private vs. Public Plans • Because plan termination is not an issue in the public sector there is no comparable calculation that is valid or necessary for public plans. • No public plan event will cause a frozen deferred accrued benefit payment stream, which is what mark-to-market measures. What is the rationale for placing a “value”, however discounted, on a benefit stream that can never exist in the real world? • Governments are not created to add economic value but rather to provide services. Impetus should be on providing those services as cost efficiently as possible for taxpayers.

17. Does This Make Sense in the Public Sector? • For measurement purposes • GASB considered but rejected the use of a single interest rate when developing Statements 25 and 27. • GASB currently studying applicaton of FE. • For funding • A significant purpose of employer sponsored pension plans is to deliver a valuable benefit as efficiently as possible, including managing both cost and risk. FE substitutes risk aversion for risk management. • FE argues current actuarial practice shifts risk to future generations of taxpayers. However it only looks at the downside. Could equally be argued MVL penalizes current taxpayers to the benefit of future taxpayers. • Cost is very great.

18. Additional Thoughts • Opportunities will exist if private sector moves to bonds. Current private sector asset base about $2 trillion. • In fact, who would buy all the equities currently held by both private and public plans? • Interesting side argument regarding DC plans – shouldn’t they be all bond portfolios as well?

19. Current Public Sector Plan Status • Actuarial Standards Board of American Academy of Actuaries to develop standards for consistent measurement of the economic value of pension plan assets and liabilities. • Public sector actuaries exploring possibility of founding organization independent of private sector actuaries.

20. Current Public Sector Plan Status • GASB is currently reviewing use and value of Statements 25 and 27. • One of the items included will be the application of financial economic theory to disclosure and funding requirements currently in those statements. • This effort is expected to take several years to complete.

21. Possible Implications of FE • If FE is applied to public plans, the initial step is likely to be disclosure of MVL and MVA. • In addition to or as a replacement of current disclosure? Depends on GASB. • Next step would be changes in funding. • Potential for more volatile and higher contribution rates. • Final step would be investments. • Move to all fixed income portfolios. • Potential for significant impact on financial markets.

22. Final Thoughts • Public pension plans ongoing – Financial Economics short-term view not appropriate. • Asset smoothing (not market value) reasonable to alleviate short-term volatility. • 7-1/2% to 8% anticipated future rate of investment return consistent with long-term nature of public pension plans.