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Asset/Liability Management Pensions and Other Post Employment Benefits. State Association of County Retirement Systems (SACRS) February 6, 2007 Navigating Public Pensions & OPEB with Liability Driven Investments Ryan Labs (www.ryanlabs.com) Sean McShea SMcShea@RyanLabs.com

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slide1

Asset/Liability Management Pensions and Other Post Employment Benefits

State Association of County Retirement Systems (SACRS)

February 6, 2007

Navigating Public Pensions & OPEB

with Liability Driven Investments

Ryan Labs (www.ryanlabs.com)

Sean McShea SMcShea@RyanLabs.com

Chris Adair CAdair@RyanLabs.com

Jason Johnson JJohnson@RyanLabs.com

1

pension opeb problems
Pension & OPEB: Problems

Problems:

  • Under Funding
  • Higher Net Costs (Accrued Liabilities)
  • Higher Contributions
  • Compounding in reverse (Negative Leverage)
  • CPI & COLA inflation < Medical inflation
  • Demographics
  • Mortality tables
  • Sunset communities vs. Sunrise communities

2

pension opeb crisis in public plans
Pension & OPEB: Crisis In Public Plans

Causes:

  • Silo effect (optimization in isolation)
  • Agency problem (no one in charge)
  • Morality issues (wealth transfer)
  • Asset Only Framework (mean variance models)
  • Actuarial Smoothing (No economic content)
  • Pro forma Accounting Return Assumptions
  • Lack of Financial Economics in pension practices
  • Peer Group (Beauty Contest)

3

client objectives public funds
Client Objectives:Public Funds

Client

NuclearDecommissioning

Corporation

Hospitals

Taft-Hartley

States&Municipalities

Endowment/Foundation

Insurance

General Accounts

Construction

Pension

OPEB Medical

Lottery

Prepaid Tuition

Defeasance

Worker’s Compensation

Custom Distribution

Custom Grant

Endowment

Pensions

Medical Liabilities

Construction Projects

Defeasance Programs

Self Insurance

Incurred Liabilities

Pensions

Medical Liabilities

Pensions

Medical Liabilities

Plan Terminations

General Accounts

Life

Workers Compensation

Property & Casualty

5

slide6

Public Plans:Assumptions

Government will not default on it promise

  • Prefunding ensures intergenerational fairness
  • Current stakeholder pays fair share current cost
  • Future stakeholder pays only for future cost
  • Minimize current costs by capturing equity risk premium
  • Protect the municipal bond rating and bonding capacity
  • Participants exchange direct for deferred compensation
  • Stakeholders own the pro rata share of balance sheet

6

slide7

Public Plans:Three Key Levers

  • Benefit Management
    • Current benefits, Benefit enhancements
  • Contribution strategy
    • % of active payroll
    • Constrained by budget
  • Asset Allocation
    • Capture equity risk premium (Reduce cost)
    • Avoid risk

7

slide8

Teams:

Asset/Liability Watch (December 2006)

2006: Good year !!

8

slide9

Assets vs. Liabilities

Funding Volatility (December 2006)

9

risk risk is based on the objective
Risk is best defined as NOT meeting the client objective:

No Risk =Assets Match Liabilities

High Risk = Assets Don’t Match Liabilities

(Surplus Volatility)

Low Risk =Assets Behave Like Liabilities

Return of Portfolio – Return of Objective

New Sharpe Ratio =

STD (Portfolio Return – Objective Return)

Risk: Risk is Based on the Objective

10

slide11

GASB 25 versus FASB 87/158

(Difference between Public & Private)

11

slide12

Public Pension Plan

Funding Policy v. Investment Policy

12

slide13

Time: Annual Financial Statements

(Private vs. Public)

Annual Reporting Requirements

Pension contribution annually

Based on present value of assets and liabilities

Private/Corporate America

Pension Expense (Income Statement)

Pension Contribution (Cash flow Statement)

Surplus or Deficit (Balance Sheet)

Public/State or City

Revenue & Expense (Municipal rating)

Funding Cost (Current tax rates)

Surplus or Deficit (Generational or resident equity)

13

rules gasb 43 45 non pension related liabilities
Rules: GASB 43 & 45(Non Pension Related Liabilities)

OPEB Other post employment benefits

GASB 43 Financial Reporting for Post Employment Benefit Plans Other Than pension plans

Requires accrual of liabilities

Replaces pay-as-you go basis

GASB 45 Requires accrual of OPEB expense

14

slide15

Playing Field: Time Frame

Long Term Horizon v. Solvency

  • Public Plans : Horizon (10 to 20 year horizons)
  • Prevailing Pension practice
  • Smoothing Assets (5, 10, 15 years)
  • Amortization of Liabilities (15 to 30 years)
  • Fully funding (assumes asset allocation return of 8%)
  • Assumes Sponsorship Longevity
  • Private : Economic Solvency
    • Best Practice methodology
    • Fair Value of Assets and Liabilities (Basel II)
    • No smoothing
    • 100% interest rate driven
    • Mark to Mark Valuation on Assets vs. Liabilities

15

slide16

Playing Field:

Solvency / Present Value $

  • Future value (Projected benefit payments)
  • Inflation, COLAS, Mortality
  • Labor costs/demographics
  • Plan design
  • Don't know the future value of assets
  • Present value
    • Determines funding adequacy
    • Required by SEC/FASB/PPA 2006
    • 100% interest rate driven
    • Priced using yield curve

16

slide18

Problem: Investment Process

Prevailing Practice vs. Best Practice

Current Actuarial Models and Methods

Current practice is not best practice

Financial Economic models expose flaws in standard modes

Calls for revision of actuarial training and practice

Financial Economics and Actuarial Practice

Tony Day

Presented at The Great Controversy: Current Pension Actuarial Practice in Light of Financial Economics Symposium

Sponsored by the Society of Actuaries

Vancouver

June 2003

18

slide20

Problem: Stakeholder

Current vs. Future

  • Generational Equality (Fair share of costs)
  • Pro Forma mechanism transfers risk ($1 equity > $1 bonds)
      • Reward is captured today, risk is transferred to the future
      • Smoothing feels good but contains no “economic” content
      • Current practice favors current management, taxpayers, plan participants, politicians, at the expense of future shareholders and stakeholders (taxpayers).

Source: Risk Transfer in Public Pension Plans, Jeremy Gold, PRC WP 2002-18, 2002, Pension Research Council

The Wharton School, University of Pennsylvania

20

slide21

Problem for Stakeholders

Expected Returns

  • Sub Optimal Decision Making
  • Benefit leakage (wage / pension negotiation)
      • Asset Allocation focused on asset only framework
      • Granting of valuable options (DROPS, skim funds)
      • Costly financing options (i.e. Pension Obligation Bonds)
      • Wealth transfer devices (i.e. Infrastructure Securitization)

Source: Risk Transfer in Public Pension Plans, Jeremy Gold, PRC WP 2002-18, 2002, Pension Research Council

The Wharton School, University of Pennsylvania

21

slide22

Problem:Actuarial Valuations (Mispricing Liabilities)

Actuarial Flaw: (Benefit Management & Funding)

Single Discount Rate

(Assumes “horizontal” term structure)

Not fully determined by market interest rates

(Usually 100 to 400 plus basis points too high)

Present Value calculation performed annually

(Usually the month plus delinquent)

Liability Term Structure not visible

(Short, Intermediate, Long, Very Long)

22

slide23
Robert North, Chief Actuary of New York City

Actuarial methods based on actuarial interest rate (AIR)

Ignores financial economics

North ratio: NYCRS 70% Funded ($14 B deficit)

2005 CAFR : NYCRS 99% Funded (No deficit)

Problem: Disclosure

A New York City Pension Story

Source: Life & Pensions magazine, March 2006

23

slide24

Problem : Generic Indexes

(Mean Variance Models)

  • Mean Variance Models based on Generic Indexes
  • Represent the market (Lehman Aggregate, S&P 500)
    • (Subjective methodology)
    • (Potential bias = Investment Banking, Trading)
    • NOT based on client liability schedule
    • (Unique to each client)
    • Does NOT represent clients’ true objective

24

slide25
Goal Measure growth, size, shape of liabilities

Features Market value, yield, duration, returns

Return Total return, index levels

Performance Money management index

Quantifies asset allocation

Scoreboard:

Custom Liability Index

25

slide26

Solutions:

Adopt Liability Benchmark

26

slide27

Structure Difference

Liabilities vs. LB Aggregate

27

slide28

Solution:

First Steps

Reduce Risk, Protect Expected ROA

28

slide29

Solutions:

Strategy Results

29

slide30
Goal Measure growth, size, shape of liabilities

Features Market value, yield, duration, returns

Return Total return, index levels

Performance Money management index

Quantifies asset allocation

Scoreboard:

Custom Liability Index

30

slide31

Solution: Custom Liability Index

  • Benefits
  • Represents client objective (funding target)
  • Supports strategic & tactical asset allocation
  • Benchmark for asset management
  • Benchmark for performance measurement
  • Benchmark for risk management control
  • Foundation for risk budgeting

31

slide32

Solution: Asset Allocation

Liability Driven Allocation

  • Asset allocation based on two portfolios:
  • Beta Portfolio = Liability Portfolio
  • Bonds to outgrow liabilities
  • Interest rate hedge
  • Bonds, Futures, Swaps
  • Alpha portfolio = Performance Portfolio
  • Non Bonds
  • Without liability constraints
  • Rebalancing = Success is rebalanced back to Beta
  • Harvest gains

32

slide33

Objective:

Understand the Liabilities

33

slide34

Problem:

Negative Leverage

34

solution new approach new methodologies
Solution: New Approach(New methodologies)

Transparency

Fair Value Accounting

Asset/Liability Management

Focus on Asset Allocation (Strategic/Tactical)

Alternative Asset Classes (Low correlation)

35

solution new approach new methodologies36
Solution: New Approach(New methodologies)

Traditional Approach

LDI Approach

Liability Risk

Asset Mix Risk

Active Risk

Source: Leo de Bever, Ontario Teachers' Pension

36

slide37

Solution: Move Away From Single Focused Strategies

Source: First Quadrant/Research Affiliates

37

slide38

Ryan Labs:

Assets vs. Liabilities Monitor

Annualized

Annualized

Twenty

Year

Returns - Period ending 12/31/05

Return

Return

16%

16%

Ryan Labs Liability

Index is represented by

the Treasury STRIP

14%

14%

curve (1 thru 25 years)

S&P 500

Wilshire Large

11.93%

Wilshire Small

Cap Value

12%

12%

Cap Growth

12.15%

Russell 2000

12.00%

11.17%

P&I Asset

10.61%

Ryan Labs

MSCI EAFE

Liability

10.00%

11.07%

Merrill Lynch

10%

10%

High Yield

Ryan Labs

9.26%

Merrill Lynch

30yr. Treasury

Yankee

8.79%

8.63%

Ryan Labs

Lehman

10yr. Treasury

FInancial Times

8%

8%

Aggregate

7.58%

Equity Pacific

7.88%

7.30

%

Ryan Labs

3yr. GIC

6.75%

Ryan Labs

5yr. Treasury

6.95%

6%

6%

Ryan Labs

Ryan Labs

2yr. Treasury

6 mo. Bill

6.16%

5.24%

Very Long

Short

Intermediate

Long

0

2

4

6

8

10

12

14

16

18

20

22

24

Volatility of Total Return (STD)

Sources: Ryan Labs, Inc.- Standard & Poor's Corporation - Lehman Brothers - Merrill Lynch - Morgan Stanley Capital International - Frank Russell Company - Financial Times - Wilshire Asset Management - Crandall, Pierce & Company

The information presented herein was compiled from sources believed to be reliable. It is intended for illustrative purposes only, and is furnished without responsibility for completeness or accuracy.

Past performance does not guarantee future results.

Assets vs. Liabilities Monitor

(Last 20 years ending 2005)

38

slide39

4%

4%

Ryan Labs Liability

Index is a proxy

2%

for pension plans

2%

Wilshire Large

Wilshire Large

Cap Value

Cap Growth

S&P 500

Ryan Labs

Liability Index

0%

0%

n

P&I Asset

Russell 2000

Lehman

n

GC Long

Merrill Lynch

Merrill Lynch

Ryan Labs

Convertible

Merrill Lynch

High Yield

30yr. Treasury

Yankee

-2%

Annualized Excess Returns vs. Ryan Labs Liability Index (%)

-2%

Annualized Excess Returns vs. Ryan Labs Liability Index (%)

MSCI EAFE

Lehman

Ryan Labs

Aggregate

10yr. Treasury

Ryan Labs

-4%

-4%

3yr. GIC

Ryan Labs

5yr. Treasury

Ryan Labs

2yr. Treasury

FInancial Times

Ryan Labs

Equity Pacific

-6%

-6%

6 mo. Bill

0

2

4

6

8

10

12

14

16

18

20

22

24

26

Annualized Tracking Error (TE) vs. Ryan Labs Liability Index (%)

Asset/Liability Return Difference

And Tracking Error (Last 20 years)

Asset/Liability Return Difference

39

slide40

Solution: Equity Correlation to Liabilities

(1) RL Treasury Long Index from 1949 to 1990, RL Liability Index from1991 to 2006,

40

slide41
Adopt Liability Driven Investment strategy

Design Custom Liability Index

Document economic solvency

Document cash flow budgeting

Segregate Liability portfolio

Segregate performance portfolio

Reduce deficit, harvest gains back to liabilities

Grow surplus

Monitor risk

Document, Document, Document

Solution: Next Steps

41

slide42
Move from prevailing practice to best practice

Create economic and actuarial reporting

Replace Policy benchmark with Liability benchmark

Understand limitations of peer group analysis

Structure fixed income to liabilities

Segregate Surplus (performance portfolio)

Positive story to trustees and rating agencies

Protect defined benefit pension plans

Solution: Small Steps

42