Column: Achieving Solvency Nirvana

From aiCIO Magazine's Summer Issue: Static approaches in dynamic markets are likely to fail.

To see this article in digital magazine format, click here.

The market volatility of 2008 and 2010 has caused many funds to reach for new concepts such as “Risk Parity,” “Risk-Based Allocations,” “Tail Risk Hedges,” and “Pension De-Risking,” with managers glad to supply such products. Many CIOs are looking to implement risk measurement systems in the hope that risks might be managed through these systems. This frantic search to deviate from the failed portfolio approaches of the last decade is understandable, as pension funds have lower solvency, endowments have tighter budgets, and the economic environment is not conducive to increased contributions to top up previous losses. However, all these approaches, along with the expensive and time-consuming risk systems being implemented, will not solve the fundamental problem in institutional investing. They repeat the mistake made earlier—namely, that static approaches to portfolio management in dynamic markets are likely to fail, with the only questions being when and how badly.

It is my opinion that setting up an adequately staffed, compensated, and empowered investment office is preferable to paying external managers high fees for suboptimal products. The objective of any fund should be to ensure that the return of assets must be greater than that of liabilities, but more important and largely ignored, is that the correlation of the two portfolios should be high. Otherwise the risk to the sponsoring company, public institution, or university will be high. Risk is not tracking error to a strategic asset allocation (SAA), but the drawdown of solvency of the portfolio (a term I call “Yield to Fire”). Given current funding levels and interest rates, with moderate equity return estimates, the only way to achieve “solvency nirvana” is to be dynamic in all aspects of managing the portfolio and to manage both the beta and the alpha of the portfolio, especially of illiquids.

The process starts with defining an Investable Liability Portfolio (a liquid portfolio of swaps to track the daily growth in liabilities). This is the benchmark to match up against in managing portfolios. Thereafter, any SAA must be based on liquid instruments and only with indices with liquid futures contracts. Choosing a benchmark index for an asset class that does not have a futures contract engenders unnecessary cost and risk that gets charged to the CIO, with no benefit to either them or the fund, and does not allow the CIO to be nimble. Similarly, illiquid assets need to be benchmarked to liquid beta equivalents (e.g., private equity is leveraged Russell 2000 beta and similarly for hedge funds) to manage this beta.

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CIOs and Boards have to realize that all decisions in managing a portfolio, from implementing an SAA to doing nothing and letting a portfolio drift within rebalancing bands, is market timing. This is not a bad thing, but has acquired a distasteful reputation by uninformed analysts. Managing a portfolio, whether a pension fund or endowment, is no different from managing a portfolio of equities at an asset management company. Hence, the same processes can be applied. Successful CIOs will be those who ask and answer four questions daily at all levels of their portfolio, namely:

(a) What Should I Do (e.g., hedge liabilities, tilt into an asset class, allocate more to a manager, or do absolutely nothing)?

(b) How Much Should I Do (e.g., 1%, 2%)?

(c) When Should I Do It (e.g., based on the evolution of the economic and market factors that drive asset and manager perfor mance as opposed to end of quarter decision-making)?

(d) Why (a good economic rationale)?

A rules-based approach is simple and effective, and can help CIOs evaluate the efficacy of meeting their solvency return and risk objectives, while at the same time removing emotion in decisionmaking. This has worked for the CIOs who implemented it, and brings the same discipline to managing their own funds that CIOs expect from their asset managers.

Asset owners also must address risk-adjusted performance calculations (as the information ratio is simply wrong and easily gamed), evaluating whether managers are skillful. They also must assess how compensation in this industry needs to be changed to pay fees only for risk and skill-adjusted performance. It is my hope that CIOs adopt these processes and evaluation and compensation metrics quickly, as every pillar of retirement gradually is being eroded and adopting static, risky approaches to portfolio management will ensure only one thing— retirement and social insecurity.

Dr. Arun Muralidhar is Chairman of Mcube investment technologies LLC (www.mcubeit.com), and CIO of Alphaengine Global Investment Solutions (AEGIS). Arun is the author of a Smart Approach to Portfolio Management: An Innovative Paradigm for Managing Risk (Royal Fern Publishing LLC, 2011) and three other books. He has worked as a plan sponsor, Asset Manager, and supplier of investment and risk management technologies. He holds a Ph.D. in Managerial economics from MIT.

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Home > News > Regulation > Column: Pension Quandary in Valuing Liabilities

Regulation June 14, 2011

Column: Pension Quandary in Valuing Liabilities

From aiCIO Magazine's Summer Issue: Legislation has been proposed in Congress that would force states to publish their liabilities using corporate rates. This all leads to the question: What really is the right rate?

To see this article in digital magazine format, click here.

What is the value of your liabilities? This is a question that should be easy to answer. After all, we read articles daily that discuss the funded status of various pension plans. Obviously, in order to state the funded status, someone must have been able to figure out the difference in the value of plan assets and plan liabilities.

Yet here is the rub: The “value” of your liabilities is not the same thing as the liabilities themselves. For most American pension plans, if you know you have to pay a pipefitter $50,000 in the year 2031, you also know that number will not change. Whatever happens to interest rates over the next 20 years, you know that you owe that pipefitter, $50,000. That is your liability.

Yet, when you need to state the “value” of that liability in today’s dollars, that is where the difficulty begins. Let’s assume the pipefitter is 55 years old, is expected to retire at age 65, and is expected to live to be 85 years old with no survivors. Also, let’s assume that your pension plan has just frozen, so the pipefitter is no longer able to accrue additional denned benefits. If you use the interest rate on AA-rated corporate bonds as prescribed by the Pension Protection Act, the present value of that liability is approximately $349,000.

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However, let’s assume that the pipefitter is a state employee. In that case you—the pension plan—do not use AA-rated corporate rates to value liabilities; you use your expected rate of return on assets. For most states, that is somewhere around 7.5%. So, the same pipefitter with the same life expectancy and retirement age with the same $50,000 annual payments due from age 65 to estimated age 85 has a value of about $256,000. In each case, the actual value of the obligation is the same—20 x $50,000, or $1 million. So why should the present value of the liability be different?

This is more than an academic question. The Pension Protection Act essentially requires the use of AA-rated corporates for private-sector plans. Government accounting standards, however, rely on the expected rate of return on assets. Legislation has been proposed in Congress that would force states to publish their liabilities using corporate rates. This all leads to the question: What really is the right rate? Or is there really only one right rate?

It is appealing to argue that states should value their liabilities the same way corporate pensions do, and this certainly has some merit. But, in the end, it is somewhat facile to simply make this assertion and leave it at that. That assertion assumes that the way corporates measure liabilities is the right way. Is it? If it is the right way for corporates, does that necessarily mean it is right for public plans? Or should liability valuation differ depending upon who is asking and why?

Corporations are required to use specified discount rates for multiple purposes. The accounting standard allows various companies to be evaluated by investors in a consistent way. Since a pension promise is an obligation of the corporation, it should be treated the same as any other corporate debt and should be valued as such. Using AA-corporates as a surrogate for cost of capital may be a little conservative, but that helps lead to better funding, and it is more akin to the way that an insurer would look at the liabilities. Moreover, since corporations are not perpetual and always face the risk of bankruptcy, it is important that accounting standards and public policy encourage high degrees of funding so that, in the event of bankruptcy, the PBGC is not burdened unfairly.

States, on the other hand, have a different cost of funds, perpetual existence, the unlikelihood that an insurance company will ever take over their liabilities, and a clear understanding that time and investing are part of how they intend to meet their obligations. They do not report earnings per share, and you cannot own shares in them. States argue that achieving a 7.5% rate of return is realistic, particularly over decadeslong time horizons. According to Callan Associates, median public pension fund investment returns were 8.7% and 8.8%, respectively, for the 20-year and 25-year periods ending December 31, 2010. The problem in state plans generally has not been the long-term performance of the assets. It has been a problem of proper funding.

It is obvious that many states will face tremendous pressures regarding pensions in coming years. Many are facing them right now. Solving them, however, has less to do with the selection of the correct interest rate and more to do with proper funding practices, fund structures, and investment policies. Whatever the interest rate, we still have to pay the pipefitter.

Charles E.F. Millard was director of the U.S. Pension Benefit guaranty Corporation from 2007 to 2009 and is now a Managing director leading Citigroup’s Pension relations team.

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