The Blindmen And The Elephant

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Wayne H. Wagner Chief Investment Officer Edward C. Story

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LarryJ. Cuneo Portfolio Researchand Operations

THE BLINDMEN AND THE ELEPHANT MONTHLY COMMENTARY #19

October 1988 from a speech by Wayne at the Institute for Quantitative in Finance in San Diego, October 2-5, 1988.)

(Summarized Research

Each of the proverbial blindmen who touched a dissimilar part of the elephant envisioned a different treast. Likewise, the various interested parties who view the pension plan develop different perspectives. The actuary, the accountant, the employee benefits administrator and the pension investment administrator all have different perspectives, but is any of these more correct?

Historically, it was the view of the actuary that dominated the management of the pension plan. Operating under the imprimatur of the profession, he discounted the accumulated earned benefits back to the present. The discount rate was a conservative, stable rate which more or less assured pension payments under all but the worst conceivable circumstances.

a

substantial margin

of

It

also created case the safety

assumptions didn't work out

in

The pension investment administrator found little reality in the actuary's assumptions, and

dealt with the world as he saw it. Usually the game was defined as a devil-take-the-hindmost horserace, restrained only by a fear of the very

real risks of falling well short of expectations.

.

The actuary's view was accurate from where he stood, yet it failed to recognize several key factors:

1.

Out of necessity, other parties responsible for other aspects of the pension plan developed their own independent views.

The employee benefits administrator generally ignored the views of both the acfuary and the pension investment administrator, and focused on the benefits and the beneficiaries.

The conservatively stated discount rate'gave

little useful guidance to the

manager charged

ENTER THE ACCOUNTANT

with implementing the investment program.

2.

The assumption of a fixed rate gave little acknowledgement to the implications of variabiliry in asset values.

3. The use of earned benefits ignored the predictable stream of changes in pension pro) mises in response to company and economic growth.

FASB 87 brought forth

a new view of

the

pension plan: that of the accountant. The accountant's new view was to valte both the

liabilities and the assets at market (not actuarially assumed) rates. The net result was a far more realistic view of the pension funding process. The view shifted toward a comprehensive and inclusive view of both sides of the assetfliability equation. The focal point became

the difference between the asset valuation and the liability valuation: What private plans usually call surplus and public plans call shortfall.

on pension payments years into the future, a risk which has little to do with December 31st interest rate quotes.

Certainly, the accountant's view provided many useful insights. Most importantly, it reduced the isolation of the pension investment administrator and made him or her rethink the nature of the investment activity in the context of the liability

Finally, and most importantly, bonds do not participate in the productive energy of the economy. In Monthly Commentary #5, we identified The Pension Promise as an adequate standard of living paid for by the ultimate pension payments. Comparable standards of living, and thus the eventual pension payments, are strongly influenced by economic productivity growth. A heavy fixed income orientation dooms pension plans into falling further behind the rising benefits. Pension investment is not as simple and one-dimensional as the advocates of FASB 8? would have us believe. Pension risks have many important dimensions beyond short term interest rate fluctuations.

side of the equation.

Unfortunately, FASB 87 also invited a considerable narrowing of the range of investment alternatives thought to be suitable to the fund. Here's how this happened: Bond prices vary with interest rates. If the present value of a liability also varies with interest rates, then a liability is an anti-bond which can be neutralized by locking it in with a bond of similar interest rate response. The natural outcome of this thought process is that bonds appear to be the ideal vehicles for funding pension liabili$ streams.

Hidden behind this seemingly simple and elegant solution is a serious flaw: The accounting rules have taken precedence over the strategic objectives. The best solution to the accounting problem (minimizing the pension plan's effects on the balance sheet and income statement) is not the same solution which would derive from a thoughtful analysis of the plan's strategic objectives.

A short term horizon has been interposed over a long term problem. From this narrow view, the most important variable in the management of the pension plan becomes the December 31st insurance company new money rate, which is the rate typically used to price the liabilities. This view has many faults. First, bonds are not

the Fixed Income vehicles they once

were: creative

inflation, interest rate volatility, and covenants have radically altered the nature of the tlpical bond. Secondly, a very short horizon was imposed on the pension plan: the December 31 valuation date. Risk has been equated to variabilif"in

short term interest rates. Yet

in realify, a

pension fund is a continuing economic entity with a horizon usually stretching into decades. The most relevant risk is that of falling behind 2

OFFSETTING THE REAL RISKS section, we will illustrate in a slightly different context how some of dimensions of risk can be offset through a policy which would at first glance appear more riskY.

In this

Medical benefits for retirees is one of those topics that no one seems eager to discuss. The big bugaboo for health plans is the rapidly expanding use of new and very expensive medical technology. Whatever current assumptions are made for financing future levels of health payments, they are likely to fall far short. There is no good way to make estimates, because it is impossible to predict the timing and cost of new medical technological breakthroughs.

Any funding strategy based on the present value of assumed future payments is tikely to fall very short.

Yet there is good news: the financial hazards of productivity gains in medical technology can be partially offset by a well conceived investment policy. The financial beneficiaries of medical breakthroughs will be the equity owners of the companies which produce the breakthroughs. The obvious hedge for a health benefit plan, then, is to invest in medical technology stocks. Asset values then rise in response to the same events that raise medical costs.

The same thoughts apply to the pension plan: a well conceived investment strategy should favor assets which will benefit from gains in

contributions and/or greater assurity of payment. This is achieved, of course, at a cost of higher short term variability. Variability, unfor-

productivity; namely equities.

tunately, is likely to create FASB 87 problems for the pension investment administrator.

OUR NEW HERO

A conflict of views is almost The actuary's view has been shown to be insuf-

ficient, the accountant's view is short sighted, the investment administrator is sometimes caught up in the romance of the asset side of the pension world.

1.

Pension funds exist to pay retirement bene-

Curiously then,

fits.

insights into the optimal investment stratery. Of all the pension blindmen, the employee benefits

2.

it is the view of the employee benefits specialist which provides the best administrator knows whv the pension plan exists: To fulfill the employees' expectation of a decent standard of living throughout retirement.

In earlier times it was the view of the actuary which had to be resisted in order to establish rational pension investment policy. Now, the viewpoint of the accountant must also be

inevitable. and the

logic behind the investment strategy must be well thought out ahead of time. Strategy must be built on a clear understandins of the nature of the pension plan: Accordingly, the asset policy must be related to the benefits policy. The actual pension benefits that will be paid in the future will reflect the then-contemporary comparable standard of living. As a result,

pension benefits will probably grow beyond current expectations due to productivity increases in the economy.

3.

The only way to hedge those long term risks

is to invest in assets which participate in the benefits of productivity gains: equity issues.

resisted.

4. It is from

the viewpoint of the employee benefits administrator that bonds are revealed as not being the end-all solution to pension funding. It is by observing the process by which pension obligations grow over time that we gain a better understanding of the nafure of pension risk. This understanding leads to a better perspective on the relative merits of different classes of assets. Equity returns not only relate best to productivitygains, they also have higher expectations which should lead to higher benefits, lower

Equity markets are volatile and will rise and fall several times before the assets are cashed in to pay pension benefits. This does not create a long term problem.

Risky assets will cause variations in year-end surplus valuations, with possible balance sheet and income statement effects on the corporation. A rational long-term pension investment strategy surely must take cognizance of these effects. but cannot allow itself to be dominated by them.