Book Review: Pension Finance

Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back Under Your Control. 2011. M. Barton Waring.

Pension finance is one of those seminal investment issues that have generally been dealt with by “whistling past the graveyard.” Avoidance has been driven by the magnitude of the underfunding problem, as well as the language and methodologies that have made the issue baffling to beneficiaries, funders, policymakers, and the general public. Now, however, the fundamental trade-off — forgo present cash salary for future pension benefits that create liabilities — is becoming more pressing as the demographics start to weigh on both public-sector and private-sector employers.

The financial ramifications of defined benefits for public employees constitute one of the most troubling policy problems in the United States. Although it may be too late to save this system for providing defined benefits, there is still a chance to save the benefits that have already been promised. This goal can be achieved, however, only through a clear understanding of plan economics.

Given the seriousness of the issues, M. Barton Waring’s Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back Under Your Control represents a timely and valuable contribution. Waring has been studying pension management for decades, and his sound economic foundation is grounded in reality through his work in the trenches. He served as global chief investment officer for investment strategy and policy at Barclays Global Investors. Drawing on this expertise, he has produced a perfect resource for anyone hoping to understand the practical aspects of measuring defined benefit risks.

This book can serve as a primer on the complexities of defined benefit programs for directors, trustees, consultants, actuaries, and union representatives. Nevertheless, Pension Finance is not an easy read. In an effort to be precise, the author frequently uses long, highly structured sentences that require careful reading. Furthermore, the pension field’s terminology and jargon demand slow, intense study. Gaining a firm grasp of the accounting principles of amortizing and the economics of discounting future liabilities is no simple task. These challenges have long made pension analysis an esoteric area of finance, inaccessible even to most finance professionals.

Waring begins his book with a near polemic against pension funds’ errors in discounting future liabilities to determine present values. It is maddening to realize the magnitude of the funding problem and the fact that it arose through the poor application of such a fundamental concept in economics. To be sure, the devil is always in the details, but the pension plans’ miscalculations are not entirely accidental. Key players have used accounting gimmicks to obscure the reality of future liabilities.

Although the actuaries charged with doing the calculations properly are not financial economists, the author wants to close that gap. He operates on the premise that proper measurement, based on a sound economic foundation, leads to truth. At one point, Waring shows how an HP 12C calculator can do most of the work necessary to provide a solid ballpark estimate of funding needs. Unfortunately, most plan sponsors will not be happy with the results of this simple analysis. The true funding risks in pension plans are formidable.

Waring provides a vast number of pension finance propositions, but his book has a few key takeaways:

• The portfolio’s expected return is not the correct discount rate.
• Risk-free and expected rates of return are not the same thing.
• High expected returns and high discount rates have high risk.
• The expected value of the portfolio is not equal to contributions plus the realized return; thus, there is a significant chance of a shortfall in the portfolio, especially at higher discount rates. This shortfall does not go away with time because any realized shortfall must be made up with a better return or, more likely, new cash contributions.
• The economic liabilities do not change with the investment strategy decisions. They are adjusted only through controlling the benefit policy.

These conclusions on discounting may seem obvious. Unfortunately, in the pension world, things become complicated by actuarial and accounting perspectives. Waring strives to peel back all the issues to the fundamental truth that economic or market value accounting alone will provide the correct answers on risks. Normal cost and accrual methods may serve to smooth liabilities, but these techniques do not alter economic reality.

Pension liabilities drive not only the funding requirement but also, through the plan surplus, the investment strategy or strategic asset allocation. In its simplest form, the strategic asset allocation consists of two portfolios: the liability-matching portfolio and the risky asset portfolio.

Pension Finance stresses the principle that new asset classes are not needed to boost returns but, rather, a strategic focus is needed to maintain an emphasis on hedging the liabilities. The hedging portfolio must match the accrued liabilities’ total return sensitivity to the real interest rate and inflation. This matching is difficult to achieve in practice, but keeping the strategic goal in mind is valuable.

For the risky asset portfolio, the plan sponsors must firmly establish their risk tolerance, which can be ascertained only with a clear idea of the plan’s surplus and an understanding that the realized return may not equal the risky portfolio’s expected return. On the investment management side, the most important challenges do not involve the details of a sophisticated asset/liability management model but, rather, surplus optimization and the risks inherent in a true economic accounting.

Waring stresses that failing to achieve the required rate of return creates substantial risks over the life of the plan. Shortfalls must be made up with real dollars because the liabilities do not go away. He presents convincing evidence, through clear diagrams, that the reduction in compounding that results from earning less than the required return creates risks that increase over time. The budget identity of any pension plan shows that management can change present values only by changing benefit policies. There is no free lunch.

Without free lunches, an underfunded pension plan can be saved only through a policy of tough love. Benefits must be adjusted downward and contributions shifted upward. A pension plan’s chief investment officer cannot pull a rabbit out of a hat through sheer investment acumen.

From a broader public policy perspective, the solution requires an overhaul of accounting and actuarial standards. Ideally, the outcome will be a single, universal measure of liabilities. Devising multiple ad hoc approaches for saving particular pension plans is neither workable nor prudent. The plans’ economics are all the same, and so their reporting requirements should be identical.

These policy issues are tricky. Amortizations must be adjusted, the expenses on the income statement must be restated, and where on the balance sheet the liabilities should appear must be decided. Moreover, as risks have increased, so too have the values of guarantees for pension plans and the intensity of the debate over deductibility. Pension Finance does not duck these issues but, rather, states that the resolutions must be consistent with the economics.

Today’s highly charged political environment is not helping matters. Waring’s well-designed framework shows that a central bank policy of low interest rates will devastate the underlying risk assumptions of most defined plans. Protests by state employees will not change the poor economics of funding.

Although current accounting practices provide answers on pension finance, in many instances those practices address the wrong questions. Information is power and poor information means that pension participants and managers are not empowered to make good decisions. Waring poses the proper questions and offers an astute set of answers. He shows that managers can make better decisions with lower risk if they focus on the basics. Solutions to the problems of defined benefit plans are within our grasp if we choose to accept them. Waring’s thorough analysis enables us to comprehend the key choices.

Waring is writing to leave a legacy for pension advisers. He has succeeded in creating one of the definitive works on the structure and management of defined benefit plans. Pension Finance forcefully dispels any notion that easy solutions exist. No accounting magic or special portfolio strategy can rid companies of underfunding. Although the sobering truth is hard to swallow, Waring’s clarity makes this book essential.

More book reviews are available on the CFA Institute website or in the Financial Analysts Journal.