2005 Pensions Convention The top 10 papers every scheme actuary should know about: abcd 2005 Pensions Convention The top 10 papers every scheme actuary should know about
Charles Cowling
5 – 7 June
Grand Hotel, Brighton
Top 10 Papers?:
Top 10 Papers? Actuaries, pension funds and investment– Arthur, Randall (1989)
The financial theory of defined benefit pension schemes - Exley, Mehta, Smith (1997)
Pensions, funding and risk - Chapman, Gordon, Speed (2001)
Reinventing pension actuarial science– Bader, Gold (2002)
Note on the relationship between pension assets and liabilities– Speed, Bowie, Exley, Jones, Mounce, Ralston, Spiers, Williams (2003)
Principles of Corporate Finance– Brealey, Myers (2003)
Essentials of corporate bonds for pensions actuaries– Forman, Freeman, Marshall, McKinlay (2003)
Funding defined benefit pension schemes – Cowling, Gordon, Speed (2004)
Longevity in the 21st Century– Willets, Gallop, Leandro, Lu, MacDonald, Miller, Richards, Robjohns, Ryan, Waters (2004)
Financial aspects of longevity risks– Jones, Richards (2004)
Top 10 Papers?:
Top 10 Papers? Actuaries, pension funds and investment – Arthur, Randall (1989)
On the risks of stocks in the long run - Bodie (1995)
The financial theory of defined benefit pension schemes - Exley, Mehta, Smith (1997)
The price of actuarial values - Gordon (1999)
Reinventing pension actuarial science– Bader, Gold (2002)
Note on the relationship between pension assets and liabilities– Speed, Bowie, Exley, Jones, Mounce, Ralston, Spiers, Williams (2003)
Essentials of corporate bonds for pensions actuaries– Forman, Freeman, Marshall, McKinlay (2003)
Pension fund asset allocation– Bianco, Cooper (2003)
Funding defined benefit pension schemes– Cowling, Gordon, Speed (2004)
Financial aspects of longevity risks– Jones, Richards (2004)
Actuaries, pension funds and investment Arthur, Randall (1989):
Actuaries, pension funds and investment Arthur, Randall (1989) Key lessons
The importance of asset / liability matching
The implications of mismatching
Performance measurement
The sponsoring employer
Investment objectives
Actuaries, pension funds and investment Arthur, Randall (1989):
Actuaries, pension funds and investment Arthur, Randall (1989) Further Reading
Objectives and methods of funding defined benefit pension schemes – McLeish, Stewart (1987)
A realistic approach to pension funding - Thornton, Wilson (1992)
On the risk of stocks in the long run Bodie (1995):
On the risk of stocks in the long run Bodie (1995) Key lessons
Measure risk by the cost of insuring against that risk
The cost of insuring against a fall in stock values increases with time
Put-call parity
The riskiness of equities (stocks) increases with time (as does the expected return)
Investment implications for individuals
On the risk of stocks in the long run Bodie (1995):
On the risk of stocks in the long run Bodie (1995) Further reading
Lifetime Portfolio Selection by Dynamic Stochastic Programming: The Continuous Time Case – Merton (1969)
Principles of Corporate Finance – Brealey, Myers (2003)
Financial Calculus An introduction to derivative pricing – Baxter, Rennie (1996)
Derivatives The Theory and Practice of Financial Engineering – Wilmott (1998)
The Pricing of Options and Corporate Liabilities – Black, Scholes (1973)
Theory of Rational Option Pricing – Merton (1973)
The financial theory of defined benefit pension schemes Exley, Mehta, Smith (1997):
The financial theory of defined benefit pension schemes Exley, Mehta, Smith (1997) Key lessons
Pension schemes and corporate finance
Measure assets (and liabilities) at market value
A blueprint for pricing and hedging liabilities
Bonds are the best match for pension liabilities
Link between equity returns and salary growth is spurious
Allocation of fund assets to bonds/equities has no material impact on economic cost of the liabilities
Pension liabilities should be priced relative to bonds (term structure models of interest rates)
View company and pension scheme as a single economic entity
Shareholder value is enhanced by pension fund investment in bonds
The financial theory of defined benefit pension schemes Exley, Mehta, Smith (1997):
The financial theory of defined benefit pension schemes Exley, Mehta, Smith (1997) Further reading
Risk and reward in corporate pension funds – Treynor (1972)
Corporate pension funding policy – Sharpe (1976)
Executive compensation, pension funding, signalling and taxation – Scholes (1979)
The tax advantages of pension fund investment in bonds – Black (1980)
Taxation and Corporate Pension Policy – Tepper (1981)
Pension funding and corporate valuation – Miller, Merton, Scholes (1981)
What are corporate pension liabilities? – Bulow (1982)
Optimal funding and asset allocation rules for defined benefit pension plans – Harrison, Sharpe (1983)
The price of actuarial values Gordon (1999):
The price of actuarial values Gordon (1999) Key lessons
Modern finance theory
Application to UK pension schemes
Actuarial myths
“Modern finance theory is not practical”
“Modern finance theory is invalid because it is based on unrealistic assumptions”
“Investing the assets of a DB pension scheme in equities reduces company cost”
“Equities are the best match for salary-related liabilities”
“Risk premiums need to be allowed for when valuing long-term liabilities”
“In the long term …”
“Smoothed values are a good thing”
Risk can be diversified over time”
The pension scheme investment success story”
Paying pensions with new money means we can ignore the short term”
The price of actuarial values Gordon (1999):
The price of actuarial values Gordon (1999) Further reading
Pension fund asset valuation and investment – Dyson, Exley (1995)
Actuaries and derivatives – Kemp (1997)
Pensions, funding and risk - Chapman, Gordon, Speed (2001)
Reinventing Pension Actuarial Science Bader, Gold (2002):
Reinventing Pension Actuarial Science Bader, Gold (2002) Key lessons
Corporate finance principles:
$1million of bonds has the same value as $1million of equities
A fair trade of a marketed security or portfolio must occur at a market price
All parties to market transactions are entitled to full current information on the market prices of the relevant assets and liabilities
A liability is valued at the price at which a reference security trades in a liquid and deep market. A reference security (or portfolio) has cash flows that natch the liability in amount, timing and probability of payment
Risks are borne and rewards are earned by individuals not by institutions
Actuarial violations of corporate finance principles
Transferring risk to future generations
Underpricing pensions in compensation decisions
Actuarial / accounting processes biasing investment decisions
Hypothetical actuarial gains concealing real economic losses
Concealing risk by smoothing
Extended amortization
Reinventing Pension Actuarial Science Bader, Gold (2002):
Reinventing Pension Actuarial Science Bader, Gold (2002) Further reading
Is the Pension Benefit Guaranty Corporation the FSLIC of the nineties – Bodie (1992)
On the management of financial guarantees – Bodie, Merton (1992)
What the Pension Benefit Guaranty Corporation can learn from the Federal Savings and Loan Insurance Corporation – Bodie (1996)
Pension deficits – an unnecessary evil – Bader (2004)
Note on the relationship between pension assets and liabilities Speed, Bowie, Exley, Jones, Mounce, Ralston, Spiers, Williams (2003):
Note on the relationship between pension assets and liabilities Speed, Bowie, Exley, Jones, Mounce, Ralston, Spiers, Williams (2003) Key lessons
Response to Myners
Greater transparency to trustees and sponsors on the relationship between assets and liabilities
Liability Benchmark Portfolio (LBP)
Monitor assets against LBP
Measure risk against LBP
Essentials of corporate bonds for pensions actuaries Forman, Freeman, Marshall, McKinlay (2003):
Essentials of corporate bonds for pensions actuaries Forman, Freeman, Marshall, McKinlay (2003) Key lessons
Sterling bonds are issued by a wide variety of issuers
Corporate bonds offer higher expected returns than gilts but with various risks
Risk profile is asymetric
Swaps can provide longer durations than the physical market
Investment grade corporate bonds are closely correlated with gilts
Essentials of corporate bonds for pensions actuaries Forman, Freeman, Marshall, McKinlay (2003):
Essentials of corporate bonds for pensions actuaries Forman, Freeman, Marshall, McKinlay (2003) Further reading
Equity Gilt Study – Barclays Capital (2005)
Pension fund asset allocation Bianco, Cooper (2003):
Pension fund asset allocation Bianco, Cooper (2003) Key lessons
Analysts are beginning to look at the pension scheme assets and liabilities as assets and liabilities of the company
Three key principles beginning to emerge:
Treat pension deficits as corporate debt
Fund pensions fully – through borrowings if necessary
Investing pension fund assets in bonds maximises shareholder value
Catalysts for change
Analysis by equity analysts (as well as bond analysts and credit rating agencies) is getting a lot better
Pension fund asset allocation Bianco, Cooper (2003):
Pension fund asset allocation Bianco, Cooper (2003) Further reading
JP Morgan, ABN AMRO, Merrill Lynch, Moody’s, Standard & Poors
Credit Rating Criteria – Standard & Poors (2004)
Did pension plan accounting contribute to a stock market bubble? Coronado, Sharpe (2003)
Do a firm’s equity returns reflect the risk of its pension plan? – Jin, Merton, Bodie (2004)
Funding Defined Benefit Pension Schemes Cowling, Gordon, Speed (2004):
Funding Defined Benefit Pension Schemes Cowling, Gordon, Speed (2004) Key lessons
Actuaries should use a solvency measure to value liabilities
Funding advice should disclose the broad impact of priority rules
Funding objectives should be well-defined
Funding targets should be described unambiguously in terms of solvency
Highlight if contributions are insufficient to maintain solvency
Reserve fully for options
Consider reliance to be placed on company covenant
Full disclosure of amortisation methods
Disclose projected solvency position at next valuation
Advise on contributions only up to next valuation
Funding Defined Benefit Pension Schemes Cowling, Gordon, Speed (2004):
Funding Defined Benefit Pension Schemes Cowling, Gordon, Speed (2004) Further reading
Should Trustees be more like bankers? - Greenstreet (2005)
Financial aspects of longevity risks Richards, Jones (2004):
Financial aspects of longevity risks Richards, Jones (2004) Key lessons
Greatest private-sector exposure to longevity risk is in companies with large DB schemes – big surprises in store?
Some longevity assumptions are dangerously out of date
Better disclosure of mortality assumptions
Longevity now dominant risk for immediate annuities
Uncertainty over projections of future mortality
Financial impact of uncertainty
Mortality differentials
Asset backing implications
Mortality projections and cohort effects
Financial aspects of longevity risks Richards, Jones (2004):
Financial aspects of longevity risks Richards, Jones (2004) Further reading
CMIB Report No 17 – Continuous Mortality Investigation Bureau (1999)
CMIB Working Paper No 1 – Continuous Mortality Investigation Bureau (2002)
CMIB Working Paper No 3 – Continuous Mortality Investigation Bureau (2004)
Longevity in the 21st Century – Willets, Gallop, Leandro, Lu, MacDonald, Miller, Richards, Robjohns, Ryan, Waters (2004)
The Cohort effect: Insights and Explanations – Willets (2004)
How long do people expect to live? Results and implications O’Brien, Fenn, Diacon (2005)
Top 10 Papers? :
Top 10 Papers? Actuaries, pension funds and investment – Arthur, Randall (1989)
On the risks of stocks in the long run - Bodie (1995)
The financial theory of defined benefit pension schemes - Exley, Mehta, Smith (1997)
The price of actuarial values - Gordon (1999)
Reinventing pension actuarial science– Bader, Gold (2002)
Note on the relationship between pension assets and liabilities– Speed, Bowie, Exley, Jones, Mounce, Ralston, Spiers, Williams (2003)
Essentials of corporate bonds for pensions actuaries– Forman, Freeman, Marshall, McKinlay (2003)
Pension fund asset allocation– Bianco, Cooper (2003)
Funding defined benefit pension schemes– Cowling, Gordon, Speed (2004)
Financial aspects of longevity risks– Jones, Richards (2004)
charles.cowling@mercer.com