Caveat Emptor

August 09, 2007

John A. Haslem

In 30 years of working with pension plans, two things have become clear: One, plans’ true objectives are liability-driven, not market-driven; two, the benchmarks they use are mired in a market-driven mentality. It should be obvious that no generic bond index could ever represent the unique cash flow structure of a liability-driven objective. In fact, any generic index would bias investments in a direction that would contradict the interest rate sensitivity of a client’s liability schedule, having either the wrong duration or the wrong cash flow schedule or both. The pension world has recently awakened to this same conclusion. Clients are faced with the decision of what benchmark best represents their true economic liability-driven objective.


Standard accounting rules and actuarial practices require pensions to price liabilities at a single discount rate, and to price those liabilities very infrequently (i.e., annually) and at a rate higher (if not much higher) than market rates. These rules are being changed to adopt more of a market focus. As a result, we have several firms offering liability indexes to the market. This report will explore the problems and solutions with any liability index. To illustrate the dramatic differences and problems, we created a proxy pension benefit payment schedule (future value) of $1 million per month for 30 years—a $360 million future value cash flow schedule with an average duration of 11.191 years. We then priced this static cash flow using various discount rate methodologies.

Pension Objective
The objective of a pension plan should be to fund its benefits at the lowest cost to the plan and with minimal volatility in contributions and the funded ratio. Indeed, many plans have this stated as their investment policy; sometimes, it is even written into state constitutions.

John A. Haslem

Such an objective would require over time a shift in asset allocation towards a matching of assets against liabilities to reduce such volatility and costs. To match liabilities on a present value basis should require a liability index or benchmark that accurately and frequently calculates the market value of liabilities, such that the economic funded ratio can be monitored. A miscalculation of the true economic value of liabilities would likely misdirect the asset allocation strategy due to a misinterpretation of the true funded ratio. Noteworthy is that total pension operational costs (including actuary, consultant, asset managers and internal staff) are usually less than 50 basis points (bps) annually. As a result, an error in calculating the present value of liabilities by 50 bps would be significant, as it would represent a full year of operational costs. To meet the pension objective, all cost factors should be managed and monitored.

The annuity is a favored way to price pension liabilities. In truth, the annuity is a rate that settles or fully funds the liability and releases the plan sponsor from any liability. However, it is a negotiated rate and seldom, if ever, is used for large plans over $1 billion. This makes it difficult, if not impossible, to use it as a discount rate. In fact, the annuity rate is really not a discount rate; it is an asset growth rate or rate of return.

Annuities are usually thought of as providing a positive growth rate with little volatility. If the annuity rate went from 5 percent to 6 percent, plan sponsors tend to assume that liabilities will now grow at 6 percent. It is usually not presented in a way that would suggest any negative growth. But if a 10-year average duration liability schedule had its discount rate change from a 5 percent rate to a 6 percent rate over one year, it should show a -5 percent present value change (price return of -10 percent + income return of 5 percent = -5 percent total return).

The other problem is that the annuity is a single rate and not a yield curve. This is certainly not indicative of market rates, which almost always have a yield curve (slope) and which could be radically different from short to long maturities, (the widest spread in recent history between the 3- month T-Bill and the 30-year Treasury was 467 bps in October 1992.) To price every liability at the same yield is inconsistent with economic reality and therefore an erroneous or hypothetical calculation. The truth is, annuities are best used as an asset strategy and not a liability discount rate. If negotiated well, they could fund some, if not all of the pension liabilities. Annuities are a very good asset strategy to defease (fully fund) liabilities if you can execute them, but not a good discount rate to value liabilities.

PBGC/Annuity Rates
The Pension Benefit Guarantee Corporation (PBGC) is the classic annuity example. The PBGC is required by their rules to use a survey of annuity rates as their discount rates. For December 31, 2006, the PBGC priced their liabilities at 5.80 percent for the first 20 years of payments and at 4.75 percent for payments beyond 20 years—a rather strange yield curve. Compared to the market (using Treasury STRIPS), there is a 5.22 percent difference in present value ($9,945,050) and a 5 percent difference in sensitivity, but only a very small duration variance. This present value and sensitivity differential of about 5 percent represents an error equivalent to about 10 years of operational costs (at 50 bps per year).

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