Pension Actuarys Guide to Financial Economics

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Pension Actuarys Guide to Financial Economics

• CCA Annual Meeting
• October 2006

Emily Kessler, FSA, EA, FCA, MAAA Staff Fellow,
Society of Actuaries
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What is Financial Economics?

• Subset of micro-economics focusing on the capital
  markets
• How individuals and institutions acquire, invest
  and save money
• Modern corporate finance is one branch of
  financial economics
• How institutions make decisions about raising and
  deploying capital
• Premise Firms exist to add value to shareholders

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Principles of Pension Finance

• Pension plan is a pass-through entity
• Shareholders own the plan
• Perspective of shareholder
• How does this apply
• Investments
• Asset mix of plan doesnt matter on 1st order
  basis, but does matter on 2nd order basis (taxes,
  agency costs, surplus ownership)
• Funding
• Efficient contracts would include full funding
• Accounting
• Fair value measurement
• Plan Design
• The Pension Actuarys Guide to Financial Economics

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Investments

• Plan investments dont matter on a first-order
  basis
• Shareholder can readjust their portfolio to
  compensate
• Plan investments do matter on second-order basis
• Tax effects
• Agency issues
• Surplus ownership

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Investments Tax Effects

• Example Pension plan in 100 equities
• Investor desires hold 50/50 equity bonds
• Adjusts personal portfolio accordingly
• Returns
• 10 equities
• 5 bonds
• Shareholder personal tax rates
• 15 equities
• 40 bonds
• After tax income 575,000

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Investments Tax Effects

• Assume pension plan adjusts asset mix to 100
  bonds
• Investor rebalances portfolio, increasing
  equities in personal portfolio
• Gross returns are same
• Net after tax income increases by 4,062

Shareholder is better off after taxes when plan
invests in bonds
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Investment Other 2nd Order Effects

• Asymmetrical value of risk taken plan surplus
  versus plan deficit
• Shareholders must make up any deficit
  (underfunding) in plan but they cant access to
  plan surplus
• Agency costs
• Shareholders are investing in the companys main
  business, not its ability to run a mutual fund

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Funding

• From point of view of the balance sheet, and
  unfunded plan is another form of debt
• Pension debt is an expensive form of debt because
  the lenders employees have a concentrated
  risk with the employer
• Charge higher interest to entity that presents
  a higher (or more concentrated) risk
• Better to raise other forms of capital to fully
  fund the plan than to lend to employees

Funded status of a pension plan is a debt
management question. Do you carry debt in the
plan or with 3rd-party lenders? Where do you get
the better deal?
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Funding Example
Augmented Balance Sheet with an underfunded plan
Once balance sheet is augmented, the deficit net
of taxes (13) becomes a reduction to shareholder
equity
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Funding Example
Assume sponsor issues debt of 13
Sponsor contributes 20 to plan (13 from debt
issue, 7 cash)
Plan is fully funded, promise to employees is
secure
Issue 13 debt
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Funding All Messed Up

• Existence of PBGC takes us out of the financial
  economists world
• Plan sponsors with poorly funded plans and dim
  prospects see PBGC insurance as inexpensive
• Rational stategy to take risk
• Upside plan becomes fully funded
• Downside put the plan to the PBGC
• Sponsors with well funded plans see cost of
  insurance as expensive
• Subsidizing poorly performing companies
• Cost of the insurance is not rational, driving
  irrational (from an economists POV) behavior

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Accounting

• Fair value measurement to improve users
  understanding of financial statements
• On the balance sheet
• No smoothing
• Components of pension cost should be properly
  characterized as operating income, finance
  charges and other income
• Otherwise distort earnings per share, share
  prices and executive compensation

13
Accounting

• PBO pricing distorts value
• Overvalues pension for younger employees,
  understates value to older employees
• Overstates value of promise to all employees
• Employees dont have any legal right to future
  salary accruals
• Measurement other than the market (accrued
  benefit) value
• FASB doesnt agree (at the moment) with this
  position

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Plan Design

• Value to shareholders can be added through plan
  design
• Focus on basics of work force management
  attraction, retention, retirement
• Reduce employee risk (e.g. annuitization,
  ancillary benefits)
• Lump sums bad for employees, shareholders

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The Pension Actuarys Guide to Financial Economics

• Published October 2006
• All members of the SOA Pension Section receive a
  free copy
• Additional copies are available on the SOA
  website (www.soa.org) (printed, bound charge of
  15)
• Guide will be used as a study note
• Webcast on 15 November 2006