Accounting Based Incentives for

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Accounting Based Incentives for U.S. Pension
Plan Sponsors Barry Freedman Stochastic
Modeling Symposium April 3, 2006
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Summary

• Focus
• U.S. defined benefit pension plans.
• Method
• Use a stochastic model to analyze financial
  impacts on plan sponsors.
• Conclusion
• Accounting rules change ALM incentives in
  significant and non-trivial ways.

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Introduction MotivationAccounting Based
Incentives for U.S. Pension Plan Sponsors

• Does accounting reflect reality?
• or
• Does accounting create reality?

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Introduction MotivationAccounting Based
Incentives for U.S. Pension Plan Sponsors

• Liability owner ALM Strategy
• U.S. pension plan 60 Stock / 40 Bonds
• U.S. insurer 100 duration-matched
• fixed income

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Introduction MotivationAccounting Based
Incentives for U.S. Pension Plan Sponsors

• Project focus product design
• Accounting rules exist and drive sponsor behavior
• Match the product to the customer

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Introduction MotivationAcknowledgments

• MetLife
• Keith Cronin, Mark Epstein, Zachary Granovetter,
  Dennis Ho, Alex Scheitlin, Sherif Zakhary
• BlackRock
• Peter Fisher, Fred Weinberger, Ben Wilson
• Disclaimer
• This paper reflects only the views of the author,
  and does not represent the opinion of MetLife,
  BlackRock, or Sun Life.

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MethodologyPension Plan Sponsor Financial
Risk-Return Analysis Model
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MethodologyEconomic Scenario Generator

• Real world (true probability) scenarios
• Calibrate with historical data
• Outputs
• Yield Curve
• Lehman Agg. total returns
• SP-500 total returns

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MethodologyYield Curve Generator

• Model changes in yield curve shape
• Use principal component analysis to find
  independent movements
• Component 1 parallel shift
• Component 2 steepening / flattening
• Component 3 central hump
• Apply mean reversion to each component
• Model percentage change in interest rates not
  absolute change

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MethodologyA Brief Introduction to FAS 87

• Liability Grows with interest and accruals
• Projected Benefit Obligation (PBO)
• No assumed future service
• Includes future salary increases
• Discount rate long fixed income rate at val
  date.
• Funded status MVA PBO
• Funded status does not appear on the balance
  sheet, but is a footnote on GAAP statements

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MethodologyA Brief Introduction to FAS 87

• Pension Cost (income statement impact)
• New (expected) PBO accruals during the year
• Interest cost (PBO x discount rate)
• - Expected return on assets
• Amortization of gains and losses
• Gains and losses due to experience differing from
  expected (including interest changes and asset
  performance) are amortized over future periods
  (unless they fall within a corridor).

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Model Results

• Pension Plan
• Under-funded
• Unrecognized losses
• Investment Strategy
• a) Initial view 60/40 Stock/Bond
• b) Compare to 100 Bond derivative overlay
• (immunizing the portfolio)
• c) Efficient frontier analysis
• GAAP financial items
• 5 year horizon
• Funded status, pension cost

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Funded Status MVA-PBOInvest in 60/40 Stock Bond
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Pension Cost (Negative Income)Invest in 60/40
Stock Bond
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Model ResultsControlling Volatility

• Controlling volatility on one financial measure
  can have negative impacts on others.
• Immunizing the portfolio
• Reduces economic risk
• Decreases volatility of funded status (MVA-PBO)
• Increases pension cost
• Increases (short-term) pension cost volatility

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Funded Status MVA-PBOCompare 60/40 to
Immunize
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Funded Status MVA-PBOCompare 60/40 to
Immunize
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Pension Cost (Negative Income)Compare 60/40 to
Immunize
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Pension Cost (Negative Income)Compare 60/40 to
Immunize
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Model ResultsEfficient Frontier

• Calculate the 5-year average pension cost
• Evaluate the mean and standard deviation over the
  economic scenarios
• All stock / bond combinations
• All stock / bond / derivative combinations

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5-Year Average Pension Cost Efficient Frontier
Analysis
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Conclusions

• 100 fixed income is inefficient
• Transforms the ALM landscape
• Derivative overlays are efficient
• Illustrates the value of a product
• The classic 60/40 strategy is close to the
  minimum risk allocation
• Explains sponsor behavior
• Accounting rules change ALM incentives in
  significant and non-trivial ways.

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Other Comments

• Results will differ with
• Time horizon (e.g., 3 years)
• Sponsors concerns / goals (e.g., cash flow)
• Sponsors initial financial position
• Accounting rules
• Possible application to those re-evaluating the
  current accounting rules

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Coda An Alternative View

• Nobody was ever meant
• To remember or invent
• What he did with every cent.
• - Robert Frost, The Hardship of Accounting

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Accounting Based Incentives for U.S. Pension
Plan Sponsors Barry Freedman Stochastic
Modeling Symposium April 3, 2006