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ffis*#L#$:&Wayne H. WagnerChief Investment OfficerEdward C. StoryClient CommunicationLarryJ. Cuneo

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THE BLINDMEN AND THE ELEPHANTMONTHLY COMMENTARY #19

October 1988(Summarized from a speech by Wayne at the Institute for QuantitativeResearch in Finance in San Diego, October 2-5, 1988.)Each of the proverbial blindmen who touched a dissimilar part of the elephantenvisioned a different treast. Likewise, the various interested parties who viewthe pension plan develop different perspectives. The actuary, the accountant,the employee benefits administrator and the pension investment administratorall have different perspectives, but is any of these more correct?

Historically, it was the view of the actuary thatdominated the management of the pension plan.Operating under the imprimatur of the profes-sion, he discounted the accumulated earnedbenefits back to the present. The discount ratewas a conservative, stable rate which more orless assured pension payments under all but theworst conceivable circumstances. It also createda substantial margin of safety in case theassumptions didn't work out .The actuary's view was accurate from where hestood, yet it failed to recognize several keyfactors:1. The conservatively stated discount rate'gavelittle useful guidance to the manager chargedwith implementing the investment program.2. The assumption of a fixed rate gave littleacknowledgement to the implications of vari-abiliry in asset values.3. The use of earned benefits ignored thepredictable stream of changes in pension pro)mises in response to company and economicgrowth.

Out of necessity, other parties responsible forother aspects of the pension plan developedtheir own independent views.The pension investment administrator foundlittle reality in the actuary's assumptions, anddealt with the world as he saw it. Usually thegame was defined as a devil-take-the-hindmosthorserace, restrained only by a fear of the veryreal risks of falling well short of expectations.The employee benefits administrator generallyignored the views of both the acfuary and thepension investment administrator, and focusedon the benefits and the beneficiaries.ENTER THE ACCOUNTANTFASB 87 brought forth a new view of thepension plan: that of the accountant. Theaccountant's new view was to valte both theliabilities and the assets at market (not actu-arially assumed) rates. The net result was afar more realistic view of the pension fundingprocess. The view shifted toward a comprehen-sive and inclusive view of both sides of theassetfliability equation. The focal point became

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the difference between the asset valuation andthe liability valuation: What private plans usuallycall surplus and public plans call shortfall.Certainly, the accountant's view provided manyuseful insights. Most importantly, it reduced theisolation of the pension investment administratorand made him or her rethink the nature of theinvestment activity in the context of the liabilityside of the equation.Unfortunately, FASB 87 also invited a con-siderable narrowing of the range of investmentalternatives thought to be suitable to the fund.Here's how this happened: Bond prices varywith interest rates. If the present value of aliability also varies with interest rates, then aliability is an anti-bond which can be neutralizedby locking it in with a bond of similar interestrate response. The natural outcome of thisthought process is that bonds appear to be theideal vehicles for funding pension liabili$streams.Hidden behind this seemingly simple and ele-gant solution is a serious flaw: The accountingrules have taken precedence over the strategicobjectives. The best solution to the accountingproblem (minimizing the pension plan's effectson the balance sheet and income statement) isnot the same solution which would derive froma thoughtful analysis of the plan's strategicobjectives.A short term horizon has been interposed overa long term problem. From this narrow view,the most important variable in the managementof the pension plan becomes the December 31stinsurance company new money rate, which isthe rate typically used to price the liabilities.This view has many faults. First, bonds are notthe Fixed Income vehicles they once were:inflation, interest rate volatility, and creativecovenants have radically altered the nature ofthe tlpical bond.Secondly, a very short horizon was imposed onthe pension plan: the December 31 valuationdate. Risk has been equated to variabilif"inshort term interest rates. Yet in realify, apension fund is a continuing economic entitywith a horizon usually stretching into decades.The most relevant risk is that of falling behind2

on pension payments years into the future, arisk which has little to do with December 31stinterest rate quotes.Finally, and most importantly, bonds do notparticipate in the productive energy of theeconomy. In Monthly Commentary #5, weidentified The Pension Promise as an adequatestandard of living paid for by the ultimatepension payments. Comparable standards ofliving, and thus the eventual pension payments,are strongly influenced by economic productivitygrowth. A heavy fixed income orientationdooms pension plans into falling further behindthe rising benefits. Pension investment is not assimple and one-dimensional as the advocates ofFASB 8? would have us believe. Pension riskshave many important dimensions beyond shortterm interest rate fluctuations.OFFSETTING THE REAL RISKSIn this section, we will illustrate in a slightlydifferent context how some of dimensions ofrisk can be offset through a policy which wouldat first glance appear more riskY.Medical benefits for retirees is one of thosetopics that no one seems eager to discuss. Thebig bugaboo for health plans is the rapidlyexpanding use of new and very expensive medi-cal technology. Whatever current assumptionsare made for financing future levels of healthpayments, they are likely to fall far short.There is no good way to make estimates,because it is impossible to predict the timingand cost of new medical technological break-throughs.Any funding strategy based on the present valueof assumed future payments is tikely to fall veryshort.Yet there is good news: the financial hazards ofproductivity gains in medical technology can bepartially offset by a well conceived investmentpolicy. The financial beneficiaries of medicalbreakthroughs will be the equity owners of thecompanies which produce the breakthroughs.The obvious hedge for a health benefit plan,then, is to invest in medical technology stocks.Asset values then rise in response to the sameevents that raise medical costs.

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The same thoughts apply to the pension plan:a well conceived investment strategy shouldfavor assets which will benefit from gains inproductivity; namely equities.OUR NEW HEROThe actuary's view has been shown to be insuf-ficient, the accountant's view is short sighted,the investment administrator is sometimescaught up in the romance of the asset side ofthe pension world.Curiously then, it is the view of the employeebenefits specialist which provides the bestinsights into the optimal investment stratery. Ofall the pension blindmen, the employee benefitsadministrator knows whv the pension planexists: To fulfill the employees' expectation ofa decent standard of living throughout retire-ment.In earlier times it was the view of the actuarywhich had to be resisted in order to establishrational pension investment policy. Now, theviewpoint of the accountant must also beresisted.It is from the viewpoint of the employee bene-fits administrator that bonds are revealed as notbeing the end-all solution to pension funding.It is by observing the process by which pensionobligations grow over time that we gain a betterunderstanding of the nafure of pension risk.This understanding leads to a better perspectiveon the relative merits of different classes ofassets. Equity returns not only relate best toproductivitygains, they also have higher expecta-tions which should lead to higher benefits, lower

contributions and/or greater assurity of pay-ment. This is achieved, of course, at a cost ofhigher short term variability. Variability, unfor-tunately, is likely to create FASB 87 problemsfor the pension investment administrator.A conflict of views is almost inevitable. and thelogic behind the investment strategy must bewell thought out ahead of time. Strategy mustbe built on a clear understandins of the natureof the pension plan:1. Pension funds exist to pay retirement bene-fits. Accordingly, the asset policy must berelated to the benefits policy.2. The actual pension benefits that will be paidin the future will reflect the then-contemporarycomparable standard of living. As a result,pension benefits will probably grow beyondcurrent expectations due to productivity in-creases in the economy.3. The only way to hedge those long term risksis to invest in assets which participate in thebenefits of productivity gains: equity issues.4. Equity markets are volatile and will rise andfall several times before the assets are cashedin to pay pension benefits. This does notcreate a long term problem.Risky assets will cause variations in year-endsurplus valuations, with possible balance sheetand income statement effects on the corpora-tion. A rational long-term pension investmentstrategy surely must take cognizance of theseeffects. but cannot allow itself to be dominatedby them.