TWO YEARS AFTER 9/11/01
IMPACT ON INSTITUTIONAL PLANS “RETHINKING THE PARADIGM" Bill Clark Deputy Director NJ Division of Investment
This Just About Sums It Up…… NJ Public Pension Plan Assets 6/30/01
6/30/03
Difference
$35,116
$29,346
$-5,770
International Equity
10,139
9,176
-963
Total Equity
45,255
38,522
-6,733
Fixed Income
23,796
20,018
-3,778
3,376
3,698
322
$72,427
$62,238
$-10,189
Domestic Equity
Cash Total
State Pension Plan Funding Is A Widespread Issue Financial Overview of State Retirement Systems ($ billions) 2000
2001
2002
$1,893
$1,917
$1,797
1,648
1,805
1,977
Difference
$245
$112
$(180)
Funding Ratio
115%
106%
91%
31%
51%
79%
Total Pension Assets Total Pension Liabilities
Underfunded Plans as % of all Plans Source: Wilshire Associates, Inc.
Corporate Plans Face Similar Funding Shortfalls Summary of S&P 500 Defined Benefit Plan Funding $300
40%
$200
30% 20%
$100
10%
$ Amt Over/Under Funded (billions)
0%
% Over/Under Funded
$0 -$100
-10%
-$200
-20%
-$300
-30% 95
96
97
98
99
00
01
02
Source: Lehman Brothers
According to the PBGC, total underfunding of single-employer defined benefit plans was over $400 billion as of December 31, 2002
Change In Funding Status Is Attributable to the Asset Allocation of Defined Benefit Plans Asset Allocation 12/31/02 Corporate Plans
Public Plans
2% 6%
Domestic Equity
4%
4% 4% 1%
International Equity
2% 41%
Domestic Bonds International Bonds
31%
1%
42% 35%
Real Estate/Mortgages 14%
Private Equity/Other Cash
Source: Pension & Investments, Wilshire Associates, Inc.
13%
What Has Led To Current Pension Plan Asset Allocation? Pension Consulting “Conventional Wisdom” – – – –
Long-dated liabilities minimize need for immunization Focus on realizing equity risk premium (beta over alpha) Primary reliance on public equity/fixed income markets Risk = Volatility of Asset Returns Only
Other “Structural” Factors – Accounting obscures reality – encourages excessive risktaking – Out-of-Date government regulation
Defined Benefit Pension Plan Participants & Vested Status
Thousands
1979 - 1998 42,000
80%
41,000
70%
40,000
60%
39,000
50%
38,000
40%
37,000
30%
36,000
20%
35,000
10%
34,000
0% 19 7 9
19 8 1
19 8 3
19 8 5
19 8 7
19 8 9
19 9 1
19 9 3
19 9 5
19 9 7
Source: US Department of Labor, Private Pension Plan Bulletin Abstract of 1998 Form 5500 Annual Reports
# Participants % Fully Vested
Volatility of a Typical Pension Portfolio Has Risen to Levels Not Seen Since the 1980s Rolling 3-Year Monthly Returns Volatility 1980 - 2003 4.0 3.5 3.0 2.5
Standard Deviation of Monthly Returns
2.0 1.5 1.0 0.5 Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
Jan-84
Jan-82
Jan-80
0.0
Typical Portfolio: 50% S&P 500 15% MSCI EAFE 30% Lehman Govt/Credit 5% 30-day T-Bills
Why? The Volatility of Domestic Equities Has Increased, Along With the Correlation Between Domestic and International Equities Rolling 3-Year Monthly Volatility and Correlation 1980 - 2003 0.9
6.0
0.8
5.0
0.7 0.6
4.0
0.5
3.0
0.4 0.3
2.0
0.2
1.0
0.1 Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
Jan-84
Jan-82
0.0 Jan-80
0.0
Correlation of Monthly Returns S&P 500 and MSCI EAFE (left)
Standard Deviation of Monthly Returns S&P 500 (right)
The “Black Box” of Pension Accounting Calculation of Pension Income/Expense Service Cost
- Increase in PV of benefits due to additional employment
+ Interest Cost
- Increase in PV of benefits due to passage of time
Assumed Return on Pension Assets
= Pension Income/Expense
- Assumed return on “marketrelated” value of assets
The “Black Box” of Pension Accounting The “Catch 22” of Pension Assumptions S&P 500 Defined Benefit Plan Assumptions 1995 - 2002 10.0 9.0 8.0 Return on Assets
7.0
Discount Rate
6.0 5.0 4.0 95
96
97
98
99
00
01
02
Plans make significant allocations to equities in order to justify a higher assumed investment return – because they desire a strong assumed investment return, they allocate funds to equities. Source: Lehman Brothers
The “Black Box” of Pension Accounting Even Plan Sponsors Don’t Believe Their Own Assumed Rates of Return Corporate Plan Survey
12.0 10.0 8.0
2002
6.0
2001 4.0 2.0 0.0 Long-Term 90-day Rate-ofTreasury Return Bills Assumption
Actively Managed Bonds
Source: Greenwich Associates
S&P 500 Mean
Equity Real International Estate Equity
Private Equity
Expected Rate of Inflation
The “Black Box” of Pension Accounting What Would True “Market-to-Market” Accounting Look Like? Hypothetical Pension Asset and Liability Market Value Returns 50
50
40
40
30
30
20
20
10
10
0
0
-10
-10
-20
-20
-30
-30
-40
-40 89 90 91 92 93 94 95 96 97 98 99 00 01 02
Source: Ryan Labs
Assets Return % (left) Liabilities Change % (left) Assets - Liabilities % Return (right)
Out-of-Date Government Regulation PBGC Premiums - $19 per participant and 90 bp of
underfunding measured on a “current liability” basis 90 bp variable premium applies only if funding is less
than 90% of current liability Premium not impacted by risk profile of investment
portfolio Additional funding required only if funding ratio drops
below 90%; required funding not adjusted for creditworthiness of plan sponsor
What Is Causing Pension Plans to Rethink Asset Allocation? Investor appreciation for the exposure/risks
associated with defined benefit pension plans Changes in accounting – FRS17
FASB IAS Potential changes in legislation due to PBGC financial health Political pressures on Public Funds to stabilize
funding levels
Three Potential Models for Pension Fund Asset Allocation 1)
Immunized Model
2)
“Cutting Edge� Endowment Model
3)
Risk Control Model
Immunized Model Understanding The Underlying Nature of Defined Benefit Pension Liabilities Present Value of Hypothetical $100 Million Projected Benefit Obligation By “Source� of Liability Retirees
15% Terminated Vested
30% 5%
Active Vested Nonvested
20%
Effect of Future Salary Increase on Past Service Future Service
25%
5%
Source: Center for Retirement Research at Boston College
Immunized Model Long-Term Fixed Income Is Most Appropriate For Accumulated Benefits, but Lack of Issuance by U.S. Government and Corporations May Make This Difficult to Implement Composition of Lehman Govt/Credit Index by Maturity 1993 - 2003 33% 31% 29%
1-3 Years
27%
3-5 Years
25%
5-10 Years
23% 21%
Over 10 Years
19% 17%
Source: Lehman Brothers
Jun-03
Dec-02
Jun-02
Dec-01
Jun-01
Dec-00
Jun-00
Dec-99
Jun-99
Dec-98
Jun-98
Dec-97
Jun-97
Dec-96
Jun-96
Dec-95
Jun-95
Dec-94
Jun-94
Dec-93
15%
Immunized Model If Pension Funds Were to Implement This Approach, It Could Flatten the Slope of Yield Curve. It Happened in the UK. US vs UK Government Note/Bond Interest Rates 6/30/03
10.0 8.0 6.0
US
4.0
UK
2.0 0.0 2-YR
5-YR
10-YR
30-YR
Immunized Model Hedging Salary Growth on Future Liabilities Investors assume equities are highly-correlated with
inflation, but data doesn’t support it (correlation coefficient of –0.15) Many plans are looking at TIPS and other inflation-
indexed products as a separate asset class But, lack of issuance and secondary-market liquidity
are a problem
“Cutting Edge� Endowment Model While Most College Endowments Have Asset Allocations Similar to Pension Funds, Several Universities Have Adopted Significantly Different Approaches Endowment Portfolio Asset Allocation June 30, 2002
Harvard
Yale
0%
18%
Absolute Return Foreign Equity *
19% 8% 12% 10%
0% 0% 10% 16%
Domestic Equity
9%
24%
* Includes Emerging Markets
Private Equity Real Assets Fixed Income
21% 26%
Cash TIPS
14% 13%
“Cutting Edge” Endowment Model Such Endowments Have Realized Superior Risk-Adjusted Returns Over the Past Five Years Compared to Pension Funds Total Returns 7/1/97 – 6/30/02 50 40 30
Harvard
20
Yale Median Pension Fund *
10 0 -10 98
99
00
01
Year Ended June 30 * Source: New England Pension Consultants
02
Risk Control Model Pension Funds Are Starting to Hedge Their Equity Exposure as a Means to Reduce Risk. The “Put Spread Collar” Is a Popular Approach Potential Equity Returns Sell Put Sell Call
Buy Put
-25%
-20%
-15%
-10%
-5%
Downside Protection
0%
+5%
+10%
+15%
+20%
Upside Give-Up
+25%
Conclusion Plan sponsors are in process of reevaluating asset
allocation Expect increased exposure to fixed income,
alternative asset classes and use of hedging strategies Shift will impact financial markets Changes in investor analysis of pension exposure
and PBGC regulation will drive portfolio changes over time