CIA Annual Meeting LOOKING BACK…focused on the future

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future Some Basic FE Principles Principle #1: $1 of bonds has same value as $1 of equities Principle # 2: If assets and liabilities have same matching cashflow, then they should have the same value Principle #3: The value of an asset is independent of how the asset is financed Principle #4: Irrelevance principle

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future Principle #1: $1 of bonds has same value as $1 of equities

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future Principle #1 Principle of no arbitrage If model constructs arbitrage, then it’s wrong Example: In 10 years: I pay you proceeds of $100,000 investment in TSE Expected Return: 10% pa Expected Value in 10 years: $259,400 You pay me proceeds of $100,000 investment in 10 year zero-coupon GoC bonds Expected Return: 5% pa Value in 10 years: $162,900

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future Principle #1 (cont’d) How much should you pay me? $37, 000, based discounted value (at 10%) of your net expected return $0, based on economic value The arbitrage opportunity: You pay me $37,000 I buy a car with the proceeds I borrow $100,000 at GoC bond rate I invest proceeds in TSE In 10 years, I pay you proceeds of my TSE investment I repay my loan when I receive bond maturity value from you

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future Principle #2 - If assets and liabilities have same matching cashflow, then they should have the same value

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future Principle #2 Since liabilities are bond like, fair value should be determined by reference to bond portfolio with matching cashflows Reference portfolio must reflect risk of liabilities If plan is well funded – use high-rated bonds If sponsor has poor credit rating and plan is poorly funded – use bond rates with lower credit rating

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future Principle #3: The value of an asset is independent of how the asset is financed

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future Principle #3 Expected return on assets to fund debt does not affect value of debt If company borrows $1m to invest in business, value of debt is $1m, not discounted value of expected corporate profits Same principle should be applied to pension plan Expected excess returns on assets should first be earned

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future Principle #4: Irrelevance Principle

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future Principle #4 First order effect of debt/equity mix of company is irrelevant in determining its value (sounds like Principle #3) Second order effects such as taxation, agency costs, etc. are relevant Decision makers re company capital structure are not always the owners Management and shareholder interests not always aligned Important to understand interests and objectives of stakeholder groups

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future Principle #4 (cont’d) First order irrelevance for Pension Plans Asset allocation decision, from shareholder’s point of view, is irrelevant If pension plan has high equity exposure, shareholder can adjust own portfolio Second order effects suggest investment in bonds is a wiser decision: Taxation effect: If bonds are taxed at a higher rate than equities outside of plan, then tax shelter advantage of investing in bonds inside plan is greater

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future Principle #4 (cont’d) Second order effects (cont’d) Surplus used for benefit of members but sponsors responsible for deficits Matching asset portfolio will: Reduce corporate balance sheet risk Increase management focus on core business Improve transparency Remove management bias in influencing assumptions

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future First three principles speak to how pension plan liabilities should be valued Principle #4 speaks to how corporate pension plan assets should be invested

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future FE and Actuarial Challenges How do we apply FE principles to going concern valuations? Financial Economists are concerned with the fair measurement of contractual obligation Little guidance on future values

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future FE and Actuarial Challenges Incomplete matching For wind up values, close match is possible For GC value with future salary increases Payout uncertainty increases Can we find an asset that matches salary increase probabilities?

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future FE and Actuarial Challenges Creating a “no-arbitrage” model on transactions for which there is no market Incorporating risk premium in the discount rate Financial Economists say this is wrong: Reward for taking on risk should be reaped when it is earned For a going concern pension plan, when exactly is this earned?

CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future What should actuaries take from FE Economic values The unbiased measurement Establishing a closely matched portfolio as a starting point for measuring mismatch risk Increase transparency of assumptions Minimizes agency bias