Corporate Yields and the SOA

[wonderer]

I have noticed that certain individuals have used ideas developed out here and taken credit as if it were their own ... I get a kick out of that because it shows we have an influence ... How about if we make a collaborative effort on this topic, since the SOA seems h***-bent on continuing the old way of life : singling out a single spokesperson :

from a blast e-mail ......

Recently there have been discussions and legislative activity regarding the discount rate used to value the current liability and lump sums under defined benefit (DB) pension plans in the U.S. There is an Administration proposal to replace the 30-year Treasury rate with discount rates based on corporate bond yields.

There is an urgent need for pension actuaries to deepen their understanding of the corporate bond yield curve and the various issues that arise in its application to plan valuations.

The Pension Section of the Society of Actuaries is commissioning a paper to provide an overview of the construction of a Corporate Bond Yield Curve, describe issues in its construction, and discuss issues in its application to pension valuations. Further details are found in the Understanding the Corporate Bond Yield Curve Request for Paper at:

http://www.soa.org/research/ucbyc_rfp.html

The need is urgent. Simplified proposals or outlines must be submitted by October 22, 2003. Please note that this paper is intended to summarize current knowledge and not represent ground-breaking research in the field.

Any questions regarding the RFP should be directed to Karen Gentilcore, Practice Area Senior Project Manager at 847-706-3595, kgentilcore@soa.org.

Thank you for your interest!

[wonderer]

Here's some :

Corporate Yields have a quality down-grade risk implicit in their price when they are from High Quality situations.

Investor preference for different maturities at any point in time introduces a concept of ficleness which could be manipulated if too many Balance sheet results were dependent on only the curve on a discrete number of days of the year. (I think this is why the 30-yr Treasury is an average for a month.)

There is more demand than supply on the long end of the curve, artifically decreasing yields.

[exactuary]

There is more demand than supply on the long end of the curve, artifically decreasing yields.

Let me understand this. Demand and supply set the price and you call it artificial? So where might we find the price that you call real?

Once we settle that, recognize that what you call artificially decreased yields are actually the yields that equate supply and demand, and then tell me how you know that demand exceeds supply. At a rate lower than today's, supply would exceed demand, a a higher rate, demand would exceed supply, at today's rate they are equal, n'est pas?

[wonderer]

That you attempt humor rather than address the concept that there is a fundamental disconnect between current market forces and the underlying goal of trying to discern the "true" long-term set of rates paints you as being pre-conceived that current market rates are all that matters imo.

This also opens potential business opportunities to take advantage of this type of mis-match.

In my mind, putting a ton of companies on the ropes simply because somebody in an ivory tower declares that a current measuring scheme is completely wrong "just ain't gonna happen".

Then again, I do tend toward being too practical to be of much value to salesmen.

[exactuary]

That you attempt humor rather than address the concept that there is a fundamental disconnect between current market forces and the underlying goal of trying to discern the "true" long-term set of rates paints you as being pre-conceived that current market rates are all that matters imo.

Guilty as charged. Not because market is right (whatever right means in such a context) but because it is the only pertinent (i.e., tradable) price.

This also opens potential business opportunities to take advantage of this type of mis-match.

Please explain. Making money is all good.

In my mind, putting a ton of companies on the ropes simply because somebody in an ivory tower declares that a current measuring scheme is completely wrong "just ain't gonna happen".

Then again, I do tend toward being too practical to be of much value to salesmen.

It is no more costly to have strong current market standards than it is to have weak off market standards (speaking at the level of the economy as a whole). For many sound companies it is cheaper (viewed from point of view of diversified shareholders) to fund fully and invest in bonds than it is to underfund and/or invest in equities.

[wonderer]

The underlying purpose currently addressed is a rock solid framework for the funding of pension plans, not reporting according to the shifting sands of time.

[exactuary]

You have always seemed like a sensible sort and usally straightforward. In the above posts, however, you seem almost enigmatic. You refer to ideas discussed here and iterated elsewhere, leaving me somewhat at a loss as to what ideas and where they were echoed. In this latest post, you tell me that the underlying purpose is rock solid funding. What underlying purpose? What context? Rock solid in regard to what threats or contingencies? I suspect you mean to focus on funding rather than accounting. If that is what you mean, then I repeat:

It is no more costly to have strong current market standards than it is to have weak off market standards (speaking at the level of the economy as a whole).

Given that this is so, are you speaking in favor of weak standards, or off-market standards, or "long-term assumptions," or tolerable degrees of underfunding, or what?

[wonderer]

I agree that I am being enigmatic.

The forces that state that "the market" is the be-all, end-all of value determination are stating a philosophical opinion, not a fact.

Imposing a snapshot standard that is only valid at that moment in time lays the groundwork for poor consulting advice in my opinion.

No doubt the market force advocates are very strong, but they are also being unreasonable when they make a presumption that others are automatically advocating underfunding of pension plans.

To me, if the state of affairs is that pension consultants need to tell their companies that these plans need to be funded from a risk-free perspective (another pie in the sky number, not a determinable fact), then in my mind the pension consultant ought to tell the plan sponsor that they have no right providing a pension unless they want to get in the financial services business. The "risk-free" advocates make a case that the only time returns in excess of the nebulous risk free rate can be utilized is after the fact.

This whole line of thinking seems more like trying to take advantage of the bandwagon mentality by arousing an emotional state than it does in trying to pursue a proper funding methodology.

As a corollary, it is beginning to make sense to me why Warren Buffett is beginning to buy companies that are not public companies. Perhaps a different funding standard needs to be set for public versus non-public companies in that non-public companies can be given the leeway to invest a higher percentage of their pension assets in their own companies, something that would probably not at all be able to be assessed very easily by "the market".

Coming up with a set of pension rules which would significantly drain cash from productive assets within a company to productive assets within somebody else's company at a time when there is a serious need for new cash flows into the markets has a certain rank odor to me.

Thanks for the comments about stability and I fully understand your implications on this topic. I am an unusual actuary because I am willing to take the risk of trying to develop cogent insights. The SOA is going to appear as nothing more than a johnny-come-lately if all they do is develop a paper on what is currently going on regarding bond indices without "brining it home" by capitalizing on what they purport as their main selling point, namely the identification and measurement of risk. (This is a creative interpretation opportunity, not a recitation opportunity.)

I am trying very hard to get actuaries to think for themselves on this issue but I am pessimistic because our training seems to be based more on "interpreting" rules than on developing, setting and understanding them.

[exactuary]

OK, then, let us suppose that I want plans fully funded at all times at a risk-free rate. I think this is what you say is the view of the market-type actuaries.

Will you tell me what value you prefer for assets (other than market) and liabilities (other than the risk-free discount of the cash flows), why underfunding (compared to my supposition) is good, and when one should recognize returns above the risk-free rate?

You seem to subscribe to the idea that funding promises you have made drains cash from productive pursuits. Aren't you saying that you would rather borrow from the employees (to whom you offer benefit promises in exchange for cash wages) than from other lenders? Money contributed to the plan does not leave the capital system. It merely passes through the hands of professional investors on the way to other productive project opportunities, no?

From society's perspective, is it sensible to concentrate the financial risk of employees by investing their deferred wages in their employer's businesses?

[wonderer]

One assumption about future liabilities is an appropriate interest rate.

Focussing on just this issue, since it appears the central driving force of your position, and trying to bring it in perspective, please let my little brain offer a corollary:

Say a company has a long-term lease of known 20 years duration on a property that is not being used. The company needs to reflect this lease obligation on their balance sheet. Say the lease is 5,000 per year. What is the amount that shows up on the balance sheet?

[Michael Davlin]

I am trying very hard to get actuaries to think for themselves on this issue but I am pessimistic because our training seems to be based more on "interpreting" rules than on developing, setting and understanding them.
That's a sad but accurate capsule summary of the entire profession's history, wonderer.

Say a company has a long-term lease of known 20 years duration on a property that is not being used. The company needs to reflect this lease obligation on their balance sheet. Say the lease is 5,000 per year. What is the amount that shows up on the balance sheet?
I'm assuming you're asking what should show up, not what does show up under current GAAP.

My answer would be that the stream of $5,000 payments should be capitalized at spot prices which reflect both the risk free yield curve under the risk-neutral distribution and the entity-specific default risk curve of the company. Naturally, both of those determinants of the lease's spot prices / deflators would vary as time marches on.

This begs the question: why should pension promises be privileged? When underfunded, why shouldn't their value also reflect sponsor default risk; just like a long-term lease? I think this is where science, loosely interpreted, exits the stage and inherently debatable ethical or normative standards come into play.

[exactuary]

I agree with Mike that the lease should reflect the value of similar debt incurred by the company. In Reinventing Pension Actuarial Science, Bader-Gold say the debt should be similar in timing, amount and likelihood of payment. This applies to financial reporting. For federally regulated plans (ERISA), Gold says (Pension Section News - September) that full funding of the ABO at risk-free rates should be required (after some weaker transition).

The default risk should be in the financial reporting measures for unfunded liabilities -- e.g., for an unfunded SERP plan. For a partially funded plan the value should reflect the default risk allowing for the partial collateralization and the asset-liability mismatch. {At the moment many insurance actuaries worldwide are fighting against recognizing the insurer's default risk when measuring its liabilities.}

The difference between the default-probability-inclusive liability and the almost risk-free value of the liability is not exactly a liability of the company -- it is a liability of the PBGC. {For insurer's, the state guaranty funds} In turn, the PBGC itself is a liability to all companies who have to pay future premiums to it {insurers who may be assessed by the state fund}, and this may be offset by the chance that taxpayers in general, rather than premium paying sponsors, will pick up the PBGC liability if it gets big enough. Can you say F-SLIC?

[wonderer]

I purport that the lease in the example above does not show up as the value suggested.

I like the idea of only focussing on reporting ABO in this market-type environment because no impact past the current year can possibly be known on a risk free basis. However, this still rubs me wrong in my gut because the actual stream of payments which will actually be paid is subject to all kinds of other items.

Perhaps the correct liability a company needs to show is the non-insured liability that has an actual claim on company assets. After all, dumping a plan, turning over the assets to the PBGC and possibly getting a bill from the PBGC is all the company is really at risk for. (Perhaps plus a reserve item for losses expected from increased PBGC premiums due to other plans being abandoned while the current plan is kept ongoing.)

However, this is all beside the point of the thread. The point of the thread is to try to make light of the various impacts of using bond indices as an interest rate basis for determining a cash contribution pattern to an assumed ongoing pension plan.

My central theme is that the vagaries of the market are inherently inconsistent with determining a rational funding scheme.

[exactuary]

Because the lease has no escalator clause, the value Mike gave is the ABO. You may want to recognize the future use asset (rent potential or something) for the property as well.

But now you have said that you are up to "defining a rational funding method." Aha. Go to it.

But before you begin, would you mind providing some objectives for this method and, in particular, if you have preferences in mind, please say whose preferences (i.e., employees, shareholders, lenders, managers, taxpayers, society) you think should be applied and why? I assume we are talking about a publicly traded company, not a sole proprietorship nor a government.

[wonderer]

Regarding funding method, I like the Street/Gold suggestion of having the IRS determine minimum and maximum deductibility corridors based on some percentage of Current Liability, thereby allowing complete actuarial freedom inbetween.

However, the issue at hand is not funding methods, but applicability of incorporating Bond Indices in the valuation. I can only conclude that this means a control of the value of Current Liability based on Bond Yield Curves since C.L. rules are already the driver in many contribution requirements.

A discontinuity incorporating Mr. Davlin's comments would include a statement that a particular company has a default risk which may be different from the default risk inherent in an Index. This may lead to an injurious position regarding bond covenants solely because of a discrete measurement method change. This is an external, unmanageable risk. On the flip side, this may also lead to a rosier picture than is desirable.

Soap Box : On this final note, one of the big laments in my life is government standards and product quality. When the government introduced minimum product quality standards, we watched the quality of many of our goods decline severely, and yet companies began to advertise that government safety standards were being met. Current Liability Full Funding Limits introduced in a Bull Market helped condition employers into getting used to not putting money into pension plans. This was a fundamental break with the actuarial tradition of putting extra money aside for a rainy day.

Government obsolesence standards suck in that they do not ask the human to strive to truly create lasting things of beauty. This short-sightedness on the part of those whose over-arching goal is power through profit has created a wedge that may not be as manageable as some think over time.

[exactuary]

Regarding funding method, I like the Street/Gold suggestion of having the IRS determine minimum and maximum deductibility corridors based on some percentage of Current Liability, thereby allowing complete actuarial freedom inbetween.

Street?

However, the issue at hand is not funding methods, but applicability of incorporating Bond Indices in the valuation. I can only conclude that this means a control of the value of Current Liability based on Bond Yield Curves since C.L. rules are already the driver in many contribution requirements.

A discontinuity incorporating Mr. Davlin's comments would include a statement that a particular company has a default risk which may be different from the default risk inherent in an Index. This may lead to an injurious position regarding bond covenants solely because of a discrete measurement method change. This is an external, unmanageable risk. On the flip side, this may also lead to a rosier picture than is desirable.

There you go again - enigmatic - are you in favor of a yield curve or a blended index, one point in time or averaged over days, months or years, quality matched to the firms credit, or collateralized borrowing rate or near riskless or riskless?

Are your answers different for accounting than funding?

[wonderer]

I do not know enough to form a conclusion. I am simply trying to enrich the discussion.

To me, a thorough venting of implications is a precursor to developing an opinion.