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Old 10-20-2015, 12:03 PM
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Mary Pat Campbell
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Default How Public Pension Plans Can (and Why They Shouldn’t) Ignore Financial Economics

a paper by Lawrence N. Bader, in the Financial Analysts Journal

It's "locked", so I'll share the summary:
http://www.cfapubs.org/doi/sum/10.2469/faj.v71.n5.1

Quote:
Summary
Public pension plan sponsors claim that their perpetual existence and taxing power exempt them from financial economics. They therefore ignore current market conditions and rely on patience and intergenerational risk sharing to overcome risk. The author shows that their use of discount rates that far exceed current market levels produces financial opacity, retirement insecurity, and intergenerational inequity, leaving the solvency of these plans dependent on the systematic mistreatment of future generations of taxpayers.

Editor’s note: This article was reviewed and accepted by Executive Editor Robert Litterman.

Long-term US Treasuries are yielding less than 3%, while US public pension plans are discounting their liabilities and basing their funding on rates of 7%–8%. This article focuses on the United States but notes that similar discrepancies between public plan discount rates and the local default-free rate appear in most developed countries, particularly in Western Europe. These discrepancies produce financial opacity, retirement insecurity, and intergenerational inequity.

Insurance companies manage their annuity business roughly in accordance with the principles of financial economics, which call for discounting insured liabilities at rates that are default-free or nearly so. Public plan sponsors ignore these principles. They invest substantially in equities and often in such alternative investments as private equity, real estate, and hedge funds. They estimate, generously, the risk premiums they expect to earn on these investments. They reflect the hoped-for risk premiums in the discount rates that underlie their financial reporting, plan contributions, and pricing of negotiated plan improvements.

Public pension plan authorities claim various justifications for their deviations from financial economics, observing that, unlike insurance companies, they have taxing power and will exist in perpetuity. They can share their investment risks among multiple generations of taxpayers—long enough for those risks to become minimal and manageable. Public pension plan authorities can thus count on earning the risk premiums embedded in the higher expected rates of return. In the worst case, they can fall back on their taxing power.

This long-term argument implicitly relies on an extreme mean reversion process. It implies that the variance of a risky portfolio’s cumulative return decreases as the measurement period extends, rather than merely increasing more slowly than under a simple random walk model. The idea that risk shrinks over sufficiently long periods has been refuted by financial economists.

The intergenerational-risk-sharing argument is also flawed. This article considers a two-period illustration in which the first taxpayer generation funds the pensions earned during its tenure. The discount rate used to determine the pension contribution includes a risk premium—in effect, the first generation uses the risk premium to reduce its contribution. It then exits the scene, having borne no risk and leaving the new generation to settle up in the second period. The second generation enjoys gains or faces losses with an average value of zero; that is, it bears the risk of gains or losses but can expect no risk premium. The risk premium, which can exceed half the true pension cost, has been confiscated by the first generation, which bore no risk. In practice, where immediate settlement is not required, risks continually pass to future generations, with surpluses swept off the table and deficits allowed to run for as many generations as possible.

Thus, the true benefit of the long government time horizon is not that it overcomes risk but, rather, that it delivers a steady supply of future involuntary risk bearers on whom the government can exert its taxing power—at least until it runs out of sufficiently affluent generations of taxpayers. In such failures, the victims can include not only taxpayers but also plan members and municipal bondholders.

Apart from the risk of demographic collapse, the dependence on future generations of taxpayers violates the fundamental principle of public finance: each generation should pay in full for the services it consumes, without passing either direct costs or funding risks to future generations. Ensuring sustainability and fairness for all generations of plan participants and taxpayers requires economically correct discount rates for financial reporting, determination of contributions, and pricing of benefit increases.
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Old 06-27-2016, 11:28 PM
DiscreteAndDiscreet DiscreteAndDiscreet is offline
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Okay, I'll bite.

Reductive formulations of financial economics ignore an awful lot of important things. I prefer to view financial economics as a set of simple statements about spot price relationships of liquid securities with inter-contingencies. This is what is actually supported by the mathematical framework. The mathematical framework does not make any predictions about price evolution or normative standards.

Supposedly risk neutral pricing can equally be described as a mixture of asset valuation strategies that may or may not pay off, comparable to mixed strategies in game theory, which has a similar theorem guaranteeing the existence of a mixed strategy equilibrium. Reductive formulations of financial economics equate risk neutral pricing with a pure strategy with ascertainable performance characteristics. This is highly dubious.

The no free lunch theorem in optimization and search shows that no a priori strategy can always be successful in all situations. At best, all effective strategies are situational based on a distribution of conditions. While this is consistent with general observations that there is a lack of clear evidence of individual investment managers outperforming the market, it also establishes why the market can't reflect all available information.

Some arbitrages exist because an arbitrageur capable of taking advantage of them does not exist. Some purported arbitrages are unarbitraged because they involve a good which is not marketable.

What keeps me awake at night isn't the worry that institutions that take on some naked risk exposure will fail to manage it. What keeps me awake at night is wondering if preaching that hedging is the only form of risk management is causing society to underproduce risk capacity. I will note that this hypothesis would be consistent with a secular decline in interest rates and increase in P/E ratios due to institutional investors and wealth preservation-focused individual investors seeking to maintain higher levels of assets than are supported by new issuance and earnings growth.

I'll also argue that Lyapunov stability of solvency strategies is an under-explored concept that I believe is much more powerful than financial economics. I can equally argue that a balance sheet focused perspective on the world under-reflects measures needed to stabilize future income, for all parties.
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Old 06-28-2016, 12:17 AM
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Mary Pat Campbell
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Originally Posted by DiscreteAndDiscreet View Post
What keeps me awake at night is wondering if preaching that hedging is the only form of risk management is causing society to underproduce risk capacity.
1. No, it doesn't. And if it does, I recommend therapy. Or Ambien.

2. Do you know any actual humans? Have you seen what people actually do, calling it prudent?

Having you seen what people actually do, even ignoring risk? Young men, in particular, take insane risks. Thus the stupid fatal period (which I'll graph in here later)

I do agree that people tend to be risk averse after big disasters. But the human ability to chase mirages in the dream of great payoffs is even bigger.

3. That said, I can think of an indicator of people taking fewer risks: falling fertility rates.

And I think that is related to the low interest rate environment, which is a reflection of a risk-averse population.

4. But the point is, those who have to fund pension plans can't drive the population to be more risk-taking than it actually is.

If you want to value the pension as of less value than the current risk-averse environment would dictate, then you need to value the option of the benefits not being paid in full.

Which still devolves to financial econ.
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Old 06-28-2016, 02:37 AM
DiscreteAndDiscreet DiscreteAndDiscreet is offline
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I'm up tonight.

Take a look at stochastic optimization algorithms. These are algorithms that use randomized behavior that explores a space of candidate solutions by moving from point to point with only a small bias in favor of good moves, and they can devote a substantial chunk of their computation time evaluating regions of the solution space that are total dead ends.

These algorithms can sometimes do a good job with problems that are intractable in their general case. Other times they just put a small dent in them. Other times they're ineffective.

Now all of this is just to show that optimal human behavior is irrelevant to the conversation, because it doesn't exist. Stupidity is a more effective tool at dealing with some problems than intelligence, if it's applied in the appropriate measure. I can give you a real world example of this. Do you think it would be possible to have a high success rate for business startups? Starting or investing in a new business is an objectively stupid idea. Each success is subsidized by a population of people dumb enough to try, fail, and tear their families down with them.

Now, when I value a pension, I usually do not care about the cost of settling the pension obligations. For the majority of my clients, there are no short or intermediate term state changes that attain that outcome even if it were desirable. What we have instead, is an iterated multi-party game. The employers, the employees, shareholders, bondholders, secured creditors, customers, and citizens who are going to make a series of choices about how to allocate each period's income among themselves and how much to trust each other's representations of their future income and the value of assets which secure that trust.

Default scenarios do not figure overly heavily in that picture, although that begins to change when the decline of an employer, an industry, a city, state, or even nation comes into play. What figures more heavily is foregone income and what I primarily study is trajectories of foregone income for my clients so that they can better understand their needs in these multiparty iterated games. I help my clients manage their future moves in this game.


Now I'm not particularly interested in the level of risk initiation in society at large. That seems to be the preoccupation of your post and even though my comments above indicate that I view this as a necessary element of society, there is no means of gauging what level of it is optimal, appropriate, or necessary. I am more interested in risk capacity viewed as the amount of volunteerism to be a counterparty to a risk that already exists regardless of the potential counterparty's actions. Put another way, my perception is that the aggregate level of diversification of counterparties has decreased.

I'm not sure that more actors modeling their actions in a financial economic manner improves social welfare due to the way that financial economically sound game moves operate on a zero-sum basis.
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Old 06-28-2016, 09:33 AM
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I agree with you about counterparty diversity.

I think there's concentration risk -- it's not so much that risk capacity is not being fulfilled, that risk is taking a different form.

Some might call this systemic risk.

I'm not really all interested in the theory so much as what's actually going to happen. FWIW, we have different approaches to valuation of pension obligations around the world, and I think we'll see that they'll have different rates of failure (and how they fail) and different trajectories of cost development.

I think one could do an empirical study to compare/contrast. I believe the Center for Retirement Research has some of these studies, at least with regards to U.S. public pensions.

http://crr.bc.edu/

Here's one:
http://crr.bc.edu/briefs/how-did-sta...e-underfunded/

Quote:
SLP#42

The brief’s key findings are:

A new analytical tool tells a clear story of why unfunded liabilities rose during 2001-2013.

The primary factor was investment returns that fell short of expectations due to the two financial crises.

A secondary factor was that many plans failed to make adequate contributions, a more serious problem among the worst-funded plans.

This type of analysis should be added to every plan’s annual actuarial valuation.
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