Actuarial Outpost
 
Go Back   Actuarial Outpost > Actuarial Discussion Forum > Pension - Social Security
FlashChat Actuarial Discussion Preliminary Exams CAS/SOA Exams Cyberchat Around the World Suggestions


Upload your resume securely at https://www.dwsimpson.com
to be contacted when new jobs meet your skills and objectives.


Reply
 
Thread Tools Search this Thread Display Modes
  #1  
Old 12-02-2009, 08:23 PM
Dan Moore's Avatar
Dan Moore Dan Moore is offline
Member
SOA AAA
 
Join Date: Jan 2008
College: University of Dallas
Posts: 2,723
Blog Entries: 1
Default Tepper arbitrage

‘Tepper arbitrage’ is a term used to refer to a recommendation in ‘Taxation and Corporate Policy’ (Irwin Tepper, The Journal of Finance, March 1981). Specifically, that corporate defined benefit plans should invest their assets entirely in bonds. The logic behind this recommendation is that this switch would benefit shareholders, as illustrated in the example starting on p. 15 of the following AAA/SOA publication:

http://www.actuary.org/pdf/pension/finguide.pdf

Currently, US private pension plans have about $1.5 trillion in assets, with about half of it invested in equities. The total US stock market capitalization is about $15 trillion.

So, US private pension plans hold equities representing roughly 5% of the US stock market. Not all of these are US equities, but there is a domestic investment bias.

Entirely missing from the Tepper paper and the AAA/SOA publication is any discussion of the impact to shareholders resulting from the drop in the demand for stocks associated with private pension plans dumping all their equity investment.

If the Tepper arbitrage recommendation were fully implemented, US private pension plans would dump equities representing 5% of the US stock market. This would unquestionably decrease the price of stocks, hurting shareholders. How could this point have been omitted from the AAA/SOA paper?
__________________
The best time to plant an oak tree is twenty years ago. The second best time is right now.
Reply With Quote
  #2  
Old 12-02-2009, 08:47 PM
Kenshiro's Avatar
Kenshiro Kenshiro is offline
Member
 
Join Date: Dec 2001
Posts: 9,914
Default

Quote:
Originally Posted by Dan Moore View Post
‘Tepper arbitrage’ is a term used to refer to a recommendation in ‘Taxation and Corporate Policy’ (Irwin Tepper, The Journal of Finance, March 1981). Specifically, that corporate defined benefit plans should invest their assets entirely in bonds. The logic behind this recommendation is that this switch would benefit shareholders, as illustrated in the example starting on p. 15 of the following AAA/SOA publication:

http://www.actuary.org/pdf/pension/finguide.pdf

Currently, US private pension plans have about $1.5 trillion in assets, with about half of it invested in equities. The total US stock market capitalization is about $15 trillion.

So, US private pension plans hold equities representing roughly 5% of the US stock market. Not all of these are US equities, but there is a domestic investment bias.

Entirely missing from the Tepper paper and the AAA/SOA publication is any discussion of the impact to shareholders resulting from the drop in the demand for stocks associated with private pension plans dumping all their equity investment.

If the Tepper arbitrage recommendation were fully implemented, US private pension plans would dump equities representing 5% of the US stock market. This would unquestionably decrease the price of stocks, hurting shareholders. How could this point have been omitted from the AAA/SOA paper?
Without reading more than page 15 of the link...

The paper assumes investors will reallocate their portfolios based on their individual risk profiles. If the plan sells equities and buys bonds, if they're rational mean variance optimizers, the investors will sell bonds and buy equities outside of the plan...and be better off for doing so.
Reply With Quote
  #3  
Old 12-03-2009, 12:33 AM
Dan Moore's Avatar
Dan Moore Dan Moore is offline
Member
SOA AAA
 
Join Date: Jan 2008
College: University of Dallas
Posts: 2,723
Blog Entries: 1
Default

Quote:
Originally Posted by Kenshiro View Post
Without reading more than page 15 of the link...

The paper assumes investors will reallocate their portfolios based on their individual risk profiles. If the plan sells equities and buys bonds, if they're rational mean variance optimizers, the investors will sell bonds and buy equities outside of the plan...and be better off for doing so.
The implementation of Tepper arbitrage by all US private pension sponsors at time zero would affect the investors as follows:

Their holdings would initially look like table 3A. Then, say all US private pension sponsors sold their equities and instead invested in bonds. To simplify, say Company A managed to get full value for their equities, and so the investors' tax-adjusted holdings in the pension plan assets are $325M in bonds.

Implementing the Tepper arbitrage shrinks the demand for stocks by $750 billion, representing 5% of the US stock market. Actually, once the market became aware that the Tepper arbitrage was being implemented in all US pension plans, a stock market crash precipitated by a scramble to exit equity positions would be unavoidable.

Glossing over the prospect of a market crash, assume, for example, that the 5% reduction in demand results in a 5% drop in stock prices. So, the $4.675 billion in stock held by the investors drops to $4.441 billion - they are worse off by $224 million, not better off.
__________________
The best time to plant an oak tree is twenty years ago. The second best time is right now.
Reply With Quote
  #4  
Old 12-03-2009, 01:26 AM
SirVLCIV's Avatar
SirVLCIV SirVLCIV is offline
Member
SOA
 
Join Date: Feb 2006
Posts: 46,904
Default

Quote:
Originally Posted by Dan Moore View Post
The implementation of Tepper arbitrage by all US private pension sponsors at time zero would affect the investors as follows:
Huh?

I would assume that the Tepper arbitrage scenario is speaking to an individual sponsor, not to the collective. It is in an individual sponsor's shareholders' best interest for the sponsor to invest in bonds.
Reply With Quote
  #5  
Old 12-03-2009, 10:56 AM
Kenny's Avatar
Kenny Kenny is offline
Member
Non-Actuary
 
Join Date: Jan 2003
Posts: 8,279
Default

Quote:
Originally Posted by Dan Moore View Post
The implementation of Tepper arbitrage by all US private pension sponsors at time zero would affect the investors as follows:

Their holdings would initially look like table 3A. Then, say all US private pension sponsors sold their equities and instead invested in bonds. To simplify, say Company A managed to get full value for their equities, and so the investors' tax-adjusted holdings in the pension plan assets are $325M in bonds.

Implementing the Tepper arbitrage shrinks the demand for stocks by $750 billion, representing 5% of the US stock market. Actually, once the market became aware that the Tepper arbitrage was being implemented in all US pension plans, a stock market crash precipitated by a scramble to exit equity positions would be unavoidable.

Glossing over the prospect of a market crash, assume, for example, that the 5% reduction in demand results in a 5% drop in stock prices. So, the $4.675 billion in stock held by the investors drops to $4.441 billion - they are worse off by $224 million, not better off.
I haven't read the specific paper you reference but I think you might be missing a couple of points:

1) This is a theoretical argument that ignores certain real world aspects, such as friction costs, and focuses on optimal choices given a specific set of simplifying assumptions, similar to the basic BS formula or CAPM or any other basic theory underlying Finacial Economics.

2) One of these simplifying assumptions is a simultaneous adjustment of the shareholders' portfolios such that for every dollar of equity sold by the pension plan an individual shareholder purchases it immediately, and vice-versa for every dollar of bonds purchased by the pension plan an individual shareholder sells it immediately so the total bond/equity holdings do not change in the overall market.

Clearly this is a simplifying assumption and there would be a certain time lag between when any individual plan sponsor shifted its portfolio and the point at which the respective shareholders realized this and adjusted accordingly.

I have noticed a consistent issue with most of your arguments that I have read here on the AO (but to be honest I haven't paid very close attention). It appears you think you are arguing against the underlying theory when most of the time you are only bringing up issues related to the simplifying assumptions. While it can be useful to point out why a certain theory may not be applicable to the real world due to the issues with the assumptions, it would be better to frame the argument as such, rather than trying to frame it as a problem with the underlying mathematical position.

And in this case you are only bringing up an issue with the transition from the current position to the theoretically optimal one. That does nothing to discount the credibility of the argument that it is the truly optimal position, absent any friction costs to get us there.
__________________
Play Free Games and Win Real Money
I am a scientist. I am sorry to disappoint you but I have never seen an elf or a troll. But who am I to exclude their existence? - Arni Bjoernsson
You are stupid and evil and do not know you are stupid and evil. ... Dumb students are educated stupid. - timecube.com
Usually while I'm reading, I'm actually thinking about...midgets riding toy horses - Roto


Reply With Quote
  #6  
Old 12-03-2009, 11:40 AM
Fuzzy's Avatar
Fuzzy Fuzzy is offline
Member
SOA AAA
 
Join Date: Oct 2001
Location: Far from the madding crowd...but closer than I used to be
Studying for the "final" exam
Favorite beer: Carlsberg
Posts: 625
Default

I've wondered about this for a while and haven't seen any discussion on this scenario, but it seems to me that the argument gets a little cyclical:

1. all/most pension plans get out of equities: demand for equities goes down (prices fall) and demand for bonds goes up (prices rise, yields fall)
2. falling bond yields pushes liability valuations up (faster/slower than bond prices? ...depends on durations involved...)
3. businesses figure out that equity financing is not attractive so they issue bonds instead
4. bond supply increases, so prices fall (& yields rise); equity supply decreases and prices rise as the aforementioned "rational investor" moves into equities since his "pension" investment is now in bonds
5. increasing bond yields result in decreasing liability valuations (again, faster/slower than bond values?) possibly pushing bond demand down again...and the supply starts to decrease as businesses figure out that bond financing is expensive
.
.
.
my head is starting to hurt with all of the options...and thinking about where/if things stabilize.

Sort of reminds me of the old days ('70's & '80's) when insurance companies were big in pensions and GICs had high returns (of course, inflation was a problem then too...) and insurers were awash in money that needed to be in fixed income but the supply dried up as businesses couldn't afford the cost of borrowing (and turned to equity financing?...) so separate accounts becaming the vogue then it all changed into a "chasing returns" game and we ended up here...deja vu all over again? Just wondering where it'l all end up......
__________________
"Don't worry about the world coming to an end today. It's already tomorrow in Australia." (Charles Schulz)
"We created an environment where we didn't know what we were doing, but it was legal and making profits."(Bill Sharon, chief executive of Sorms)
"As soon as we solve one problem, another one appears. So let's try to keep this one going for as long as possible." (Pepper...and Salt, WSJ, 5/4/2011)
Reply With Quote
  #7  
Old 12-03-2009, 08:15 PM
Dan Moore's Avatar
Dan Moore Dan Moore is offline
Member
SOA AAA
 
Join Date: Jan 2008
College: University of Dallas
Posts: 2,723
Blog Entries: 1
Default

Quote:
Originally Posted by Kenny View Post
2) One of these simplifying assumptions is a simultaneous adjustment of the shareholders' portfolios such that for every dollar of equity sold by the pension plan an individual shareholder purchases it immediately, and vice-versa for every dollar of bonds purchased by the pension plan an individual shareholder sells it immediately so the total bond/equity holdings do not change in the overall market.
I'm reminded of something my boss taught me several years ago about actuarial communications. They should have the following three components (the assumption part of this is similar to ASOP 41 paragraph 3.1):
- a complete summary of the assumptions made;
- a description of the plan or proposal under consideration;
- the cost or other financial results.

You make an interesting speculation about an assumption the authors may have made. If they did make that assumption, they chose to not mention it. Another possibility is that the authors were so convinced of the soundness of the argument that they never seriously considered any objections to it.

Note that this assumption requires a group of market participants who are willing to buy stocks at the current price in the event of a complete Tepper arbitrage implementation, but otherwise, they wouldn’t be willing. Who are these market participants?

Quote:
Originally Posted by Kenny View Post
And in this case you are only bringing up an issue with the transition from the current position to the theoretically optimal one. That does nothing to discount the credibility of the argument that it is the truly optimal position, absent any friction costs to get us there.
It’s impossible to go back in time and change history so that pension plan sponsors always invested exclusively in bonds. To implement any change, it’s necessary to start at the current state and take actions necessary to arrive at the target state.
__________________
The best time to plant an oak tree is twenty years ago. The second best time is right now.
Reply With Quote
  #8  
Old 12-03-2009, 08:24 PM
Kenshiro's Avatar
Kenshiro Kenshiro is offline
Member
 
Join Date: Dec 2001
Posts: 9,914
Default

Quote:
Originally Posted by Dan Moore View Post
I'm reminded of something my boss taught me several years ago about actuarial communications. They should have the following three components (the assumption part of this is similar to ASOP 41 paragraph 3.1):
- a complete summary of the assumptions made;
- a description of the plan or proposal under consideration;
- the cost or other financial results.

You make an interesting speculation about an assumption the authors may have made. If they did make that assumption, they chose to not mention it. Another possibility is that the authors were so convinced of the soundness of the argument that they never seriously considered any objections to it.

Note that this assumption requires a group of market participants who are willing to buy stocks at the current price in the event of a complete Tepper arbitrage implementation, but otherwise, they wouldn’t be willing. Who are these market participants?



It’s impossible to go back in time and change history so that pension plan sponsors always invested exclusively in bonds. To implement any change, it’s necessary to start at the current state and take actions necessary to arrive at the target state.
From page 12.
Quote:
The debt/equity mix of pension plan assets does not affect shareholder value on a firstorder
basis. Shareholders are able to adjust their personal portfolios to reflect the pension
plan’s holdings.
From Page 15 (bolding added)
Quote:
We start by addressing the
impact of corporate taxes. We then follow with an example of how investors could re-align their
personal portfolios (outside the pension plan) to compensate for asset allocation changes made
to the corporation’s pension plan.
Finally, by applying personal taxes, we are able to quantify
the extent to which shareholder value is destroyed when pension plans invest in equities.
Quote:
Corporation A has the balance sheet shown in Figure 1 and Corporation A invests its
$500MM pension plan entirely in equities.
 Consider a group of individual investors (hereinafter referred to as “Investors”) who in
aggregate own A. These Investors have a combined portfolio of $10BB.
 Our Investors re-balance their portfolio in order to maintain a 50/50 equity/bond
allocation. Thus, these Investors’ combined $10BB individual portfolios are split evenly
into $5BB in equities and $5BB in bonds.
Quote:
The following assumptions were used to develop the all-bonds strategy in the prior chapter:
 Transparency: Shareholders can always see the plan assets and liabilities.
 Corporate Valuation: Shareholders can value corporations economically by reference to
the capital markets.
 Risk: Rational investors will adjust their own portfolios to their desired level of risk.
 Default: Promised benefits will be paid by the plan because it remains sufficiently funded
and/or the corporation is strong enough to make up any pension deficits.
Dude...did you even read this paper? Almost every page talks about the assumption that investors will rebalance their portfolio based on what the pension plan does.
Reply With Quote
  #9  
Old 12-03-2009, 08:31 PM
Kenshiro's Avatar
Kenshiro Kenshiro is offline
Member
 
Join Date: Dec 2001
Posts: 9,914
Default

Quote:
Originally Posted by Dan Moore View Post
Note that this assumption requires a group of market participants who are willing to buy stocks at the current price in the event of a complete Tepper arbitrage implementation, but otherwise, they wouldn’t be willing. Who are these market participants?
Let me try short sentences.

Based on my risk tolerance, I invest 50% in equity and 50% in bonds. I own stock in company A.

Company A's pension plan is invested 100% in equity.

Company A's pension plan decides to sell all its equity and buy bonds.

This changes my personal allocation. To return to 50% equity and 50% bonds, I must sell bonds and buy equity. This same is true for all of Company A's shareholders.

Ignoring taxes and transaction costs, this gets us exactly back where we started. On a first order basis, the pension plan's allocation does not matter.

If I consider taxes, I'm better off if the pension plan owns bonds.

To answer your question, the market participants are the shareholders of the company that sells equity to buy bonds.
Reply With Quote
  #10  
Old 12-03-2009, 09:21 PM
Psychotic Troll Psychotic Troll is offline
Member
 
Join Date: Sep 2009
College: Wyoming
Posts: 33
Default

http://users.erols.com/jeremygold/ryan/ryanb.pdf

look at the date
__________________
PT: an homage to AP, RIP
Reply With Quote
Reply

Thread Tools Search this Thread
Search this Thread:

Advanced Search
Display Modes

Posting Rules
You may not post new threads
You may not post replies
You may not post attachments
You may not edit your posts

BB code is On
Smilies are On
[IMG] code is On
HTML code is Off


All times are GMT -4. The time now is 02:22 AM.


Powered by vBulletin®
Copyright ©2000 - 2020, Jelsoft Enterprises Ltd.
*PLEASE NOTE: Posts are not checked for accuracy, and do not
represent the views of the Actuarial Outpost or its sponsors.
Page generated in 0.77222 seconds with 11 queries