Wednesday, January 28, 2009

FAS FSP 132R-1

Plan sponsors will be required to provide more transparency about the assets in their defined benefit pension plans based on FASB’s recently issued FSP FAS 132R-1, "Employers’ Disclosures about Postretirement Benefit Plan Assets."

This new disclosure guidance addresses perceived inadequacies about the types of assets and associated risks in retirement plans. Plan sponsors generally provide info on only four asset categories: equity, debt, real estate, and other investments. The growing popularity of alternative assets and their lack of homogeneity and unique risks make the "other investment" category particularly challenging for financial statement users to evaluate.

The new disclosures are designed to provide additional insight into:

• The major categories of plan assets
• The inputs and valuation techniques used to measure the fair value of plan assets
• The effect of fair value measurements using significant unobservable inputs (Level 3 measurements in FASB Statement 157, Fair Value Measurements) on changes in plan assets for the period
• Significant concentrations of risk within plan assets
• How investment decisions are made, including factors necessary to understanding investment policies and strategies

Required for financial statements with fiscal years ending after December 15, 2009.

Sunday, January 18, 2009

Pension Expected Return Assumptions - Hitting Back


Current pension accounting allows pension plans to use an estimate of expected future returns instead of actual returns to compute periodic pension costs. The logic behind this accounting is that, in the long run, a combination of company resources and investment earnings must equal plan obligations. Pension plan liabilities are long lived and therefore some stable long run estimate of corresponding asset returns should be used to determine the periodic cost to the business of meeting plan obligations. Accounting further recognizes that annual differences between actual and expected returns are inevitable. These are accumulated and amortized into periodic cost over time.

There is a natural asymmetry to how this accounting regime is viewed depending on market performance. In bull markets, most seem satisfied in the conservatism reflected by periodic pension costs being higher than current earnings might suggest. Yet in bear markets, critics become vocal about the potential manipulation and overstatement of income as a result of using positive expected returns when market returns are negative. The wider the gap the more vocal the critics and the more concerned the actuaries and auditors who have a professional tendency towards asymmetrical conservatism. A recent article reflects this view.


“That 8 percent annual return on investment you and your pension fund manager were banking on is now looking almost as optimistic as Madoff’s magic 12 percent, as deleveraging and deflation bite. With extremely low or negative interest rates and everyone from consumers to banks trying to shed debt and assets at the same time, what seemed like reasonable projections for a mixed portfolio of stocks, bonds and other assets are now substantially too high.”
It is a well accepted fiduciary notion that short term investment results are very noisy and carry little useful information to guide long term investment strategies. Yet, after market drops like 2008, misguided critics insist that plan sponsors should be lowering their expected return assumptions to accommodate what ever change in strategic assumption they would argue has been revealed by the market drop. In this case, presumably, overleveraging was explicitly factored into past return forecasts rather than being a source of an unexpected positive variance from past forecasts.

In fact, long term expected return assumptions as defined by FASB, properly based on long horizon strategic factors, should not be subject to frequent marginal shifts given; the likely estimation error in any such forecast, the infrequency of major structural market changes and the provisions of accounting to amortize actual to forecast return differences overt time. Further, unless the market principle of mean reversion has been suspended, it is fallacious to assume that forward expected return forecasts should be lower after a market collapse. Historically, periods of heavy losses have been followed by periods with above average returns. Diamond Hill calculated that if the S&P 500 only returned to its April 2000 level in the year 2016, that appreciation, coupled with the dividend yield, would result in an annualized total return of over 12%.

While we are not expressing a view as to whether the average pension plan’s expected returns accurately reflect future returns, it is illogical to presume that the passage of the last year has provided plan sponsors with significant additional insight on strategic factors that were embedded in their long term forecast assumptions. Though it is understandable from a risk aversion perspective, it is also illogical that pension actuaries and auditors should bias plan sponsors to lower long term expected returns after the market has seen its worst decline in 50 years. Given their biases, pension plan fiduciaries should not unduly allow their advisors to tactically influence their strategic pension accounting assumptions.

Sunday, January 11, 2009

The Perils of Cumulative Returns

In addition to having to confront miserable absolute returns in their investment programs, investment fiduciaries will have to contend with more than the usual number of relative performance issues where investment funds are not meeting their performance benchmarks. This is because of the higher than average fund performance dispersion in 2008 and the surprisingly significant impact that a single high deviation performance year can have on 3 and 5 year cumulative returns.

Short term investment performance is generally regarded as having a high noise to signal ratio. This means short term performance patterns usually do not persist into the future and therefore provides little useful information for investment decision making. Yet, 1 year performance variances, positive or negative, can substantially infect longer term 3 and 5 year cumulative performance measures, which are routinely used by investment fiduciaries in investment decision making. The larger a fund’s annual performance variance, the higher that years impact on 3 and 5 year cumulative performance. We have estimated that equity mutual fund performance return dispersion is 31% higher in 2008 than the average annual return dispersion since 2003. This suggests that the 3 & 5 year cumulative return rankings for investment funds will be subject to more fluctuation, influenced by a broader range of positive and negative 1year variances.

To counteract the effects of these short term performance biases, it is particularly important that investment fiduciaries look at a mosaic of other quantitative measures such as long term (5 +) and life of fund performance as well as rolling period data when evaluating fund returns. Fiduciaries might be considered imprudent not to consider other factors besides returns in their analysis. A number of risk measures are routinely used in conjunction with returns. Some studies, such as that by Martin Eling, Does the Measure Matter , point out that the Sharpe ratio is a reasonable and adequate measure to rank funds for additional due diligence work, though these measures are time period dependent as well.

In truth, even multiple statistical tools may not capture the critical attributes and dynamics of an investment fund. Subjective analysis and investment judgment will always be required to transform investment data into prudent investment decisions. Evaluating the fallout of 2008 will put a particular premium on those skills.

Sunday, January 04, 2009

Investment Fiduciary Mulligan


Investors and investment fiduciaries may be wishing they could take a mulligan on their long term equity oriented investment strategies in the face of this decade’s second equity market implosion. Global equity (MSCI World) returns have been nil over the last decade ending November while global bond returns (MLGBM) were about 5.2% annualized.

Certainly, fiduciaries might surmise that, had they learned their lesson after the technology wreck in 2000, and either teed up a more conservative portfolio with less equity exposure or diversified their portfolios into alternative asset classes, they would be much better off today. Surprisingly this would not be the case. Since the market bottom in 2002 through November 2008, neither a more defensive asset allocation nor a more diversified allocation using alternative investments would have provided much relief.

Annualized returns for the period from the bear market bottom in October 2002 through November 2008 for various portfolios suggest that the positive equity returns enjoyed by investors over the intervening years was directly proportional to the losses they suffered in 2008. In other words, higher equity allocations lost a similar proportion of their past gains in 2008 as portfolios with lower equity allocations implying that the degree of equity allocation made only a modest difference in portfolio return over this period. The following benchmark portfolio returns illustrate this (Stocks=75% R3000, 25% MSCI EAFE, Bonds=Barclays US Aggr, rebalanced quarterly)

Portfolio 6Yr 1Mnth Return
Stock 80% Bonds 20%     4.16%
Stock 70% Bonds 30%     4.27%
Stock 60% Bonds 40%     4.36%
Stock 50% Bonds 50%     4.41%
Stock 40% Bonds 60%     4.43%
Stock 30% Bonds 70%     4.42%

Another investment strategy made popular by the large endowment funds was designed to diversify portfolios away from equity market risk. These strategies featured an asset allocation which included “alternative” investments. For all but the largest portfolios, this typically would have included allocations to real estate, commodities and hedge funds, through a fund of fund vehicle.

For comparison purposes we created a benchmark portfolio which included a 30% allocation to alternative assets (10% Wilshire global REITs, 10% HFRI Funds of Funds and 10% S&P GSCI) and an 80% allocation of remaining assets to stock and 20% to bonds. The 30% alternative portfolio returned 5.36% annualized for the 6 years through October 31, 2008 vs. 5.12% for the standard 80% stock 20% bond portfolio. The allocation to this set of alternative assets over this period added a modest .24% to portfolio returns (reduced porftolio volatility by a small amount) yet exposed investors to other non-statistical risk factors which are still playing out in the markets.

So, while all investors lost strokes over the last 6 years, mulligans were awarded for virtually every differential investment strategy. Investment fiduciaries have had the opportunity to learn a number of important lessons about the markets, about risk and about their own risk appetites and investment psychology. These should be carefully considered as part of their course management. Though no one knows what lies ahead in the markets, a big risk is that investment fiduciaries will rely too much on their “muscle memory” of 2008 in teeing up their investment strategies going forward.