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The Pension Promise and the Shadow Asset

The Pension Promise and the Shadow Asset

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Published by Wayne H Wagner
Hands-on techniques for dealing with the pension promise considering the shadow asset of future pension contributions.
Hands-on techniques for dealing with the pension promise considering the shadow asset of future pension contributions.

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Published by: Wayne H Wagner on Jul 15, 2010
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10/25/2012

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Wayne
H.WagnerChief Investment
Officer
Edward
C.
Story
Client CommunicationLarry
J. Cuneo
Portfolio Research
and
OperationsINVESTMENT
MANAGEMENT
SERVI
CES
Economic
ComponentStrategiesSpecific
ThrustPortfoliosPortfolio
AssuranceMaster
Tradins
THE
PENSIONPROMISE
AND
THESHADOWASSET:
TWO HIDDEN
REALITIES OFPENSIONFINANCEMONTHLY COMMENTARY
#5
February
1987
New
hands-on
techniques
for
dealing
with
pensioninvestment
risk
require
a
clear
understanding
of
the
true nature
of
risk
The
PENSION
PROMISE
defines
what
is
at
risk
in
the
broadest
sense,
and
the
SHADOWASSET considers
an
aspect
of
pension
riskthat
is
seldomaddressed
by current
risk
managementpractice.TTIE
PENSION
PROMISEPension
plansexist
for
two
reasons:
The
employer creates
them
to
promote
workiorce
stability,
and
the
society
sanctions
them
through
favored
tax
status
as
a
means ofsetting
aside
privatefunding
for
future
living
expenses
when
those
expenses
can
no
longer
be
paid
through
contemporaneous
earning
ability.
In
a
veryreal
sense
it
is
simply
deferredcompensation;
in
another
important
sense
it
is
an
agreement between
the
employer
and
theemployee
wherein the employer
guarantees
more
than
just
a
fixed
compensation.
The
Pension Promise
implicitly
assures
the
em-
ployee
that
his
employer
will
act
to
provide
the
maintenance
oi
a
decent standard
of
livingduring his
retirement
It
is the
expectations
of
the
Pension Promise
that
leads
an
employee
to
trade
oif
current
income
in
favor
of
income
years
later.
It
is
the
broadesteconomic
defini-
tion
oi
a
pension
plan,and,
as
we
will
show,goes
well
beyond
most
actuarial,
accounting
o{.
contractual deiinitions.
Actuarial
science
is
essentially
a
process
of
accountins
for
events
that
have
alreadv
occurred: each
year
the
retirement
beneiits
earned
by the
employees
during
the
year
are
tabulated and theyearlyobligation
determined.
The
only
forecasting
involved
concerns
mortality
rates and
a
(purposefully
conservative)
investment
earnings assumption.
The
essential
nafure
of the
acfiiarialcomputation
is that
it
is
a
dying
plan
computa-
tion;
it
describes
the liabilities thatwould
exist
if
the
planwere terminated
today.
It
is
based
solely
on
an
accounting
of
past
employment,
andprojectsnothing
with
respect
to
the
on-
going
fortunes
of
the
employees
and
the
company.
Eventhough
the
actuarial
definitions
determine
the
immediate
effect
on
company finances, they
are
totally
inadequate
from
a
pension planning
viewpoint.
Except
for
rare
cases
of
grosslyoverfunde
d
plans
or
companies
in
severe
economic
trouble,
it
is
simply unrealistic to
base
policies
on
anassumption
that
the
pension
plan
will
be
terminated.
The
thought
processes
that
support
labor
negotiations
and
pension
benefit
reviews
provides
a
morerobust
view
of
pension
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economics;
when
changes
in
the
contractualagreement
are
contemplated,
both
employer
and
employeeconsider
the
long term
economic
effects
of
pension
contracts.
Over
time,pensioncontract
changes
reflect:
-
an
evolving
assessment
of
income
needed
to
support contemporary retirement living
standards, and
-
the
company's
desire
to
share
with
theemployees
the
success
of the
company.
Both
of
these
issues
reflect
changes
in
productivity.
Changes
in
living
standard
expectations
reflect
the
economy's
gain
in
productivify;
the
company's
pension
(orcompensation)
policy
ultimately
must
reflect
micro-economic,
or
company,
gains
in
productivity.
An
adequate
view
of
pension
economics
includes
an
appreciation
of
theeffects
of
productivity
changes
on the wolution
ofpension
obligations
To
illustrate how
economic
productivity
affects
pension
obligations, consider
the
transportationneeds
of
a
retiree
who
buys
the
same
make
of
automobile
every
five
years.
Over
time,
automobiles
have
incorporatedfeatures
thatmake
them
safer,
more
reliable,
more
efficient
and
morecomfortable.
In
the
process,
automobiles
havebecome
more
expensive,
above
and
beyond
adjustments
for inflation.
Yet
they
remain
affordable
because
gains
in
national
productivity
have
made
the
worker's
contribution
more
valuable.
Henceworkers
can
still
afford
these
enhanced
vehicles,
and
manufacturers
can
continue
to
build
in
improvementsdemanded
by
an
increasing
affluent
society.
The
expectations
of
each retiree
necessarily
risesalong
with the
expectations
of
his
neighbors.
The
implication:Maintaining
a
reasonable
comparative
standard
of
livingimpliesparticipating
in
economy-widegains
inproductivity.
It
follows
that
pension
policymust
account
for
expected
gains
in
nationalproductivity,
not
only
until
the time the
employee
tetires,
but
as
long
as
he collects
retirement
benefits.
contributed
and
will
continue
to
contribute
additional funds
needed
to
maintain
retiree
living
standards.
In
the late
1970'slearly1980's,
raging
inflation
eroded the buyingpower
of
many
retirees. Asinflation
reduced nationalincome
and
wealth,many
companies
were
called
upon
to
"chip
in"
additionalbenefits,
in
order
to
adhere
to
a Pension Promise
to
retirees
and
current
employees
that
was
neither
anticipated
nor
agreed
to.Pension
Promise
expectations
must
also
reflect
the
micro
economic
companygains
in
produc-
tiviS.
As
many American workershave
sadly
learned
in
recent
decades,
a
company
or
an
industry
that
does
not
keep
apace
with
productivity
gains
cannot continue
to
support
the
same
standard ofpension
(or
compensation)
promises.
To
summarize.
the real
risk
to
the
beneficiaries
of
a
pension
plan
is
thatthe
company
will
not
be
able
to
fulfill the
Pension
Promise.
Actuaiallaccounting
definitions
of
pension
obligations
obscure
the
true
economic
nature
of
the
pension
plan,andlead
to
a
misunder-standing
of
risk.
An
improperly
conceived
risk
management
policy
may
result.
THESHADOWASSET
-
A
MATOR SOURCE
OFPENSION
RTSK
The ability
of
apension
fund
sponsor
to
fulfill
the
Pension
Promise
depends
on two
major
factors:
-
Irryestmentperformance
on
previous
contributions
in
excess
of
the
assumed
actuarial
return, in
combination
with
-
Continuing
contributions
by
the
company,
a.
to
fund
pastservice
credits,
b. to
fund
new
seryice benefits
as
accrued,
c.to
fund
new
benefits
that
arc
granted,
d.
to
fund
any shortialls
in
investmentreturns,
and
e.
to
provideadditional funding
in
case
retirement
expenses
rise.
The
presentvalue
of
expected
contributions
can
be
thought
of
as
a
SHADOWASSET
of
the
pension
plan.
It
is
very
real,
but
it
doesn't
sa
practical
L
matter,
companies
have

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