Book Recommendation: Waring, M. Barton. Pension Finance – Putting the Risks and Costs of Defined Benefit Plans Back under Your Control. New Jersey: John Wiley & Sons, Inc., 2012. Print

1. Robert R. Mudra, CFA
September 2013
Book Recommendation: Waring, M. Barton. Pension Finance – Putting the Risks and
Costs of Defined Benefit Plans Back under Your Control. New Jersey: John Wiley &
Sons, Inc., 2012. Print
About the Author:
“M. Barton Waring is a financial economist and lawyer, and an active researcher in
pension finance and investing. He retired in 2009 from his role as Chief Investment
Officer for investment strategy and policy, emeritus, at Barclays Global Investors. Mr.
Waring is well known in the pension industry for his many thoughtful and often
prizewinning articles. He serves on the editorial board of the Financial Analysts Journal
and as an Associate Editor of the Journal of Portfolio Management.”
I highly recommend Pension Finance to you with its very timely guidance on the
management of defined-benefit pension plans. Mr. Waring presents a complete treatment
of the overall pension accounting system on a market-value basis for the purposes of
improving plan management. Even if not adopted for financial reporting purposes,
implementation of a mark-to-market based pension accounting system with a surplus
optimization investment strategy could provide significant benefits to both labor and
management. He also presents a thorough discussion of risk management and investment
strategy. In short, with better economic information and more informed risk management
strategies, better management decisions can be made and defined-benefit plans can be
well funded and managed with lower risk.
The following quotation aptly describes Waring’s view of the need for economic
accounting information:
"While it may appear that going to market value accounting causes new
problems for the plans, the fact is that it doesn’t – the plan’s status is what it
is, regardless of the accounting. But economic accounting brings a benefit, a
clear-eyed view of what is really going on in the plan, a means of
understanding the plans true financial condition, a means of understanding
the true cost of benefit changes, and a means of understanding the true level
of contributions needed to support the benefit promises. It even provides a
path to investment strategies that reduce risk to the deficit and to
contributions. So while there may be short-term pain, the path to longevity
for pension plans must include economic accounting and actuarial
approaches. Traditional accounting and actuarial work held sway as plan
solvency declined; the path back is to use better tools.”
p. 225
The total unfunded pension plan debt for all plans (public and private) in the United
States is currently estimated to be at least $4 trillion dollars. The size and complexity of
this crisis as revealed through current actuarial and accounting methodologies have
provided misleading information to both plan sponsors and participants. The fact that the
pension funding crisis is as bad as it is should tell us that the current approach is not

2. Robert R. Mudra, CFA
September 2013
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working. This is big money and it’s intended to be available to solve the most difficult
financial problem that most people face during their lives: safely accumulating the means
to retire comfortably after their working years are over. Clearly, these are significant
issues for employers and employees alike and Mr. Waring provides an objective analysis
that can assist in both labor negotiations (such as recognizing the Full Economic Liability
which includes both off-book and on-book liabilities) and pension plan management. In
addition, Waring outlines 22 Propositions which are important pension finance principles
that may come as a surprise to many.
Several of the traditional pension management tools have simply not delivered the
desired results. Actuarial asset/liability studies have led to recommended portfolios of
80% equities and 20% bonds or 60% equities and 40% bonds. Yet, the portfolios do not
hold enough long bond durations to hedge the liability which means that in declining
interest rate environments the liability goes up dramatically while the value of the fixed
income assets barley follow. On the equity side, these high allocations could increase
your deficit by 10% of assets every time the market falls by 10% which adds significant
volatility. The studies often over-complicate the analysis with Monte Carlo simulations
which are misused as an “actuary in a box.” Waring explains that asset/liability studies
are not needed as “surplus optimization” handles the investment strategy problem
perfectly.
Surplus optimization controls the economic “surplus” (or deficit) of the plan. First, the
interest rate and inflation risks of the liability stream (future benefit payments) are
hedged through a Liability-Matching Asset Portfolio (LMAP). This is the single biggest
risk management decision of the plan and hedging the economic liability can reduce over
half of the variance of the plan. The accounting always follows the economics, if not
sooner than later, and this approach will then significantly reduce the volatility in pension
expense and contributions. Second, a Risky Asset Portfolio (RAP) can be added in a risk-
controlled manner, if desired, but this is completely optional. One approach for the RAP
would be to put in place an improved Dutch system: If the sponsor wants to invest in
risky assets over and above an LMAP hedging portfolio, it must be fully funded – and
then some. This policy can be improved by qualifying it: The cushion should be
established relative to the surplus risk generated by holding the RAP in such a way as to
manage the probability of becoming underfunded.
In developing the LMAP, you match the accrued liability’s total return sensitivity by
matching (1) the dollar real interest rate duration and (2) the dollar inflation duration.
This effectively provides immunity of the surplus or deficit of the plan to market risk and
thus protects the funding level. In addition, it addresses a key goals of pension managers
which is to stabilize the economic normal cost which is the expense accrued to the
sponsor in this period for benefits that will be owed to employees at their future time of
retirement and stabilizes future contributions.

3. Robert R. Mudra, CFA
September 2013
3
The actuarial funding method concept is another relic of the past that should be
eliminated. This approach assumed that future benefits would be paid out of
contributions plus earnings on the investment. In reality, the funding method was a
“balancing act” in which contribution levels were experimentally adjusted up or down
while the “expected” rate of return assumption was adjusted up and down as well. The
temptation was to select higher “expected” rates of return to reduce contributions as well
as reduce the “valuation” of the liability. In short, the required rate of return should not
be used for the management of the pension plan. When holding a LMAP, contributions
are really just a function of the benefit policy plus or minus some minor gains or losses
from the RAP (if held).
Waring makes a huge point of the fact that plan sponsors and strategists agonize over
which new asset classes to add to their portfolios (e.g. hedge funds, venture capital,
exotic beta classes, etc.). Yet there is no “magic” asset class that always goes up and that
you are able to accurately choose in advance. He reminds us that finance theory is quite
clear on this matter and that the Risky Asset Portfolio (RAP) should be a market-
capitalization weighted portfolio of all risky assets. Otherwise, we are assuming that our
asset manager has some specific, unique market knowledge that suggests he can
outperform the market over a finite period of time on a risk-adjusted basis. In reality, the
results will be a random outcome and not a good strategic decision.
Some sponsors may attempt to “pay for the plan” by adding even more risky assets to the
portfolio. However, the point cannot be under emphasized that sponsors will not “get”
the “required” or “expected” rate of return on their investments over time. In fact, a
realized (actual) return is drawn from a wide distribution of returns if you’re investing in
risky securities. Market returns can be quite volatile and long periods of bad luck
(realized returns less than expected returns) are just as likely as long periods of good luck
(1980s-1990s). The market declines of 1998, 2002 and 2008-2010 damaged the asset side
of most plans as well as significantly increased deficits. This type of volatility typically
adds to the deficits because sponsors typically don’t want to make up the loss with
contributions. In the end, the deficits are left in place hoping that they will go away in the
future. They could potentially or they could also get worse, much worse.
Another common misconception is that risk goes away over the long term but in fact it
accumulates with time. The standard deviation of returns increases by the square root of
the number of years. For example, if the time horizon is 25 years then the standard
deviation of returns (risk) over the period is √25 years = 5 times wider than the one-year
standard deviation of returns. The risks to wealth accumulate with time and we must
remember that markets will fail to meet the expected return assumption.
The key conclusion is that the biggest single risk to hedge in a pension plan is the
liability. Sponsors spend a lot of time focused on asset allocation decisions which can
only marginally help the plan while ignoring the decision to hedge the liability. In short,
sponsors should do three things in this regard (1) hedge the interest rate risk of the
liability (2) revisit the risk tolerance decision, it is a real investment decision (3) be very

4. Robert R. Mudra, CFA
September 2013
4
careful about any active or tactical decisions that require special skills in order to yield
success.
The process really begins with gaining a full understanding of the economic cost of the
plan. The “Full Economic Liability” FEL is the proper starting point for a plan sponsor to
gain a complete picture of the on-book and off-book economic liability. The off-book
liability will inexorably make its way on book eventually. Waring points out that an
economically determined accrued liability and its associated normal cost method will
accrue portions of the full economic liability related to current employees onto the books
over time. On some agreed basis, which will generate the economic accrued liability
whose form can be chosen and interpreted as an acceptable funding target for benefit
security purposes.
Since the ABO (Accumulated Benefit Obligation) and PBO (Projected Benefit
Obligation) are accrued “subsidiary” measures of the liability by definition they leave
something off the table. That something is the portion which is still unaccrued for both
current and future employees. Mr. Waring suggests that wise management teams do
consider the off-book (non-legal) obligation and they consider its value when talking to
labor during negotiations.
In order to determine the proper economic value of the liability in today’s dollars one
must use market-based discount rates. Some people continue to believe that the expected
rate of return on the asset portfolio is the appropriate economic discount rate to use when
valuing the liability (future benefit payments). This is still used quite frequently for State
pension plans. Yet, the only rates of return we have the power to “require” are the rates
on the risk free spot rate curve for a particular time horizon. And the correct rate to use is
the spot rate curve for inflation protected government securities which is hedgeable.
Therefore, you can finance these benefits with little risk to the plan sponsor. Although the
accounting liability increases with a lower discount rate the actual economics of the plan
(actual cash flows for the benefit payments) are not changed and also cannot be
magically reduced if someone elects to use a higher discount rate. In fact, a higher
discount rate establishes the rate you must earn on funds borrowed from employees to
pay future benefits. From this perspective, if sponsors guarantee higher returns on risky
assets which are not realized then they are eventually faced with the realization that the
liability was higher than they originally thought and that planned contributions were too
low – a “double whammy.”
A key component of pension expense is normal cost. Waring uses the term “Full
Economic Normal Cost” which represents the expense accrued in this period for benefits
owed to employees at their retirement (also called service cost) however, it does not
contain the panoply of other items such as investment returns, financing costs, etc. which
are in service cost. There are many different normal cost methods (ABO – accumulated
benefit obligation, projected benefit obligation, present value benefits or “initial funding
method”, the “cost prorate constant dollar method” or EAN Entry Age Normal cost

5. Robert R. Mudra, CFA
September 2013
5
methods which is a level payment approach). Ironically “normal cost” does not affect or
control costs over the long term. Rather, costs are a function of the benefit promise.
Although all of the normal cost methods must terminate at the full funding requirement,
the speed or pace of the accumulation of the accrued liability must be observed carefully.
Therefore, it has an important impact on benefit security. Waring prefers the economic
version of the EAN method because it makes sense to those who think of a pension as a
constant proportion of the overall pay package which is then useful in both budgeting and
benefit negotiations and seems to be the right compromise between labor and
management.
The practical point is that if the “notional normal cost” entries were in fact real monetary
contributions which were calculated similar to a payment amortizing a debt and placed
into a liability-matching asset portfolio then the possibility of becoming underfunded
through investment results will be substantially eliminated. In this case, the pension
assets would grow following the same line as the on-book accrued liability. The funds
would ultimately be there to pay the liabilities when they come due.
Waring recommends the use of this economic mark-to-market “management accounting”
picture because today’s smoothing and amortization of pension accounting data is not a
hedge and does not provide risk control. There are no “smoothed” assets to purchase to
hedge against a smoothed liability. An economic hedge on the surplus/deficit will
naturally smooth out pension expense and contributions and is a superior approach. The
fact is that conventional amortization and smoothing of data actually add risk rather than
reduce it.
Importantly, even if the formal accounting continues to be done on a conventional basis
(until political and regulatory changes are made IASB, FASB, GASB) moving to an
economic accounting view for management of the plan is highly recommended. In
addition, once the underlying economic risks of the plan are properly measured, the
conventional accounting risk measures will also be under control. In short, it provides
guidance to discover what’s really going on “under the hood” of the plan.
Plan sponsors must be good stewards of the plan assets that are required to provide for
employees in their old age. Across the industry, confusion and fear has led many plan
sponsors to switch to defined contribution (DC) plans because they provided more clarity
of both cost and accounting for such plans. However, Mr. Waring contends that the best
defined-contribution (DC) plan is still not as good as the worst defined-benefit plan.
Why? Because, defined contribution plans have not been shown to accumulate the level
of resources an employee needs to adequately be prepared for retirement. For example,
one detailed study showed the average account value for employees over the age of 60,
that has been in a DC plan longer than 30 years, was only about $180,000 which is too
low to provide for retirement. Mr. Waring points out that DC plans don’t seem to be the
answer but that DB plans can be saved if one first recognizes the need to measure them
on an economic basis and then optimize the surplus of the plan.

6. Robert R. Mudra, CFA
September 2013
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Mr. Waring believes the best way to address the problem is to face it head on. The
advantages will be to establish more certain costs now and minimize the probability of
further negative surprises later. Managing the accounting is not the route to controlling
pension-funding risk or cost. Rather, only good benefit policies and some lucky
investment returns will help. And good policies can only come from meaningful
economic information.
Pension Finance is an excellent read for anyone in the defined-benefit pension plan
administration or management roles. I completely enjoyed Pension Finance and applaud
Mr. Waring for his forthright analysis of the subject.