Section 2: Risk Management for Institutional Investors

1. Section 2: Risk Management for Institutional Investors Financial Risk Management UC Berkeley Prof. Jeff (YuQing) Shen

2. The BIG Picture Institutional Investor Investment Bank Hedge Fund • Theory • Efficient Frontier • Asset/Liability Framework • Alpha/Beta risk budgeting • Practice • Pension Crisis • GM Pension Plan • Yale Endowment • Theory • VaR • Stochastic behavior of asset returns • Worst case scenario • Practice • Investment bank VaR • Bear Stearns • The Theory • Active Portfolio Management • Quantitative equity models • Hedge fund investment • The Practice • Hedge fund industry • Aug 2007 crisis for quant 1

3. Institutional investors in the US 2

4. Asset allocation trend 3

5. Significant turnover of managers 4

6. Institutional investor risk management • US corporate defined benefit plans • Endowment and foundation

7. The liability is the present value of benefit cash flows Present value (discounted at 7.0%)= $2.56 billion liability Year

8. Duration estimation in a pension plan

9. The liability risk is sensitive to discount rate changes $3.5 billion @ 7% • Duration measures the sensitivity of a liability’s value to changes in interest rates. • Bottom Line: Rates = Liabilities and Rates = Liabilities • A duration of 14 means that the liability value will increase (decrease) by 14% given a 1% decrease (increase) in rates. Longer duration = greater sensitivityof liability value to rate changes.

10. ABO and PBO • ABO (Accumulated Benefit Obligation) is the value of all benefits earned to date. It includes nonvested as well as vested benefits. It may approximate the value of benefits payable on a plan termination and is the basis of a potential balance sheet liability. • PBO (Projected Benefit Obligation) is a measure of the liability for accumulated service, but reflects future salary increases. “Projected” refers to the projection of salaries. • The key difference is that PBO reflects future salary growth, which can be driven by at least two important factors: • Inflation • Productivity growth

11. Funded ratio is a key risk measure for managing pension plan

12. Case study: Pension Crisis of 2002

13. Pension Crisis of 2002 • Institutional context • Funded status • Assets • Liability • Contribution

14. Significant assets in corporate DB plans

15. Industry distribution of DB plans

16. Pension Crisis of 2002 • Institutional context • Funded status • Assets • Liability • Contribution

17. Funded ratios were at an all-time low in 2002 PBO funded ratio — Top 200 corporate plansFive-year intervals since 1987 Top 20% Median Bottom 20% 1987 150% 119% 82% 1992 142% 107% 79% 1997 147% 112% 90% 2002 113% 80% 60% Source: S&P Compustat

18. A volatile history with a dramatic drop Funded ratio of a hypothetical DB plan 145% Funded 80% Funded Assumes beginning Funded ratio of 100% in 1975, 10 duration, 6% benefit payouts, 3.5% Service cost. Asset returns reflect a hypothetical portfolio of 60% S&P 500/40% Lehman Aggregate Bonds. Discount rate is the AA Corp. Bond Yield. Assumes zero contributions.

19. Funded ratio status 18

20. Underfunding crisis

21. Pension deficit relative to market cap

22. Pension Crisis of 2002 • Institutional context • Funded status • Assets • Liability • Contribution

23. Asset allocation

24. Equity and fixed income allocations

25. Asset allocation over time

26. Different views of the world 25

27. What are the pros and cons of owning the company stock in the pension plan?

28. Pension Crisis of 2002 • Institutional context • Funded status • Assets • Liability • Contribution

29. Discount rate 28

30. Discount rate 29

31. Discount rate distribution 30

32. Pension Crisis of 2002 • Institutional context • Funded status • Assets • Liability • Contribution

33. Contribution

34. Contribution

35. Pension income/expenses

36. What happened? • Interest rate • Asset return • Corporate finance implication

37. Liabilities “outperformed” assets Annual asset returns and liability growth (hypothetical plan, before benefit payouts) Assets outperform Liabilities outperform 17% 16% 12% -1% -4% -9% For illustrative purposes only. Assumes 10-duration liability, 3.5% Service cost. Asset returns reflect a hypothetical portfolio of 60% S&P 500/40% Lehman Aggregate Bonds. Discount rate derived by the Lehman AA Long Corp. Bond and Moody’s AA Long Corp. Bond Yields. Assumes zero contributions. Benefit payouts are not reflected in individual years’ annual growth. Assumes rates dropped 135bp, from 7.85% at end of 1999 to 6.50% as of end of Aug 2003, as follows: 2000: -50bp; 2001: -60bp; 2002: -25bp; 2003: 0bp. Without rate drops over the last 4 years, liabilities would have outperformed assets by 46.5%. 36

38. Declining discount rate => increase in liability

39. Corporate finance risk implications

40. Cash contribution required after extended funding holiday Lower reported income (GAAP) Liquidity requirements Decrease in book value Rating agency pressure Quality of earnings Large bottom-line impacts • Large negative effect on earnings resulting from pension expense • Writedown of book equity due to critical under-funding • Overhang of increasing net pension liability • Shareholder aversion to earnings volatility created by pension income 6

41. Shareholder exposure

42. Diversion of cash from core operations to cure deficits and meet statutory contribution minimums Equity write-downs from ABO underfunding can threaten debt covenants Attracts rating agency attention and may contribute to downgrade Poor plan performance is often correlated with weak operating environment for core business Severely underfunded plans must give notice to employees describing pension condition May add to non-cash earnings However, excise taxes prevent company from realizing a cash benefit May reduce or avoid the need to make ongoing contributions Risk levels required to generate high returns can lead directly to the harsh consequences of pension deficits Accounting and corporate finance implications of pensions are asymmetric - the risks are weighted to the downside Downside associated with poor performance Upside associated with strong performance There is greater downside to the corporation when the plan does poorly than upside when the plan does well 7

43. Financial economics and corporate pensions risk managementThe shareholder’s perspective • If shareholders want equity leverage they can obtain it directly themselves • Companies should prefer to borrow in the capital markets or buy-back stock if they want to increase leverage – not mis-match pension liabilities • Pension investment decisions should be justified relative to other uses of corporate capital

44. What are the lessons learned? Did we manage pension risk well?

45. Did we really learn the lessons?

46. 2008 Pension crisis

47. What happened in 2008 for the pension plans? What happened to • Equity return? • Interest rate? • Contribution?

48. Funded ratio

49. Asset liability performance

50. Discount rate change