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Wayne H. Wagner INVESTMENT MANAGEMENT SERVI CES

Chief Investment Officer - Economic Component Strategies
Edward C. Story Specific Thrust Portfolios
Client Communication Portfolio Assurance
Larry J. Cuneo Master Tradins
Portfolio Research and
Operations

THE PENSION PROMISE AND THE SHADOW ASSET:

TWO HIDDEN REALITIES OF PENSION FINANCE

MONTHLY COMMENTARY #5
February 1987

New hands-on techniques for dealing with pension investment 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 SHADOW ASSET considers an
aspect of pension risk that is seldom addressed by current risk management
practice.

TTIE PENSION PROMISE occurred: each year the retirement beneiits

earned by the employees during the year are
Pension plans exist for two reasons: The tabulated and the yearly obligation determined.
employer creates them to promote workiorce The only forecasting involved concerns
stability, and the society sanctions them mortality rates and a (purposefully conservative)
through favored tax status as a means of investment earnings assumption.
setting aside private funding for future living
expenses when those expenses can no longer be The essential nafure of the acfiiarial
paid through contemporaneous earning ability. computation is that it is a dying plan computa-
In a very real sense it is simply deferred tion; it describes the liabilities that would exist
compensation; in another important sense it is if the plan were terminated today. It is based
an agreement between the employer and the solely on an accounting of past employment,
employee wherein the employer guarantees more and projects nothing with respect to the on-
than just a fixed compensation. going fortunes of the employees and the
company.
The Pension Promise implicitly assures the em-
ployee that his employer will act to provide the Even though the actuarial definitions determine
maintenance oi a decent standard of living the immediate effect on company finances, they
during his retirement It is the expectations of are totally inadequate from a pension planning
the Pension Promise that leads an employee to viewpoint. Except for rare cases of grossly
trade oif current income in favor of income overfunde d plans or companies in severe
years later. It is the broadest economic defini- economic trouble, it is simply unrealistic to
tion oi a pension plan, and, as we will show, base policies on an assumption that the pension
goes well beyond most actuarial, accounting o{. plan will be terminated.
contractual deiinitions.
The thought processes that support labor
Actuarial science is essentially a process of negotiations and pension benefit reviews
accountins for events that have alreadv provides a more robust view of pension

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economics; when changes in the contractual
agreement are contemplated, both employer and
employee consider the long term economic
effects of pension contracts. Over time,
pension contract changes reflect:
- an evolving assessment of income needed
to support contemporary retirement living
standards, and
- the company's desire to share with the
employees 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 (or
compensation) policy ultimately must reflect
micro-economic, or company, gains in
productivity. An adequate view of pension
economics includes an appreciation of the
effects of productivity changes on the wolution
of pension obligations
To illustrate how economic productivity affects
pension obligations, consider the transportation
needs of a retiree who buys the same make of
automobile every five years. Over time,
automobiles have incorporated features that
make them safer, more reliable, more efficient
and more comfortable. In the process,
automobiles have become 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. Hence workers can
still affordthese enhanced vehicles, and
manufacturers can continue to build in
improvements demanded by an increasing
affluent society.
The of each retiree necessarily
expectations
rises along with the expectations of his
neighbors. The implication: Maintaining a
reasonable comparative standard of living
implies participating in economy-wide gains in
productivity.
It follows that pension policy must account for
expected gains in national productivity, not only
until the time the employee tetires, but as long
as he collects retirement benefits.
As a practical matter, companies have
L
contributed and will continue to contribute
additional funds needed to maintain retiree
living standards. In the late 1970'slearly
1980's, raging inflation eroded the buying power
of many retirees. As inflation reduced national
income and wealth, many companies were called
upon to "chip in" additional benefits, 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 company gains in produc-
tiviS. As many American workers have 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 of pension (or compensation)
promises.
To summarize. the real risk to the beneficiaries
of a pension plan is that the company will not
be able to fulfill the Pension Promise.
Actuaiallaccounting definitions of pension
obligations obscure the true economic nature of
the pension plan, and lead to a misunder-
standing of risk. An improperly conceived risk
management policy may result.
THE SHADOWASSET - A MATOR SOURCE
OFPENSION RTSK
The ability of a pension fund sponsor to fulfill
the Pension Promise depends on two major
factors:
- Irryestment performance on previous
contributions in excess of the assumed
actuarial return, in combination with
- Continuing contributions by the company,
a. to fund past service credits,
b. to fund new seryice benefits as
accrued,
c. to fund new benefits that arc
granted,
d. to fund any shortialls in investment
returns, and
e. to provide additional funding in case
retirement expenses rise.
The present value of expected contributions can
be thought of as a SHADOW ASSET of the
pension plan. It is very real, but it doesn't
show in the accounting reports. The Shadow
Asset is very large for most companies,
especially those with younger work forces. It
is probably the largest "asset" of the pension
plan, typically representing more than half of
the present value of the Pension Promise.
Although no one typically looks upon it as an
asset, it still represents a claim on the
corporation, perhaps best thought of as a "good
times" claim.
From the standpoint of the potential bene-
ficiary, it is a uniquely hazardous asset: It is
undiversified, and in all the worst ways. It is
subject to the same economic shortfalls as the
employee's other major asset, his current and
future earnings stream. In a very real sense,
the Shadow Asset puts the General Motors
Pension Plan substantially in the automotive
business. Simultaneously, it puts General
Motors in the pension finance business in a
major way.
Typically, the shadow asset is not considered by
investment managers as they pursue their
individualistic "styles." As a result, pension
portfolios are far less diversified than is
commonly assessed by considering simply the
disposition of investment assets. Economic
events or scenarios that strain corporate cash
flow could compound and confound pension
risks, thus simultaneously weakening both the
pension plan and the company itself. By this
standard, most pension plans are highly
undiversified.
A pension plan that explicitly considered the
risk of the Shadow Asset would devise invest-
ment diversification and hedging strategies that
offset company-specific risks.
Curiously, much of current pension investment
policy tends the other way: investment in the
company is considered healthy and beneficial to
both the company and the employee. Risk-
amplffig practices such as contribution of
company stock to the pension plan or the
availability of a company stock purchase option
in a savings plan are both common and popular.
From the view of the Pension Promise, it is
much more sensible to use pension investment
policy as a diversifier rather than an amplifier
of company risks. Some may consider this
"disloyal" to the company, but it is clearly in
both the company and the employees best
interests: it results in an increase in the
probability of fulfilling the Pension Promise. It
is thus assuredly in the fiduciary interests of
the beneficiaries, not only as a potential pen-
sioner, but also as a contemporaneous wage
earner. It also serves the interests of the
corporation in that it serves as a diversifier on
claims to the earnings of the company.
Much of corporate strategy, particularly mergers
and acquisition activity, is concerned with
increasing company diversification and
decreasing susceptibility to specific economic
scenarios. Yet here, in the pension plan
holdings, is an asset:
- that under FASB 87 and 88 has a direct
effect on the financial statements;
- that has a major claim on corporate cash
flow, probably larger than the effectS oi
most acquisitions;
- who's diversification contribution can be
adjusted virtually instantaneously and at
minimal cost, and
- who's management requires little intensity
and nuts-and-bolts specialized skills from
corporate staff.
Despite these advantageous features, the
pension plan is virtually ignored as an asset
who's risk profile can be easily adjusted to
compensate for other corporate risks.
*{r * * * * * * * * * ** {. * ** * * * *
(c)1986, PLEXUS GROUP
A General Partnership
You are welcome to reprint quctations or
extracts from this material with credit given to
Plexus Group, 606 Wilshire Boulevard, Suite 200,
Santa Monica CA 90401. TeL (213\ 45b5A75.