1. CIA Annual Meeting LOOKING BACK…focused on the future

2. CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future 1 Funding Issues Investment Issues Funding Issues Investment Issues

3. CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future 2 Forgotten point: Important to differentiate between a liability and a funding target Given a defined benefit, the liability measure should be unique Forgotten point: Important to differentiate between a liability and a funding target Given a defined benefit, the liability measure should be unique

4. CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future 3 Funding target and contribution strategy depend on Desired pattern of contributions Desired level of current contribution “Sponsor asset allocation” Asset allocation Equity between generations of “risk takers” Funding target and contribution strategy depend on Desired pattern of contributions Desired level of current contribution “Sponsor asset allocation” Asset allocation Equity between generations of “risk takers”

5. CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future 4 FE argument is to fund accrued benefit and to “match” with bonds Each year’s contribution is equal to the change in the value of the accrued benefit FE argument is to fund accrued benefit and to “match” with bonds Each year’s contribution is equal to the change in the value of the accrued benefit

6. CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future 5 If accrued benefit defined in nominal terms Contribution pattern is volatile and not generally budgetable Accrual pattern inconsistent with compensation theory If accrued benefit defined in nominal terms Contribution pattern is volatile and not generally budgetable Accrual pattern inconsistent with compensation theory

7. CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future 6 Consider asset allocation Matched assets “Risky” assets Knowledgeable employees should reduce compensation value of pensions if fund invests in risky assets Consider asset allocation Matched assets “Risky” assets Knowledgeable employees should reduce compensation value of pensions if fund invests in risky assets

8. CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future 7 Employees not generally knowledgeable, BUT They do undervalue pensions, even lower than if knowledgeable Employees not generally knowledgeable, BUT They do undervalue pensions, even lower than if knowledgeable

9. CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future 8 In this environment, rational for employers to try to reduce expected costs to employees’ expectations AND push risk to employees Job risk Risk to other elements of compensation In this environment, rational for employers to try to reduce expected costs to employees’ expectations AND push risk to employees Job risk Risk to other elements of compensation

10. CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future 9 Similarly it is rational for employees to accept “risky” compensation Why? Similarly it is rational for employees to accept “risky” compensation Why?

11. CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future 10 Risky Investment Policy 80 85 90 95 100 105 110 115 120 125 130 135 2004200520062007200820092010 Funded Ratios 90th% 75th% 50th% 25th% 10th% Matched Investment Policy 70 75 80 85 90 95 100 105 110 115 120 125 20042005 2007200820092010 Funded Ratios 90th% 75th% 50th% 25th% 10th%

12. CIA Annual Meeting Session 4305 Financial Economics and Pensions LOOKING BACK…focused on the future 11 Key messages: Don’t think of a liability as a funding target Funding policy becomes very important in an environment of “surplus certainty” Even an FE argument can lead to investment mismatch Key messages: Don’t think of a liability as a funding target Funding policy becomes very important in an environment of “surplus certainty” Even an FE argument can lead to investment mismatch