1. Employer Pensions, Risk and Asset Allocation Mike Orszag Rome, April 2, 2003

2. Guarantees for Individuals Pensioners paid first Others paid next Example: pension scheme 75% funded, 50% of liabilities pensioner liabilities Pensioners are paid in full, others get 50% of benefits

3. Level of Exposure to Risk FTSE100 returns for 2001 Pension liabilities / market cap: –average = 40% in 2001 –8 companies over 100%

4. Deficits 2001 FTSE100: £11bn By end of 2002 much, much worse (£170bn in equities in 2001)

5. Liabilities Matter Correlations: –volatility and pension liabilities/market cap - 0.46 Volatility and pension liabilities/free operating cashflow – 0.50 Pension risk variables can explain roughly 25-35% of cross-sectional volatility in the market

6. Employer Asset Allocation Minimum risk is not necessarily in bonds Equity in pension fund should depend on: –Maturity of pension scheme –Size of exposure to risk by company –Covenant risk

7. Empirical Evidence FRS17 disclosures for FTSE 100 for 2001 How much do risk fundamentals impact on asset allocaiton?

8. Empirical Evidence Pension liabilities relative to wage/salary bill is a good measure of maturity How correlated is it with equity allocation of pension fund? Elasticity of equity share with respect to pension liabilities/wage salary bill is - 0.002

9. Maturity

11. Empirical Evidence Covenants – volatility of equity prices is a potentially good measure of how much debt a company has and therefore how strong the pension promise is Implied and historical volatility Elasticity of implied at the money volatility on calls on Nov. 19 is -0.039 (t statistic -0.34)

12. Covenants

13. Exposure Pension liabilities relative to market cap is one measure –Elasticity is -0.26 – statistically insignificant from 0 Pension deficits relative to pension liability is another –Elasticity is -0.13 – again statistically insignificant

14. Pension Surplus/Pension Liability

15. Pension Liabilities/Market Cap

16. Putting it Together

17. Putting it all together Our four variables can explain only about one-tenth of cross-sectional differences in equity shares of pension funds. High exposure to risk by companies Not necessarily less risk for individuals