Defined Benefit Pension Plans Must Manage Short-Term Risks

PASADENA, Calif., Dec. 4, 2014 /PRNewswire/ -- The first task of any long-term investor is to survive in the short term.  For a defined benefit (DB) pension plan to have a high probability of succeeding long term, it has to think about more than long-run returns.  It must manage short-term risks – or risk insolvency.

This is the subject of a new white paper released by Legg Mason affiliate Western Asset Management, "Why All Defined-Benefit Plans are Short-Term Investors."  The paper's author, Western Asset product manager/economist Michael J. Bazdarich, believes that because a DB plan makes regular benefit payments, it simply cannot afford to focus only on long-run returns.

"There is always substantial risk that a run of only modestly bad luck — combined with regular benefit payments — could so deplete assets that the plan could not recover even when and as asset returns rebounded to long-run averages," he writes.

The white paper can be accessed via this link: http://www.westernasset.com/us/en/pdfs/commentary/WhyDBPlansAreShortTermInvestors201411.pdf?cmpid=WhyDBPlansAreShortTermInvestors201411

According to Mr. Bazdarich, there are two steps a DB plan can follow to reduce the risk of asset exhaustion: it can tailor the risk aspects of its plan assets to match those of its liabilities; and/or it can fund the plan in excess of what would be considered adequate.

"Even with the highest expected returns (and corresponding volatility levels), chances of near-term insolvency will be substantial, unless the plan is willing to dramatically overfund the plan initially or make large contributions later," Mr. Bazdarich concludes. "And the whole point of investing in high-return/high-risk assets is to minimize the costs of the plan: to minimize contributions."

"There is no 'low-cost allocation' that also protects against risks of insolvency (or of massive future contributions).  This doesn't mean that all DB plans should de-risk, but it does mean that they all have to manage short-term risks and provide for contingencies, rather than merely relying on the mantra of the 'long-run investor.'"

"Meanwhile, plans can de-risk through 'matching' allocations that reduce or eliminate the random return features that drive high insolvency probabilities in our simulations.  These matching allocations work just as well for a public plan as for a corporate one. While they involve higher levels of initial funding, the long-term costs of these allocations may not be any higher in actual practice than those of more 'aggressive' allocations."

Executive Summary of "Why All Defined-Benefit Plans are Short-Term Investors:"

• Because of its need to make regular benefit payments, a DB pension plan simply cannot afford to behave like a long-term investor. It must be cognizant of short-term risks.
• Monte Carlo experiments Western Asset ran found a better than 50 percent chance of asset exhaustion for DB plans (insolvency) for even an adequately funded plan whenever asset returns varied randomly with some level of volatility.
• Fixed-income portfolios can reduce the risks of insolvency because they can be structured to match the maturity profile of the plan's liabilities, and because their random variations display more mean-reversion than do other asset types.
• All these results are just as relevant for public plans as for corporate and multi-employer plans.  That is, Western Asset's simulations were based on asset exhaustion, not of tracking a particular liability valuation (based on a particular accounting regime).

About Michael J. Bazdarich

With 36 years of experience, Michael Bazdarich has been a product manager/economist with Western Asset Management since 2005.  Previously he was a consulting economist with MB Economics, from 1986 to 2005; a senior economist at UCLA Anderson Forecast, from 2003 to 2005; director of the UCR Forecasting Center, from 1993 to 2003; vice president, forecasting/advisory services at Claremont Economics Institute, from 1981 to 1986; vice president and deputy director of research with United California Bank, from 1980 to 1981; and an economist with the U.S. Federal Reserve Bank of San Francisco, from 1977 to 1980.  Mr. Bazdarich earned a Ph.D. in Economics from the University of Chicago and a B.A. in Economics from the University of Santa Clara.

About Western Asset Management

Western Asset Management is one of the world's leading fixed-income managers with $472 billion in assets under management as of September 30, 2014.  The firm is a wholly owned, independently operated subsidiary of Legg Mason, Inc. (NYSE: LM)  From offices in Pasadena, Hong Kong, London, Melbourne, New York, São Paulo, Singapore, Tokyo and Dubai, the company provides investment services for a wide variety of global clients, across an equally wide variety of mandates.

About Legg Mason

Legg Mason is a global asset management firm, with $720 billion in AUM as of October 31, 2014. The Company provides active asset management in many major investment centers throughout the world. Legg Mason is headquartered in Baltimore, Maryland, and its common stock is listed on the New York Stock Exchange (symbol: LM).

All investments involve risk, including loss of principal. Past performance is no guarantee of future results.

Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed-income securities falls.

©2014 Legg Mason Investor Services, LLC, member FINRA, SIPC. Legg Mason Investor Services, LLC and Western Asset Management Co. are subsidiaries of Legg Mason, Inc.  TN14-539

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SOURCE Legg Mason, Inc.; Western Asset Management Company

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