I found an interesting comment by Girard Miller in his latest column “COLA Freezes: Pension Reform’s Third Rail” (http://www.governing.com/columns/public-money/col-COLA-freezes-government-public-pension-reform-third-rail.html, June 7, 2012)I thank Norman for sharing his insights with me. Have long argued that the funded status of any pension plan isn't just based on investment returns (see my comment covering Ontario Teachers' 2011 results).
“In Baltimore, Md.; San Jose, Calif.; and a number of other municipalities, a similarly idiotic "COLA" surrogate or supplement was installed, giving retirees a pension increase or "13th paycheck" in years that markets outperformed the average. That policy guarantees that the pension fund will never achieve its expected return. The good years are skimmed off while the taxpayers have to cough up for market losses. Even worse, these schemes siphon off more from the plan when markets become more volatile as they have since 1997.”
I find this comment remarkable because it hints at something that I have been working on over the last few years and that I have injected into the pension reform debate before. Miller suggests that it isn’t investment returns alone that determine whether a pension plan achieves its expected rate of return. Obviously, plan sponsor actions such as “idiotic” COLA increases or a “13th paycheck” when markets are doing well will affect the relevant plan sponsor return.
It would have been good if Miller would have elaborated on what that relevant plan sponsor return really is. I believe that Miller is onto something interesting here, yet I also believe that up until now, no return metric exists that can be meaningfully compared to a pension plan’s expected rate of return. However, if no such measure exists, there is nothing that prevents us from creating one.
Introducing the Pension Plan Internal Rate of Return (PenPIRR)
I have been arguing for years against using the reported time-weighted rates of returns as a proxy of whether a pension plans has achieved or exceeded its expected rate of return. I have demonstrated before that time-weighted returns cannot account for the Path Dependency Effect – i.e., different funding outcomes for a given time-weighted average return and external cash flow pattern. The Path Dependency Effect arises because of intra-period external cash flows (such as contributions into and benefits out of the fund) in a volatile market environment. Only money-weighted returns are able of correctly capturing the Path Dependency Effect.
While I may have been successful in convincing GASB to require the reporting of money-weighted returns (See Exposure Draft on GASB Project No. 34, "Financial Reporting for Pension Plans – An Amendment of GASB Statement No. 25), I later realized that (standard) money-weighted returns aren’t a good proxy of total pension plan success either (See my second comment letter to GASB on that epiphany).
I have always felt that money-weighted returns for mutual funds investors and money-weighted returns for DB pension plan sponsors need to be calculated differently. DB pension plans are materially different from mutual funds since the latter have no funded status. The funding levels of pension plans, on the other hand, contain a great deal of information about their financial health and overall success.
A better measure of total pension success is a money-weighted type of return that also considers changes in funding status due to non-investment related influences – typically plan sponsor decisions to change the benefit structure or to not fully fund new benefit accruals.
The only tricky thing is to properly separate the changes in funding status due to the peculiar nature of investment returns (which average return and which particular return sequence) from those that are solely attributable to plan sponsor decisions and are thus completely outside the investment manager’s realm.
In order to avoid a terminological confusion with traditional money-weighted returns, I suggested to GASB calling this new return measure the Pension Plan Internal Rate of Return (PenPIRR). It uses a money-weighted return methodology, but considers one additional cash flow that traditional money-weighted returns ignore. A funding deficit that is caused by an increase in pension benefits, for instance, would require one additional hypothetical cash flow from the plan sponsor into the fund.
PenPIRR is a return measure that goes beyond the investment sphere. PenPIRR translates the funding status effects of typical plan sponsor actions into return space. All factors that influence overall pension plan success (e.g., investment returns, benefit and funding decisions) become comparable to each other. PenPIRR measures overall pension plan success and is thus the only return measure that can meaningfully be compared to one’s expected rate of return.
Different Scenarios – Same Money-Weighted Returns, Different PenPIRRs
Let us briefly investigate the shortcomings of standard money-weighted returns as a measure of total plan sponsor success in more detail. Since they do not take funding status information into account, they can be the result of very different funding cost scenarios. Assume that we have two pension plans A and B with initially identical liability structures and identical cash flow patterns over the entire reporting period.
Scenario I – Fully Funded at the Beginning and at the End of the Investment Period
When both pension plans start and end the performance evaluation period fully funded, no further modification to the cash flow structure is necessary. Traditional money-weighted returns and the Pension Plan Internal Rate of Return coincide.
Scenario II – Benefit Increase at the End of the Investment Horizon
For scenario II let us assume that everything unfolds identically to scenario one – except for a benefit increase for plan B at the end of the investment period. All cash flows during the performance evaluation period remained identical; therefore, the standard money-weighted return measure would not be affected by the final increase in the present value of liabilities. However, everybody would agree that the financial health of the now underfunded pension plan B is worse than that of a pension plan A.
PenPIRR accounts for that change in financial condition by immediately recognizing in full the funding status effect of the benefit increase. Traditional money-weighted returns would gradually recognize this benefit increase as it will affect only future cash flows.
Scenario III – Insufficient Contributions to Fund New Benefit Accruals
Net cash flows are generally the result of contribution and benefit payments. However, the standard money-weighted return methodology does not relate the actual contributions to the required contributions (normal cost + shortfall amortization). Assume that contributions are sufficient for plan A, but insufficient for B to fully fund their normal cost. Plan B will accumulate a funding deficit over time.
All these scenarios would result in the same standard money-weighted return measure as they have not (yet) affected cash flows. Each of these scenarios, however, depicts a different pension success story. The new return measure PenPIRR is able to differentiate between these different scenarios and ranks them accordingly.
I commend Girard Miller for pointing out that plan sponsor actions do affect the relevant plan sponsor return. Investment returns alone aren’t responsible for total plan sponsor success. Once we can agree on this, then we can better measure our past performance – the prerequisite of learning the right lessons from our past.
The comment demonstrates how stupid policies that having nothing to do with investment decisions are impacting the funded status at pension plans. I would argue that even on the investment side, pension plans should provide the internal rate of return, net of fees and foreign exchange transactions for internal and external public and private market investment portfolios.
Below, an animated video which provides an explanation of the differences between time and money-weighted returns to measure the performance of investment portfolios. If you require more information on the topic above, please contact Norman Ehrentreich directly at firstname.lastname@example.org.