Dedication Does Make Sense

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CFA InstituteDedication Does Make SenseAuthor(s): Crawford E. Laing and Robert FergusonSource: Financial Analysts Journal, Vol. 42, No. 4 (Jul. - Aug., 1986), p. 79Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4478955 .Accessed: 18/06/2014 02:05Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp .JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact support@jstor.org. .CFA Institute is collaborating with JSTOR to digitize, preserve and extend access to Financial AnalystsJournal.http://www.jstor.org This content downloaded from 185.44.77.82 on Wed, 18 Jun 2014 02:05:39 AMAll use subject to JSTOR Terms and Conditionshttp://www.jstor.org/action/showPublisher?publisherCode=cfahttp://www.jstor.org/stable/4478955?origin=JSTOR-pdfhttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/page/info/about/policies/terms.jspLetters to the Editor Dedication Does Make Sense In his "Editorial Viewpoint" in the July/August 1985 issue of Financial An- alysts Journal, Mr. Robert Ferguson ar- gues that "Dedication Doesn't Make Sense." I disagree, on three counts. First, Mr. Ferguson bases his argu- ment on the presumption that securi- ties such as stocks have a higher ex- pected rate of long-term return than bonds. Historically, it is possible to produce figures to prove that this has been the case over certain periods in the past, but that is no guarantee that the same will apply in the future- whether over the short or long term. This actuary, for one, is still waiting to be convinced that North American eq- uities are likely to outperform a real rate of return of over 6 per cent on a dedicated portfolio. Second, Mr. Ferguson takes a sim- plistic approach to the responsibilities of the actuary. He insists that the nature of the assets is irrelevant to the actuary, who, he asserts, has no justi- fication for using a discount rate that differs from that provided by a dedi- cated portfolio, whatever the actual investments. Mr. Ferguson sees no difference between $100 million in Treasury bills and $100 million in stocks-any stocks, including Canadi- an Commercial Bank and Penn Central Railroad, or just the ones he thinks today will consistently, over the whole future lifetime of the pensioners, pro- duce a real rate of return in excess of that provided by a dedicated portfolio? The nature of the assets-and, more particularly, the "duration" of the as- sets-is of fundamental importance to the actuary, if he is to exercise a proper level of professional responsibility to his clients. And the "clients" include not only the plan sponsor, but also the beneficiaries who are relying on his actuarial certification as their guaran- tee that the benefits will be available as and when promised. I agree that the actuary can and should relax his assumptions if the investment strategy reduces or elimi- nates some of the investment risks- not excluding the risk that surplus cash flow cannot be reinvested at the same rates Mr. Ferguson would have us assume today. The real rationale for dedication is a clear understanding by corporate management of the nature of the long-term liabilities, and a de- sire to minimize unnecessary risks where possible. In this, they have an identity of interest with the actuary whose business really is risk manage- ment. Third, I don't agree that Mr. Fergu- son has proved "dedication doesn't make sense." Dedication makes a lot of sense-at least to an actuary with over 30 years of experience. -Crawford E. Laing CEL Group West Vancouver, B.C., Canada The Author Responds Mr. Laing says that my piece pre- sumes that securities such as stocks have a higher expected rate of long- term return than bonds. He is correct in a sense. The manager of a pension fund whose expected return for stocks is below that for a dedicated bond portfolio is likely to prefer a dedicated bond portfolio to a stock portfolio. After all, the dedicated bond portfolio represents her riskless asset. There is no motivation to hold stocks in the pension fund if the riskless asset earns a higher return. My piece will be total- ly uninteresting to such a manager. But the fact is that most pension fund managers have expected long- term returns for stocks that exceed those for their dedicated portfolios. Mr. Laing notes that I believe that a correct economic view is that the na- ture of a pension fund's assets is irrele- vant to the actuary, who has no justifi- cation for using a discount rate that differs from the return provided by a dedicated portfolio, whatever the ac- tual investments. He goes on to note that, to me, there is no difference between $100 million in Treasury bills and $100 million in stocks. As noted in my piece, the only eco- nomically correct measure of the cur- rent funding status of a pension fund is the current value of its assets less the current value of its liabilities. When you think about it, this is obvi- ous; it is no more than saying that your net worth is what you have less what you owe. The current value of the plan's as- sets is the market value of those as- sets, whatever their nature: $100 mil- lion of stocks, by definition, can be sold for $100 million, whatever their nature; $100 million of Treasury bills yields precisely the same $100 million. The current value of the plan's liabil- ities is also known. It is the market value of a dedicated bond portfolio that will fund those liabilities. The current value of the plan's liabil- ities can be found by constructing the dedicated bond portfolio and pricing it. No discount rates are required at all. But if, for an extraneous reason, an actuary wishes to derive a value for the liabilities by discounting the plan's future payments, then only the use of the dedicated bond portfolio's return as the discount rate will result in a discounted value for the liabilities that is equal to their known market value. Mr. Laing also claims that "the real rationale for dedication is a clear un- derstanding by corporate manage- ment of the nature of the long-term liabilities, and a desire to minimize unnecessary risks where possible." While I doubt the level of understand- ing of these issues is as high as Mr. Laing thinks, I agree with him about the rationale itself. The liabilities of a pension fund can be viewed, from a portfolio analysis standpoint, as a forced short position in a dedicated bond portfolio that would fund them. This is why the decision to invest the plan's assets in a dedicated bond portfolio results in a riskless portfolio. It is perfectly hedged. But the issue in portfolio anal- ysis is not to minimize risk. It is to achieve an attractive balance of excess return and risk. For the vast majority of individuals, pension fund managers or not, this involves a significant com- mitment to risky assets. -Robert Ferguson Leland O'Brien & Rubenstein FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1986 '- 79 This content downloaded from 185.44.77.82 on Wed, 18 Jun 2014 02:05:39 AMAll use subject to JSTOR Terms and Conditionshttp://www.jstor.org/page/info/about/policies/terms.jspArticle Contentsp. 79Issue Table of ContentsFinancial Analysts Journal, Vol. 42, No. 4 (Jul. - Aug., 1986), pp. 1-80Front Matter [pp. 1-78]Editorial Viewpoint: Deciding What to Do with Those Excess Pension Assets [p. 6]Guest SpeakerEthics in Investment: Divestment [pp. 7+10]FYI: Editor-in-Chief's Annual Report [p. 11]Pension Fund Perspective: Bond Portfolio Guidelines [pp. 12-14]Financial Implications of South African Divestment [pp. 15-29]South African Divestment: Social Responsibility or Fiduciary Folly? [pp. 30-38]Determinants of Portfolio Performance [pp. 39-44]A Fundamental Multifactor Asset Pricing Model [pp. 45-51]The Affordable Dividend Approach to Equity Valuation [pp. 52-58]The Changing Dow Jones Industrial Average [pp. 59-62]Technical NotesA Passive Futures Strategy That Outperforms Active Management [pp. 63-67]Mutual Fund Performance and Market Capitalization [pp. 67-70]Do Timely Interim Reviews Lessen Accounting Error? [pp. 70-73]Evidence on Stock Market Overreaction [pp. 74-77]Letters to the EditorDedication Does Make Sense [p. 79]Book ReviewsReview: untitled [pp. 80+77]Back Matter