October 2004 |

## Asset / Liability Scoreboard

IndexReturns

YTD 2004Estimated

WeightsLiabilities :

Market (Treasury STRIPS)

Pension Bill (Corporates)

ROA (8% constant rate)

9.29 %

10.32

6.67100%Assets :

Ryan Cash

Lehman Aggregate

S&P 500

MSCI EAFE Int’l

Asset Allocation Model

0.89 %

4.22

3.05

8.20

3.59

5

30

60

5

100%Assets – Liabilities

Market

Pension Bill

ROA

-5.70 %

-6.73

-3.08The year 2004 is another tough year for Pensions no matter which pricing methodology is used for liabilities. Through October, assets have underperformed liabilities by

-5.70%using market valuations (i.e. STRIPS); by-6.73%using the new Pension Bill valuation (moving average of three corporate indexes); and by-3.08%using the ASOP 27 methodology of a constant ROA.Using market valuations, the cumulative Asset/Liability deficit since December 1999 is now at -49.62% suggesting funding ratios below 60% for most pensions.

Total Returns20002001200220032004Pension Assets-2.50-5.40-11.4120.043.59Pension Liabilities25.963.0819.471.969.29Difference-28.46- 8.48-30.8918.08-5.70Cumulative-34.53-54.75-46.57-49.62

Discount Rate Confusion

The actuarial discount rate can certainly be confusing and lead to erroneous target rates of returns. Private Plans are under the IRS requirement from the new Pension Bill to use the average yield from three corporate bond indexes over a four-year weighted average to calculate the present value of liabilities used in determining the funding ratio for the minimum contribution. Public Plans are guided by ASOP 27 which requires the estimate of asset growth (ROA) as the discount rate to calculate the present value of liabilities. In both cases,the discount rate is an estimate of the long-term growth of the present value of liabilities. In truth, the discount rate is a price.Just like a bond portfolio, the yield determines the market price (present value). In order to calculate annual growth (total return) you need both a beginning yield (beginning price) and an ending yield (ending price). If the discount rate went from 7% to 6% over a one year period, the present value of liabilities would not grow at 7% nor 6% but 17% (assuming 10-year duration). As the discount rate goes down, the annual growth rate of liabilities goes up… just like a bond portfolio. Annual growth rates are important since all of the liability calculations are done annually that affect the level of contributions, credit ratings, funding ratios and tests of solvency.

Long Term vs. Annual

Pensions are certainly a long-term business, perhaps into perpetuity (I.e. Public Plans). Unfortunately, annual tests and calculations are done that affect the near-term cost and viability of a pension plan. However, just like a bond portfolio, if we bought and held a zero-coupon bond to maturity then its yield to maturity (annualized) would be a correct measure of liability growth to maturity (liability payment date) and would accurately connect present value to future value. So,if we used a zero-coupon yield curve as the discount rates we would have an accurate measurement of long-term growth of liabilities. This would allow for proper long-term asset strategies to be used.But, if we use inaccurate, smoothed weighted average yields to price liabilities (no yield curve) then long-term asset strategies are in jeopardy of being given the wrong hurdle rate or return objective.If a 15-year zero-coupon bond yields 4%, then mathematically its

average growth ratefor 15 years will be 4.04% (4% compounded annually). Naturally, it should exhibitannual growth ratesmuch differently than 4.04% with potentially high positive and even negative annual rates but in the end (maturity) these annual growth rates must average out to equal the purchase yield. Well, that is exactly how liabilities should be viewed with volatile annual growth rates and a stable low long-term growth rate from today's yield levels.The error today is in using

estimatesinstead ofrealmarket rates that you can buy to match or defease liabilities.If the discount rate is not purchasable, it is not real and leads to growth rate and present value distortions.Long-term asset strategies require accurate long-term measurements of liabilities. Given today's Government zero-coupon yield curve with rates from 2% (short maturities) to 5% (long maturities) it is obvious thatpensions are using too high a discount rate making the assets think they have to work harder than they do. If it is true that zero-coupon bonds match or defease liabilities, then it is true that their yield (annualized) is the long-term hurdle rate to outperform for each liability maturity. The practice of using one single discount rate for all liabilities is not real, not purchasable and certainly not the long-term hurdle rate for each and every liability.

Pension Solutions !

Ryan ALM will begin a series of Pension Solutions research papers.

We will alert you through our monthly newsletters with the first one coming this month called...Pension Solution # 1 Custom Liability Index.

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