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Strategies & Market Trends : The Residential Real Estate Crash Index -- Ignore unavailable to you. Want to Upgrade?

To: Les H who wrote (11553)	7/10/2003 8:50:48 AM
From: Les H	Read Replies (1) \| Respond to of 306849

The financial economists' key charge against the actuaries is this: Their models for long-run pension performance assume, wrongly, that over the long run investments in the stock market will rise fast enough to overcome essentially underfunded pension structures. For years, pension funds operated under the assumption that equities are on a long-term growth track that can be counted on to cover pension liabilities. The market meltdown of the last two years blew the model away, leaving pension plans and corporations facing massive losses that wiped out billions in pension assets across the world. Financial economists, however, says the risk of losses of that magnitude, while viewed with surprise by pension managers, has always been there. It's just that the actuaries failed to acknowledge the existence of such risk. Indeed, they failed to acknowledge any risk at all. The key paper in the field is "Reinventing Pension Actuarial Science", published in January by Lawrence Bader and Jeremy Gold, two U.S. actuaries. They argue that the actuarial pension model, by ignoring the fact that equities are more risky than government bonds, creates a deception. One simple illustration from the Bader-Gold paper helps explain the fundamental flow in the actuarial model. Under the model, $1-million invested in equities is worth more than $1-million in bonds. If the bond is yields 5% over 10 years, it has a present value of $1.6-million. But if the $1-million in equity is arbitrarily expected to return 10% over 10 years, it is valued at $2.6-million. That equity premium might work for the actuaries, but it does not reflect market reality. Under the discipline of financial economics, there is no such equity premium. The market has priced the equity at $1-million based on risk assumptions. The difference in the value of the bonds and equities is zero. "The equality of the value of returns on all marketable securities is not an arbitrary quirk of financial economics," say Bader and Gold. There is no equity premium that can be counted on into the future. Inevitably, when the actuarial model breaks down, the pension plans engage in a variety of techniques to try to cover over the shortfalls. This is known as smoothing, allowing pension managers to conceal losses and give the impression of long-term health. Another leading critic of pension management and actuarial practice is Zvi Bodie, of Boston University's School of Management. In a paper back in in 1994, Prof. Bodie foreshadowed the Bader-Gold critique. He debunked the universally held theory that stock market investment is a long-term sure thing that will eventually produce superior returns. This, he said, is a fallacy. On the contrary, he concluded, "the riskiness of stocks increased rather than decreases with the length of that horizon." The lesson from financial economics for pension managers, and for all individuals who are planning for their retirement, says Prof. Bodie, is simple: "Stocks are not a hedge against fixed-income liabilities even in the long run." nationalpost.com