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Don’t Kill the Golden Goose
Conference of Consulting Actuaries
2006 Conference Annual Meeting
October 24, 2006
Westin Mission Hills ResortRancho Mirage, California
M. Barton Waring
Chief Investment Officer for Investment Policy & Strategy, Emeritus
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The pension funding crisis
Defined benefit pension plans are in danger United Kingdom, Australian experience CIEBA survey of US corporate DB plans: mark-to-market makes them risky!
The perception is that pension funding risks and costs are unmanageable Today’s investment policy practices aren’t effective at controlling
pension funding risk Today’s active management policy practices are inefficient Today’s contribution practices can be improved Today’s pension costs seem too high too high to be sustainable
But the perception is not correct: We do have the tools to fix DB plan problems
If we want to save defined benefit plans, we have to be “on a mission” to adopt and use these new tools
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DC plans aren’t the answer
Flexible, yes Transportable, yes
But they seldom if ever grow large balances A couple of hundred thousand dollars won’t support much
of lifestyle in retirement ($44,000 median balance!) Only a small augmentation of social security But they are fully funded! (Or are they?)
DC plans aren’t really retirement plans
Your goose may already be cooked!
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DB plans have many advantages: Golden Geese
A big advantage: Higher (implicit) savings rate
Professional management and state of the art risk control (policy asset allocation)
Lower fees and costs (wholesale versus retail)
More skillful manager selection, in many cases
Higher average returns (2%–4% per year)
Another big advantage--the insurance principle: Spread mortality risk across a large group
Allows all to have lifetime protection at reduced cost
Personal example: For DC, I need to fund for 105 year possible life. In DB, I only need 88 years.
A male age 65 retiree needs only 65% as much savings in a DB plan as in an unannuitized DC plan, for the same monthly draw
DB plans are successful in replacing some realistic part of income on retirement; DC plans generally are not (as used today in the US)
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What is the investment objective for DB pensions?for developing investment policy
Many investment objectives are stated today Asset-only?
Asset-only, followed by monte carlo simulation of the accounting?
Focus on risk/return relationship of contributions, or of pension expense, or of A/L ratio?
Minimize present value of future contributions, or of future normal cost?
Or . . . . ?
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“The goal of asset allocation analysis should be stated in terms of surplus. The objective is to maximize the risk-adjusted future value of the surplus.”
- from Asset Allocation by William F. Sharpe, Nobel Laureate in Economic Science
The utility function is specified in financial economics
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A solution: controlling pension funding risk
Surplus optimization Surplus efficient frontier Definitions, and Two Fund Theorem explanation
Economic views of the liability
The “three decisions” for controlling pension funding risk: A case study A practical application of pension funding risk control
Mark-to-market: Problem, or benefit? Transparency turns out to be the key to progress You can’t hedge a book value liability!
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The portfolio of interest is the assets less the liabilities – the surplus or deficit
Pension Plan “T-Account”
ContributionsExpense (corporate)A/L ratio
Deficit (Surplus) [=PVFC]
Assets Liability (economic measure)
If we control the economic surplus risk, we also control all the accounting risks
Surplus optimization simultaneously satisfies all conventional objectives
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The new toolkit for managing pension funding risk
A. Surplus optimization: A “two-fund theorem” problem1) The Liability-Matching Asset, or “Hedging Portfolio:” Duration matching controls the interest rate mismatch between the assets and the
liabilities,1 or “surplus duration” Duration is a measure of how a financial asset or liability changes in value when
interest rates change Pension surpluses have dual durations: Inflation sensitivity and real interest
rate sensitivity Think of these net surplus durations as just “factor betas” for explaining surplus
changes with rate changes
2) The “Risky Asset Portfolio:” Controlling “surplus beta,” the net market risk exposure of the assets relative to the liabilities2
Market risk is rewarded, but it is risky! How much market risk do you want to take?
B. Adding alpha through active management: Manager structure optimization manages your active managers, tactical positioning, hedge funds, etc.3,4
Rewarded if skillful!
See Waring, et al, Journal of Portfolio Management, Summer 20041, Fall 20042, Spring 20003, Spring 20034
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An economic view of the liability is essentialfor doing surplus optimization
Conventional actuarial view of the liability is expressed as if it were in dollars, but it’s a different kind of dollar!
Determined with wrong discount rate, with smoothing. “Sasquatches,” The bottom line: dollars and sasquatches are different units Unlike dollars, sasquatches can’t be plotted on the same graph as things that
happen in actual, real dollars of value
An economic measure of the liability, by construction, is in genuine dollars, not in sasquatches So its returns and risks can be used in surplus optimization, making surplus
optimization “doable” You’re still a non-believer in market discount rates? Set up a laddered portfolio
of coupons and bonds to pay off the liability: It will require an amount = $EL FWIW, there is universal agreement among actual financial economists that the
government bond curve provides the right discount rates for fully funded plans
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Pension expense volatility can be controlledIf you control investment risk to the surplus, you control expense risk
Using surplus optimization (the “two fund” version) together with economic accounting, we can confirm that if we control investment risk we control expense risk:
normal and supplemental costs
0,1 0,1
0L
PE NC SC
r L
income returns
0L Lr D L
capital gains returns
Liability
0Ar A
income returns
0A Ar D A
capital gains returns
Assets #1:
Assets #2: (excess return over hedge
Hedging Portfolio
*0
Risky Asset porPortfol
tfolio)io
Ar A
If the liability is matched and all interest rate risks are hedged with a Hedging Portfolio, there is no investment risk except that taken intentionally in the Risky Asset Portfolio
Pension expense (level and volatility) are then reduced to just that of normal cost, supplemental cost, and the risky excess return of the Risky Asset Portfolio – exposure to the latter being in your complete control.
Pension expense risk can be dramatically reduced!
Supplemental costs do have some risks, but these might be managed to some degree with better actuarial tables and continuous improvement of decrements. They can’t be eliminated.
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Contribution volatility can be controlledIf you control investment risk to the surplus, you control contribution risk
Economic views of the contribution are similar to those for expense, but we add in any starting deficit (surplus):
0
1 1 1
1 0 0
0
beginning deficit
normal and supplemental cos
,1 0,1
ts
Contrib
Contrib
Lr L
L A
L A
NC SC
income returns
0L Lr D L
capital gains returns
Liability
0Ar A
income returns
0A Ar D A
capital gains returns
Assets Hedging Portfolio #1:
*
0
Risky Asset PorAssets #2: (excess return o
tfolver
iohedge)
Ar A
Pension expense risk can be dramatically reduced!
Economically, the required contribution is simply the shortfall of the assets against the economic measure of the liability, at period end (time 1). In turn, this is just the shortfall at time 0, adjusted by normal and service costs, interest costs, and asset returns, i.e., by pension expense.This is all identical to the
contribution calculation, other than for the inclusion of the starting economic deficit. The only “risky” terms, again, str supplemental cost and the risky asset portfolio. And so again, investment policy can control nearly all risks!
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What is surplus optimization?First, look at asset-only optimization
Expected risk
Exp
ecte
d r
etu
rn
Asset-only frontier
A stylized view:
Cash
Bonds
Large Cap Equity
International Equity
Small Cap Equity
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What is surplus optimization?Add in a liability-matching portfolio (beta factors only), decide risk level
Surplus Frontier
Expected risk
Exp
ecte
d r
etu
rn
Liability
The Hedging Portfolio
Surplus beta decision: The Risky Asset Portfolio
Asset only frontier
How much surplus beta risk?
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What is surplus optimization? Consider alpha from active management
Expected risk
Exp
ecte
d r
etu
rn
Liability
How much surplus beta risk?
Active riskE
xpec
ted
alp
ha Active frontier
… and how much alpha risk?
Active risk decision
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Section Summary: Managing DB pension funding risksUsing surplus optimization and the economic liability
Three key investment policy decisions are always presented: 1. Extending portfolio duration (the liability match,
or Hedging Portfolio)
2. Reconsidering the stock-bond mix and its risk/return tradeoff (the Risky Asset Portfolio)
3. Using active management (beating the zero sum game?)
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Controlling pension costs What is really happening “Under the hood” of conventional accounting
There is an economic “pension budget identity” that reveals that contributions and periodic normal costs have present values equal to that of the liability (ab initio):
A plan’s periodic normal cost is controlled solely by the total present value of the benefit level, not by the accounting!
To control costs, control the benefit level And to control the benefit level, both management and labor
need good valuations, transparency
balance sheet: income statement: cash flow statement: economic liability economic normal cost; expense economic contributions
PVFBP PVFNC PVFC
How could it be any different?
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A case study Asset-only optimization is the usual tool
Current holdings appear “efficient” in asset-only spaceE
xpec
ted
ass
et r
etu
rn
Expected asset risk
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
0% 5% 10% 15% 20% 25% 30%
Alternatives
TIPS [D=9]
Cash
Domestic EquityInternational Equity
Nominal Bonds [D=5]
Current Policy
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Today’s Hedging Portfolio: The assets aren’t well matched to the liabilities!
Asset Class Durations Real duration Inflation duration
Composition Duration $ Dur.(m) Duration $ Dur.(m)
Equity and Equity-like 75.0% 8.00 $820 0.00 $0
Nominal bonds(5.25 year nominal duration) 22.5% 5.25 $161 5.25 $161
TIPS (9 year real duration) 2.5% 9.00 $31 0.00 $0
Aggregate Plan Assets 100% 7.41 $1,012 1.18 $161
Liability Durations Valuation Real duration Inflation duration
Weight Duration $ Dur.(m) Duration $ Dur.(m)
1) Retired/Inactive 55.2% 12.87 $926 12.67 $912
2) Current employees 44.8% 22.89 $1,335 8.41 $490
Aggregate Plan 100% 17.36 $2,261 10.76 $1,402
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How much net (surplus) interest rate risk is left over?
What this means for this plan sponsor: These surplus durations represent uncompensated risk For a 1% decrease in the real rate, surplus will go down by roughly 9.6%, or $1,249m For a 1% decrease in the inflation rate, surplus will go down by roughly 9.5%, or
$1,241m
Summary: Today’s plans have large bets on both inflation rate increases and real rate increases
Surplus calculations based on using the market-valued benefit security A/L of 105%.
Real duration Inflation durationDuration $ Dur. (m) Duration $ Dur. (m)
Liability 17.36 $2,261 10.76 $1,402Assets 7.41 $1,012 1.18 $161
Surplus duration (9.58) ($1,249) (9.52) ($1,241)
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Asset model
We use BGI assumptions for this analysis. Assumptions can be modified to incorporate the companies expectations, however for modest changes the results will be materially similar.* Represents the company’s existing nominal bond portfolio with a nominal duration extension to 45 years.** Represents the company’s existing TIPS portfolio with a real duration extension to 45 years.
Arithmetic
Asset class Expected return (%) Expected risk (%)
Domestic Equity 8.75 15.50
International Equity 8.75 16.25
Bonds (5 dur) 4.75 6.00
Bonds (15 dur) 5.35 14.00
Bonds (45 dur)* 7.15 38.00
TIPS (9 dur) 4.50 6.00
TIPS (15 dur) 4.86 9.30
TIPS (45 dur)** 6.66 25.80
Alternatives 11.20 30.00
Cash 3.25 1.50
Dom Eq Int’l Eq Bonds TIPS Alts CashDomestic Equity 1.00International Equity 0.65 1.00Bonds 0.20 0.15 1.00TIPS 0.28 0.20 0.70 1.00Alternatives 0.65 0.40 0.20 0.28 1.00Cash 0.00 0.00 0.00 0.00 0.00 1.00
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Detail: The surplus efficient frontier
In “surplus graphical space”
Exp
ecte
d s
urp
lus
retu
rn
Expected surplus risk
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
0% 1% 3% 5% 7% 9% 11% 13% 15%
Case 1 (Minimum surplus risk, 4% Equity)
Case 5 (75% Equity)
Case 4 (60% Equity)
Case 3 (45% Equity)
Case 2 (30% Equity)
Current Policy
More complete hedging of liability
Less complete hedging of liability
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The ratio of domestic equity to international equity to alternatives is constrained to be in a 50 : 15 : 10 ratio, consistent with current policy.
Optimal mixes from the surplus efficient frontier
Surplus optimal mixes
Asset class: Current Policy Case1 Case 2 Case 3 Case 4Case 5
Equity-Like 75.0% 4.3% 30.0% 45.0% 60.0%75.0
Domestic Equity 50.0% 3.3% 20.0% 30.0% 40.0%50.0%
International Equity 15.0% 1.0% 6.0% 9.0% 12.0%15.0%
Alternatives 10.0% 0.0% 4.0% 6.0% 8.0%10.0%
Bonds 25.0% 95.7% 70.0% 55.0% 40.0%25.0%
Nominal Bonds 22.5% 60.6% 50.8% 43.6% 34.9%24.3%
Duration 5.25 16.9 20.2 23.5 29.342.1
TIPS 2.5% 35.2% 19.3% 11.4% 5.1%0.7%
Duration 9.00 16.9 20.2 23.5 29.342.1
Expected surplus return 2.76% 0.20% 1.36% 2.02% 2.68%3.32%
Expected surplus risk 13.24% 0.08% 3.86% 6.09% 8.32%10.55%
Duration mismatch
Real -9.58 0 (Matched) 0 (Matched) 0 (Matched) 0 (Matched)0 (Matched)
Inflation -9.52 0 (Matched) 0 (Matched) 0 (Matched) 0 (Matched)0 (Matched)
Asset-only return 7.99% 5.43% 6.59% 7.25% 7.91%8.55%
Asset-only risk 12.07% 12.40% 12.95% 13.73% 14.78%16.06%
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The impact of funding ratio on the surplus frontierConstrained and unconstrained
2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Surplus Standard Deviation
Su
rplu
s R
etu
rn
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
-2.5%
-2.0%
-1.5%
-1.0%
-0.5%
A/L= 100%
A/L = 75%
A/L = 50%
Unconstrained
Constrained
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Asset return distributions: a reminderLeft: Asset “tulip,” minimum surplus variance portfolio (mostly fixed income, asset beta .405)Right: Asset “tulip,” 100% equity portfolio (asset beta 1.44)
$100
$1,000
$10,000
0 5 10 15 20
Years
0 5 10 15 20Years
$100
$1,000
$10,000
Seeking higher returns (steeper slope) means accepting a wider distribution of ending wealth
95%
75%
Mean
Median
25%
5%
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Current policy: 75% Equity-like asset classesFunded ratio (A/L) distributions, over time
Current holdings modestly improve the expected funded ratio over time but imply an unattractive downside scenario
This and all other forecasts are focused exclusively on financial risk/return tradeoffs and exclude the impact of future cash flows and all other unhedgeable risks such as mortality risk and other experience risks.
Exp
ecte
d f
un
din
g r
atio
(A
/L)
260%
176%
134%
102%
69%
95%
75%
50%
25%
5%
Time (years)
50%
100%
150%
200%
250%
0 2 4 6 8 10
105%
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Current policy: 75% Equity-like asset classesAn equivalent picture, but showing impact in dollars of surplus space
Exp
ecte
d d
oll
ars
of
su
rplu
s ($
b)
Time (years)
0 2 4 6 8 10
$25.6b
$13.4b
$6.8b
$0.6b
-$9.6b
Investments paying
for the planInvestments causing
higher contributions
30
20
10
0
-10
$0.3b
95%
75%
50%
25%
5%
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Improving investment policyImpact of extending duration to hold a proper Hedging Porfolio
Exp
ecte
d s
urp
lus
retu
rn
Expected surplus risk
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
Case 1 (Minimum surplus risk, 4% Equity)
Case 5 (75% Equity)
Case 4 (60% Equity)
Case 3 (45% Equity)
Case 2 (30% Equity)
Current Policy
0% 1% 3% 5% 7% 9% 11% 13% 15%
Extending the dual durations of the bond portfolio improves the expected surplus returns and reduces the expected volatility of the surplus Expected surplus return = 3.32% Expected surplus risk = 10.55%
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95%
75%
50%
25%
5%
Impact of extending durationFunded ratio (A/L) distributions over time
Time (years)
Exp
ecte
d f
un
din
g r
atio
(A
/L)
224%
166%
135%
110%
82%
260%
176%
134%
102%
69%
(Current policy in background)
50%
100%
150%
200%
250%
105%
0 2 4 6 8 10
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Improving investment policyImpact of reducing stock-bond mix to 60/40, in addition to extending duration
Exp
ecte
d s
urp
lus
retu
rn
Expected surplus risk
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
Case 1 (Minimum surplus risk, 4% Equity)
Case 5 (75% Equity)
Case 4 (60% Equity)
Case 3 (45% Equity)
Case 2 (30% Equity)
Current Policy
0% 1% 3% 5% 7% 9% 11% 13% 15%
Reducing the stock-bond mix to 60/40 (from 75/25) reduces the volatility of surplus but has minimal impact on the surplus return Expected surplus return = 2.68% Expected surplus risk = 8.32%
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95%
75%
50%
25%
5%
Impact of extending duration, changing stock-bond mixImproved funded ratio (A/L) distributions over time
Time (years)
Exp
ecte
d f
un
din
g r
atio
(A
/L)
193%
152%
129%
110%
87%
260%
176%
134%
102%
69%
250
200
150
100
50
105%
(Current policy in background)
0 2 4 6 8 10
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Improving investment policyImpact of all changes (extending duration, reducing stock-bond mix, and incorporating active management)
Exp
ecte
d s
urp
lus
retu
rn
Expected surplus risk
Case 1(Minimum surplus risk, 4% Equity)
Case 4 (60% Equity)
Case 3 (45% Equity)
Case 2 (30% Equity)
Current Policy
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
Case 4A (60% Equity, including alpha)
0% 1% 3% 5% 7% 9% 11% 13% 15%
A 1% expected alpha overlay (with 1% expected active risk) on the entire plan improves expected surplus return with only a small change in surplus risk Expected surplus return = 3.68% Expected surplus risk = 8.38%
Case 4 (60% Equity)
Case 5 (75% Equity)
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50%
75%
100%
125%
150%
175%
200%
225%
Impact of adding active managementFunded ratio (A/L) distributions over time
This and all other forecasts are focused exclusively on financial risk/return tradeoffs and exclude the impact of of future cash flows and all other unhedgeable risks such as mortality risk and other experience risks.
Exp
ecte
d f
un
din
g r
atio
(A
/L) 193%
152%142%
120%
95%
212%
167%
129%
110%
87%
Time (years)
0 2 4 6 8 10
105%
95%
75%
50%
25%
5%
(Case 4 in background)
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95%
75%
50%
25%
5%
Impact of all changes (extending duration, reducing stock-bond mix, and incorporating active management)Funded ratio (A/L) distributions over time
(Current policy in background)Time (years)
0 2 4 6 8 10
Exp
ecte
d f
un
din
g r
atio
(A
/L)
50%
100%
150%
200%
250%
212%
167%
142%
120%
95%
260%
176%
134%
102%
69%
105%
This and all other forecasts are focused exclusively on financial risk/return tradeoffs and exclude the impact of of future cash flows and all other unhedgeable risks such as mortality risk and other experience risks.
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How much tolerance for investment risk?The integrated corporate balance sheet
Corporate “T-Account”
S/H Equity
Operating assets Debt
.
Pension assets Pension Liability
If the pension assets are a large part of the total assets, beta risk from the risky asset exposure will have a large effect on S/H equity beta risk
So, bad investment experience in the plan may compound an otherwise bad period for the company
The weighted avg. beta of the assets = weighted avg. beta of the liabilities
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Risk Tolerance: How much equity?What does bad investment experience mean to you?
To hold more equity increases the expected or average return, but it also increases the cumulative probability of very bad returns over long periods of time Equivalently, contributions and expense can be expected on
average to be smaller, but the probability that they will be larger does go up
Can you afford greater contributions, expense when markets are generally depressed?
Enterprise view: Today’s 75% equity allocations are probably going to come down
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Exceeding the limits of the possible: Do you feel lucky with your aggressive investment policy?
• Too much pressure is placed on the possibility of getting extraordinary, high returns, in order to solve funding problems
• But “feeling lucky” is a poor substitute for fair expectations, risk control
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Conclusions: Don’t kill the golden goose!
Prescription: Use core teachings from modern portfolio theory to control true pension funding risks and costs
Pension funding risks are manageable, with 3 tools: The Risky Asset Portfolio: Surplus efficient frontiers help manage equity,
or market, risks The Hedging Portfolio: Dual duration management techniques manage
both types of interest rate risks (real interest rate, and inflation) Active management, skillfully employed, can significantly improve
surplus performance
Costs can be managed if benefit levels are negotiated using economic measures of the liability If costs are controlled, then contributions and expense are also controlled
DC plans are not a good substitute!
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Biography
M. BARTON WARINGManaging DirectorChief Investment Officer for Investment Policy & Strategy, Emeritus
Barton Waring ran BGI’s Client Advisory Group from 1996 until his recent decision to retire. His research and published articles on investment policy and strategy issues have significantly contributed to the ability of today’s investors to control their risks and enhance their returns, in both beta and alpha dimensions. While most of his client work has been for BGI’s “strategic” clients, the largest of the world’s institutional investors (defined benefit retirement plans, foundations, endowments, social security systems, and central banks), it was also often directed at the needs of individuals in their personal and defined contribution retirement plan accounts. He has published over two dozen articles on surplus asset allocation, manager structure optimization and risk budgeting, as well as many on defined contribution/individual investor investment strategy. Four of these articles have won “outstanding article” awards from their respective journals, and these and many others are widely cited as setting the bar for today’s standards of practice. He serves on the Editorial Advisory Boards for the Journal of Portfolio Management, the Financial Analysts Journal, and the Journal of Investing.
His background prior to BGI also dealt intensively with classical investment strategy and policy issues. He was the manager of the specialist investment strategy consulting firm Ibbotson Associates, co-leader of Towers Perrin’s asset-liability practice and the head of its Central and Western regional asset consulting practices. He started and led the original defined contribution business for Morgan Stanley Asset Management in 1992, implementing the lifestyle fund concepts that he pioneered in 1989 and which he has written about frequently. Barton received his BS degree in economics from the University of Oregon, his JD degree from Lewis and Clark, with honors, and his masters degree in finance from Yale University.