I was very fortunate to spend the last three days at the Florida Public Pension Trustees Association’s (FPPTA) educational conference listening to many bright, passionate presenters. If you’ve attended one of these before you wouldn’t be surprised to read that there were roughly 90 presentations on various investment strategies, actuarial related sessions, fiduciary standards, communication, healthcare, performance measurement, and even a couple on a DB plan’s liabilities (amen). But, the most common theme was related to the plan’s ROA or return on asset assumption, that is used to both discount liabilities and as a target for the plan’s assets. Through our research and based on what was shared at the conference, it appears that 7.5% is the most common target for the plan’s ROA.
Given recent volatility in and poor performance of the global markets, the performance for the most common indexes is flat to negative for the 12 months ending September 30, 2015. In fact, one would have to be making a meaningful style overweight favoring growth versus value (in all capitalization ranges) to see reasonably positive numbers of 2% or more or an over-weighting in fixed income relative to equities to accomplish the same objective (Barclays U.S. Aggregate is up 2.94% for the last 12 months). But, we know that public DB plans have been reducing fixed income exposure with the anticipation of rising interest rates.
It is doubtful that a “traditional” 60 / 40 (equity / fixed income) allocation is representative of today’s asset allocation, but if it were, it would show a 0.81% return for the 12 months, falling substantially behind the average ROA. If we used an equity allocation that included non-US equities at a 10% allocation, the 12-month return falls to 0.21%. However, it certainly seems to us that many plans have taken their international allocation up, while also diversifying into emerging markets. If the plan allocated only 5% of the domestic equity to emerging markets, so that the new allocation was 45% US equity, 10% Int’l – developed, 5% Int’l – emerging and 40% fixed Income, the return falls to -3% for the year, as emerging markets have gotten destroyed, a full 10.5% behind the “average” ROA.
Unfortunately, as yields on bonds fell below the ROA in the late ‘90s and early 2000s, asset consultants began reducing allocations to fixed income, fearing that any allocation would prove to be a drag on the plan’s ability to achieve the ROA. As a result, most public fund DB plans have substantially less in domestic fixed income than they should or historically have had. Once again, it appears to us that most plans have less than 25% allocated to traditional U.S. fixed income. If this is correct, it is likely that the performance numbers highlighted above would be weaker.
Compounding the fact that most plans will have a total fund performance that falls substantially below their ROA objective during this period, is liability growth, which during the last 12 months has increased by 9.6% (according to Ryan ALM). As we discussed at the conference, a plan’s specific liabilities should be the primary objective for performance reviews, but regrettably that hasn’t proven to be the case. Comparing your assets to your plan’s liabilities in 2015 would reveal a nearly 12.6% underperformance in the last 12 months.
DB Plan sponsors have been very pleased with returns relative to their stated ROA objective since the great financial crisis concluded in March 2009, but the reality is that liability growth has outpaced most plans’ asset growth during the same period. However, this fact is mostly unknown since most plans don’t get regular updates on their fund’s liabilities. Unless a fund sponsor has access to a custom liability index (CLI) measuring the performance of the plan’s specific liabilities there is no way to know that fact.
Asset Allocation should be driven by your plan’s liabilities and funded ratio, and not the ROA. Asset allocation should also be responsive to changes in both, but in order to implement a responsive asset allocation, one needs greater transparency on the liabilities. Let us help you understand the true economics of your plan.