I can’t tell you how many times I heard those words uttered by my mom when I was a youngster, and it usually pertained to my eating habits! For instance, did I really need to consume the whole quart of milk and the entire, newly-opened bag of cookies? Probably not, but invariably I did. Well, if my mom understood what many (most) non-corporate DB plans were doing today, she’d chastise them, too, and with good reason.
Regrettably, GASB allows public pension DB plans to discount their plan liabilities at the ROA, and not at a “market rate” such as FASB (AA corporate) or the more conservative mark-to-market rate, such as US Treasury STRIPS. As you’ve heard us mention on numerous occasions, liabilities and assets don’t have the same growth rate, so it makes no sense to discount liabilities at the ROA. Why does this matter? It matters a heck of a lot, and it is leading to inappropriate asset allocation decisions that are being exacerbated in this market environment.
I attended the Tri-State Institutional Investor Forum today at the Harvard Club. It was a well-attended conference, with very good presenters, but as usual, the singular focus was on the asset side of the DB equation. In attendance were several representatives from a very large public pension plan from a state near and dear to my heart. Each of this state’s representatives mentioned that their fund had a 7.9% ROA. They also mentioned that they weren’t particularly focused on the liabilities given GASB’s ridiculous accounting methodology, and as a result they didn’t have much exposure to traditional fixed income, as the low yield environment would be a “drag” on performance, as if the only thing that mattered was the yield?
However, what they did do was to “equitize” their fixed income exposure by allocating to high yield, emerging market debt, preferred securities, and other more exotic alternative sources of fixed income exposure, betting that these securities would presumably benefit from rising equity markets. Unfortunately, our equity markets are not cooperating, and instead of holding higher quality, more liquid fixed income (Treasuries) that have rallied significantly (the yield on the US 10-year has fallen by more than 50 bps so far in 2016), these equity alternatives are under significant pressure. UGH!
So, again, I ask, “just because GASB permits liabilities to be discounted at the ROA, should plan sponsors do this? NO! Asset allocation decisions undertaken in an attempt to achieve a 7.9% ROA are accomplishing little in terms of generating return, but are certainly a breeding ground for volatility and uncertainty. Public pension plans should pay some heed to their liabilities. They should use the current funded status to drive asset allocation decisions and not some generic ROA objective that has nothing to do with how liabilities actually perform. As a plan gets closer to full funding, the plan should de-risk, and not subject the entire corpus to unnecessary risk-taking.
Just like me when I was a kid, these plans need to pause before they continue to gorge unnecessarily! In the case of these DB plans they are choking on the risk associated with an asset allocation policy designed to achieve the ROA, with little likelihood of getting the benefit that they desire.