The Role of Fixed Income?

There was an article yesterday from Chief Investment Officer Alert highlighting the fact that CalPERS’s fixed income group had received a D grade from their lead consultant Wilshire. As it turns out, the grade was given primarily as a result of key turnover in the leadership of the fixed-income unit and not related to the implementation of their bond program.  However, it got me thinking about bonds. Do you think about bonds?

Where do bonds go in Asset Allocation for defined benefit pension plans? What is the value of owning bonds? Very simply, CASH FLOW!

  • Bonds are the only assets with a certain future value (FV)
  • They provide the best fit for matching the future value of benefit payments
  • Don’t sell bonds in this rising interest rate environment, put it to work more efficiently!

Ryan ALM and KCS have been traveling across the country discussing alternative approaches to asset allocation for much of the last 6 years. In fact, we will be presenting some of our ideas at the Florida Public Pension Trustee Association (FPPTA) next week. I will then be presenting on the same topic in three weeks at the International Foundation of Employee Benefit Plans (IFEBP) in New Orleans.

The idea is very straightforward. Bonds have one role, and that is to provide certain future values that can be used to match the value of future benefit payments. This strategy is the preferred implementation of the three (annuities and LDI being the other two) being proposed within the Butch Lewis Act legislation. Furthermore, cash-flow matching has been a strategy employed by pension executives since DB plans were first introduced.

However, this strategy lost some luster when asset consultants came into being with the promise to build a better pension mouse trap focused on the return on asset assumption (ROA). As a result, asset/liability studies were conducted with a focus on generating a return that would exceed the ROA and NOT on the principle of meeting the promise (benefits) at the lowest cost and at reasonable risk.

Unfortunately, with a focus on return, consultants and plan sponsors have dramatically reduced fixed income exposure in most pension systems during the last two decades as yields fell (asset allocation models use yield as a proxy for return) causing these plans to miss one of the greatest bull markets ever for bonds.

In addition, the growing fear that U.S. interest rates would rise rapidly caused many plans to further reduce their bond allocations. As a result, public pensions systems have equity exposures that are greater than those we witnessed in 2007, and this after 9 1/2 years of a historic equity bull market.

We believe plan sponsors would be best served by bifurcating their portfolios into two components – de-risking assets and growth assets. The de-risking assets would be a cash-flow matching strategy aimed at the current retired lives benefits, while the growth portfolio is focused on beating liability growth for active participants.

Timing any aspect of the markets has proven incredibly challenging for most market participants. Our strategy takes the guesswork out of the equation. We are happy to share our presentations with you on how a cash-flow matching strategy can be used to enhanced the funded status and stabilize contribution expense.



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