“Should We Just Take Our Lumps?”

Oh, my!

I’m attending the Opal Public Funds Summit in Scottsdale this week.  Opal produces this critical forum twice per year at which public fund plan sponsors, consultants, actuaries, and invesment managers gather to discuss the state of the U.S. retirement industry while considering strategies to address issues and opportunities. Given how troubled our industry is, particularly after a challenging 2018, this year’s program takes on heightened urgency.

The title above, “Should We Just Take Our Lumps?” were words uttered by a plan sponsor during their panel discussion regarding the current environment for fixed income. This plan has roughly 22% in traditional fixed income instruments, and the sponsor was concerned that a rising interest rate environment might weigh heavily on future returns for their program. Instead of exploring options for the current exposure they were considering just letting the exposure get whacked while hoping the remaining 78% could generate alpha to make up for this potential underperforming asset class.

Thinking a little outside the box. We would recommend that the plan sponsor bifurcate their portfolio into insurance and growth assets. The insurance assets would be their current fixed income exposure converted from a return generating asset to a cash flow matching portfolio designed to meet near-term liabilities. This conversion will improve liquidity to meet those benefit payments while eliminating the interest rate risk that the sponsor was concerned about.  Furthermore, by building an immunized portfolio to meet near-term payouts the investing horizon gets extended for the growth portfolio. This strategy buys time for the growth assets to capture the liquidity premium that exists in many assets outside of fixed income.

By focusing on the return on asset assumption (ROA) as the primary objective, the sponsor was fearful that a conversion of the fixed income portfolio to meet near-term benefit payments would impact their ability to meet the ROA.  However, converting the current fixed income exposure to a cash flow matching (immunized) strategy, the portfolio’s yield is likely going to be enhanced, which would actually improve the plan’s ability to exceed their return objective.

Conferences, such as Opal, are potentially great sources of knowledge provided that one attends with an open mind to new and different ideas.  For too long our industry has been walking down the same path together (return focused), and we are now at a critical intersection in which the path less traveled needs to be explored.

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