As discussed in our previous blog post, many, if not most, public fund and multiemployer plans have injected greater risk into their investment processes by allocating significantly more assets to equities and alternatives in an attempt to best the return on asset assumption (ROA). On the surface, that decision is fine depending on the plan’s investing time horizon. However, given that many of these plans have significant negative cash flow situations (paying out more in benefits than they are receiving in contributions) the greater use of these asset classes brings about less liquidity while forcing the plan to have a shorter time horizon.
When it comes to evaluating market risk, one’s time horizon is a key factor to consider. As a general rule, shorter time horizons require more caution than do longer ones. Yet, plan sponsors have adopted an entirely different approach. The dilemma: how does a plan meet its liabilities in the short-term while creating a potential return that can beat both the ROA and liability growth longer-term.
Investing for the long-term eliminates the “noise” of short-term market moves and the longer-term averages get one closer to an expected return that is more realistic. In the current construct for most DB plans, a single asset allocation is used to create a return that will exceed the ROA, but performance results are looked at quarterly, making long-term investing difficult to achieve.
Ryan ALM produces performance results quarterly for a generic asset allocation of 60% domestic equities, 5% MSCI EAFE, 30% Bloomberg Barclay Aggregate, and 5% cash. When looking at annualized monthly returns since 12/99 (222 12-month periods), the average return is 6.02% and the standard deviation of those returns is +/- 10.8. Wouldn’t it be great to have an asset allocation that can successfully achieve both desired outcomes of meeting near-term liquidity needs while producing fairly consistent longer-term results? If successful, both the funded status and contribution expense would be more stable.
I am pleased to write that there is a way to achieve these two important objectives in managing a pension system. First, asset allocation should be bifurcated. There should be two buckets for the assets, which will have very different objectives. In order to meet near-term liquidity needs a cash flow matching strategy should be built through investment grade (and in some cases high yield) corporate bonds to meet monthly benefit payments in chronological order from nearest payment as far out as possible. Second, the remainder of the assets should be invested in instruments that are lowly correlated to traditional bonds, as liabilities are bond-like in nature.
As mentioned above, the one-year return for that generic asset allocation had a 10.8% standard deviation meaning that 68% of the time that annual return since 12/99 could have been as good as 16.8% or as poor as -4.8%. Furthermore, extending to 2 standard deviations (95% of the observations) would produce a range of results that has one seeing equal chance of a 27.6% return to one at – 15.6% or more than 43% from top to bottom. Tough to manage a pension plan with that type of volatility, yet that is precisely where we are today.
If one had the resources to dedicate enough assets to the cash flow matching portfolio the standard deviation of returns falls precipitously from 10.8% to less than 1/2 at 5 years (5.05) and to nearly 1/3 of the risk at 10 years (3.6), increasing the odds that the expected return will be achieved, the required benefits paid, and a glide path established toward full-funding.
Does this sound to good to be true? Hardly, as cash flow matching strategies have been used for more than 7 decades to achieve the desired goals stated above. Furthermore, it is one of only three strategies (along with annuities and duration-matching) to be considered as part of the Butch Lewis Act (H.R. 397) regarding how the loan proceeds can be invested. Many alternative investments are designed to provide good long-term results, but they need time to capture the liquidity premium that exists. Only through an extended investing horizon will this be accomplished.