Ron Ryan and I are presently spending a few days in Newport, RI at the Opal Public Funds Summit East. The sessions on day one were outstanding, and the audience was very engaged. One theme, in particular, continues to echo through the conference facility related to the inclusion of traditional fixed income in their pension plan’s asset allocation.
The question to ask at this time given this low-interest-rate environment is whether fixed income is a performance asset, an anchor to windward (given the extended bull market for U.S. stocks), a source of cash flow, or none of the above? We would posit that the primary role for fixed income is as a source of cash flow to meet net benefit payments (after contributions) through a cash flow matching strategy.
Through this approach, a portion of your portfolio will be transitioned (most likely your existing fixed income) to a “beta” portfolio where the objective is to match each benefit payment, net of any contributions, in chronological order from nearest out as far as the asset allocation will permit. By using this approach a plan would benefit by having no interest rate risk in the beta portfolio since we are funding future values, better liquidity to meet those future benefit payments, and an extended investing horizon allowing for the greater use of alternatives in the alpha portfolio, which will now have time to capture the liquidity premium that exists. As a reminder, the “alpha” portfolio should look similar to a traditional asset allocation minus investment grade fixed income that is highly correlated to the plan’s liabilities.
The performance objective of the plan’s asset allocation will now become that plan’s specific liabilities and no longer the return on asset assumption (ROA). As the plan’s alpha portfolio outperforms liability growth, “excess” assets should be ported to the beta bucket extending the cash flow matching of benefits and further de-risking the plan toward full funding. We would be happy to discuss this asset allocation technique in further detail.