I found an article in The Hill this morning, titled “If A Recession Is Coming, Pension Managers Need To Prepare”, and I got excited that the writer, Jarrett Skorup, opinion contributor, might actually discuss strategy. Unfortunately, that wasn’t to be the case. He did highlight the fact that in recessions it is easy to find excuses not to fully fund the plan through the annual required contribution, which is important, but not preparing your portfolio for a recession and its likely impact on the plan’s performance because of the asset allocation is much more critical.
As Ron Ryan and I have been espousing for years, asset allocation predicated on the return on asset assumption (ROA) places the plan on the asset allocation roller coaster from hell. Your plan will ride up and down through the various markets until eventually the fund, like the roller coaster, ends up broken. We’ve seen it too many times before, and after this protracted run of very good equity and bond market returns are you prepared to see your plan’s funded status get crushed once more?
Another one of the biggest problems facing plan sponsors during the last significant and protracted bear market was liquidity risk. Many plans that had invested heavily in equities and alternatives were forcing liquidity where it wasn’t naturally found thus compounding the downward spiral for these assets.
As a result of these events, contributions ratcheted significantly higher. Ryan ALM estimates that most public pension systems have seen contributions increase by 5 to 10 times what they were in 2000. We are aware of at least one fund that has seen their contributions increase from $68 million to more than $3 billion, a >38Xs increase in the last 18 years. Incredible, outrageous, abominable – pick your adjective of choice!
However, there is an easy way to mitigate these risks, but it will force you to take a different path. Let’s all embrace Robert Frost, who “took the one less traveled by, and that has made all the difference”. What we are talking about is bifurcating your asset allocation and adopting a new objective for your plan, which should have been the objective all along. We believe that managing a pension plan should be about meeting the promised benefits at both reasonable cost and risk. By bifurcating your asset allocation to focus on Retired Lives in the near-term and Active Lives longer-term, we can insulate the portfolio from the ups and downs associated with the market and economic moves.
Unfortunately, most plans have dramatically reduced the fixed income exposure because of their fear that the ROA would not be achievable given these low level of interest rates. However, through a combination of a cash flow matching strategy (beta) using corporate bonds to meet Retired Lives and a growth (alpha) strategy heavily dependent on equities and alternatives, the combination will accomplish many objectives, including reducing interest rate risk, enhancing liquidity, and extending the investing horizon for the growth assets to capture the liquidity premium that is associated with these assets.
If in 2006 you weren’t preparing for the possibility of a major market crash you likely got crushed. Well, it is 2019 and we are now 10+ years into a bull market for equities, the yield curve has recently inverted, and global growth is waning. If you aren’t preparing your portfolio for the inevitable market decline then please be prepared for the consequences of a falling funded status and escalating contribution costs. Act now before it is too late.