Have We Outsmarted Ourselves?

I entered the retirement industry in 1981 when asset consulting was still in its infancy. At that time many defined benefit plans were managed by a single balanced investment program (60% equity and 40% fixed income), and often it was a bank trust department that was responsible for the program’s implementation. They had recently taken responsibility for pension assets from fixed income managers who defeased the pension liabilities in a similar fashion to how lottery systems were managed then as they are today. That low-risk approach was deemed to be too expensive.

Unfortunately, plan sponsors were coerced into believing that asset consultants possessed a better mousetrap and through this enhanced asset allocation framework asset performance would be superior and contribution expense would be lower. So specialist managers were added and then real estate when stock and bond managers didn’t produce enough return to meet the ROA objective. As U.S. interest rates fell and U.S. equities outperformed, more plans shifted assets further away from the only assets (bonds) in the portfolio that were highly correlated to plan liabilities thus creating a huge mismatch.

Things got much more interesting when interest rates continued to fall and equities got smacked around twice by significant bear markets. In an attempt to enhance returns and lower volatility, significant exposure was given to alternative investments including private equity and debt, timber, agriculture, commodities, infrastructure, and worse, hedge funds! When this combination of products became too much for many plan sponsors to handle from an education and monitoring standpoint, the OCIO model was introduced.  Unfortunately, funded status has plummeted for many plans, while contribution expenses have risen rapidly.

One must now ask are we better off today than we were in 1981?  It seems as if going back to a single manager – the OCIO – hasn’t necessarily improved performance, but it certainly has created a far more complicated structure. It is amazing to see how exposure to U.S. equities has fallen for all plan types to about 26% (P&I) for Union and Public plans, while corporates are at about 16.5%.  Most pension plans would have benefitted last year from a good old fashion 60% equity/40% fixed income portfolio, as it would have generated a roughly 22.4% return slightly topping plan liabilities that came in at 22.2% (FAS 715 rates). Unfortunately, the more complicated asset allocation with very little exposure to US equities generated a roughly 15.7% return that underperformed liabilities by 6.5% and a traditional 60%/40% mix by nearly 7%. OUCH! Public and multiemployer plans faired better as the slightly greater exposure to US large-cap equities helped plans to a roughly 17.9% and 17.6% returns, respectively.

We’ve been running around the country speaking about bringing the basics back to pension plan management with a greater focus on liabilities.  It seems that a return to basics on the asset side of the equation may be warranted, too. How about building a simple portfolio that has the first 10-years of Retired Lives liabilities defeased, which might take between 20%-40% of the assets depending on the funded status, while the remainder of the assets is invested in traditional equities.  I would favor small-cap value for periods greater than 10 years, but that is just me.

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