On January 29, 2020, I penned a post on this blog asking the question “have we outsmarted ourselves?” Well, I don’t think that there is any question that we, as an industry, have, and it is crushing the very funds that we were tasked with trying to help. The whole idea that managing a pension has morphed into a return seeking game is the biggest problem of all. DB pension plans should have focused on the promised benefits (plan liabilities) and NOT the return on asset assumption, which isn’t a calculated number in the first place and achieving that number doesn’t guarantee a successful outcome.
Had these plans remembered that the only thing that matters is securing the promised benefits at low cost and appropriate risk, we wouldn’t be once again subjecting the plan’s assets to the proverbial asset allocation roller-coaster and plan participants to an uncertain retirement future. P&I recently published an article that highlighted the boring nature of Idaho’s (PERS) 70/30 asset allocation, which doesn’t seem so boring, but rather aggressive. However, according to a leading consultant quoted in the article, “we’ve seen public pension funds tiptoe away from 60/40” and “if anything, it’s now 80/20, an even greater reliance on return-seeking assets.” Oh, my!
Where is the reference to plan liabilities or funded status driving asset allocation? Why does it make sense that asset allocation is driven by the ROA? If two plans have 7.25% as their ROA, should they have the same asset allocation even if one plan is 60% funded and the other is 90%? Of course they shouldn’t, but in our industry more times than not they do.
How has that move into more equity-like product paid off? It shocks me to think that a majority of plans had greater equity exposure at the start of this year than they had in 2007. When will we learn? A pension plan should always be on a glide path to full funding, whether they are 50% funded or 90%. A single asset allocation geared to the ROA is what is wrong. Pension plans should utilize a bifurcated approach to managing their assets. A cash flow matching bond portfolio should be used to defease the first 10 years of the Retired Lives liability. This will improve liquidity, eliminate interest rate risk, secure benefits, and extend the investing horizon for the remainder of the assets that now have time to capture the liquidity premium. The balance of the assets can be managed more aggressively as they are no longer a source of liquidity. Their goal and objective is to outperform future liabilities.
According to the same article, public pension systems have roughly 21% in fixed income. It is a very good time to shorten both maturity and duration to take advantage of the historic move in US rates. Bonds with maturities greater than 10-years should be used to build the cash flow matching program. As rates find a more normal level, liability growth will likely be negative allowing for a potentially rapid recovery in funded status.