The asset consultant has always been tasked with a difficult assignment, as they try to secure the promises (benefits) that have been made by their client to the client’s plan participants.
When I first got into the pension/investment industry in 1981, asset consulting was still in its infancy. The job at that time was easier in the sense that U.S. interest rates, both long and short, were providing double-digit returns, and a traditional 60/40 asset allocation (equities/bonds) was providing more than enough return to meet the long-term return objective (ROA). In fact, the average yield in 1981 for the U.S. 30-year Treasury was an incredible 13.45%.
As we’ve moved through time, U.S. interest rates have plummeted to where the U.S. 30-year Treasury bond is now yielding 1.42% (8/18 at 9 am) and a traditional 60/40 asset allocation will likely not produce anything close to what plan sponsors need to meet long-term funding requirements. In addition, as more and more money is put to work in a variety of asset classes, expected returns continue to be compressed to the point that the average manager of domestic active strategies for both equities and fixed income have failed to exceed their benchmarks on a fairly consistent basis.
Asset consultants are thus tasked with two major challenges: asset allocation and manager selection, both of which have become incredibly difficult. With regard to asset allocation, the original 60/40 asset mix has evolved into a much more sophisticated blend of traditional and alternative investments that often require the plan sponsor to learn a completely new vocabulary. They also present challenges related to liquidity, fees, transparency, etc.
Manager selection requires a consultant’s research team to dive deep into an asset manager’s investment process to determine if the stock (or bond) selection criteria still have forecasting ability. If they do, have those ideas been eroded over time as more money chases too few good ideas creating a hurdle to achieve the forecast excess return objective. This is absolutely an unenviable task. We witnessed a collection of systematic managers go through a period of outrageously poor performance in the late ’00s, as too much money was chasing the same ideas. These managers didn’t get stupid overnight. The fundamentals of the market changed without warning.
Given the current environment for DB pension plans, mistakes regarding either asset allocation or manager selection cannot be tolerated. The idea that public or multiemployer DB plans can make up for difficult investing environments through greater contributions is just not based in reality. What the asset consultants need today is greater certainty than ever before. They need to know that the plan’s benefits are secure and that the long-term return objective will be achieved with moderate risk. Again, this is not an easy task.
That said, we believe that a Cash Flow Driven investing approach (CDI) is up to that challenge that will help asset consultants and plan sponsors accomplish both objectives. As a reminder, a CDI process matches cash flows from bonds with monthly benefits and expenses. It doesn’t matter whether interest rates are rising or falling or if spreads among various fixed income instruments are widening or narrowing. All that matters is that the cash is there to meet the plan’s cash flow needs. While this is occurring, the remainder of the portfolio, especially important for the alternative investments, has bought time by extending the investment horizon in order to capture the liquidity premium that exists in those strategies.
The securing of the plan’s benefits and expenses is THE primary objective in managing a DB pension plan. Wouldn’t it be so comforting to be able to tell a plan sponsor’s participants that their benefits are secure for the next 10 years? I know that if I were back on the consulting side of our business where I’ve spent about 20 of my 39 years, I would want to engage in a strategy that removes so much risk from the equation.
As a result of adopting a CDI approach, I would no longer be worried about liquidity to meet benefits, interest rate risk in this low-interest-rate environment, or manager selection risk in choosing the “right” fixed income manager. I would be able to focus my attention on putting together a world-class alpha portfolio consisting of traditional and alternative strategies to meet the long-term return needs that now have 10-years to achieve the objectives. With the longer the investing horizon, we greatly increase the probability of success. Let’s improve the odds!