The graph above compares major asset class index benchmarks versus the Ryan U.S. Treasury STRIPS indexes as a yield curve of 30 distinct indexes. This analysis provides a picture (more than 1,000 words in my humble opinion) of the relative risk/reward of each asset class versus the risk-free Treasury STRIPS yield curve. Since liabilities are to be priced as zero-coupon bonds, the Ryan Treasury STRIPS yield curve indexes are a good proxy for the economic risk/reward behavior of pension liabilities. Importantly, please note there are no equity index benchmarks that have outperformed liabilities for the same relative volatility (i.e. risk) for the last 20-years through December 31, 2020. Foreign equity exposure, as measured by EAFE, has dramatically underperformed during this time.
The only indexes to outperform STRIPS during this 20-year period are fixed income related. But, here’s the rub: most plan sponsors have been reducing their exposure to fixed income during this lengthy period of falling interest rates fearing that lower bond yields would create lower future returns and become a drag on the total pension fund’s ability to achieve the return on asset assumption (ROA). The primary reason to own bonds, despite a 20-year period of outperformance, is for their cash flows. Separating the plan assets into Beta (bonds) and Alpha (non bonds) assets helps pension plans to improve and designate liquidity to meet the promised benefits, eliminate interest rate risk, buy time for the alpha assets to perform (and they may need 20+ years, as we see from above), and stabilize the funded status. That is a strong array of benefits from a minor tweak in strategy.
Given where equity valuations are at this time, does it really make sense to continue to look at the asset allocation as a single bucket? Separate your assets Beta (liquidity) and Alpha (growth) and buy time for your portfolio to potentially recover from periods of underperformance. The last thing anyone wants to do is force liquidity into the portfolio to meet benefit payments when asset prices are falling. That strategy failed miserably in 2000 – ’02 and certainly 2008. It won’t do any better during the next major correction.