Moody’s has recently published a very balanced analysis on the current state of public pension systems. Most of the article discusses the outstanding, perhaps historic, performance results achieved during fiscal year-to-date 2020-2021. Let’s hope that the last couple of weeks in this fiscal year don’t bring any surprises. As a result of the terrific performance and slightly higher interest rates, most DB plans have witnessed improvement in the plan’s funded status. There weren’t many people in our industry who would have expected this performance turnaround when we were living through the depths of uncertainty brought on by the Covid-19 pandemic during 2020’s first quarter.
Despite the rosy performance picture, Moody’s does remind us that “unless US public pension systems move to significantly de-risk their investment portfolios, the potential downside to government credit quality from their reach-for-yield strategies will remain” even after these recent outsized returns. Given the heavy exposure to both equities and alternatives, the average public pension fund’s asset allocation “carries significant volatility risk”. Whether these pension plans de-risk remains quite uncertain. But according to Moody’s, given the 7% target return, the average asset allocation has a one-in-six chance of producing a -5% return or worse annual result. They also suggest that these mature systems, with their large benefit payouts, could see funding gains evaporated and funded status fall to June 2020 levels should the poor performance results occur.
When we at Ryan ALM discuss de-risking DB plans, we are not encouraging a UK-like process. According to John Authors, Bloomberg, the average UK pension plan has reduced equity exposure from 61% to 20% during the last 15 years, as UK regulators encouraged DB pension systems to de-risk. We believe that costs will be dramatically increased if the US were to adopt a similar approach. At Ryan ALM, we suggest that DB pension plans convert their current fixed income exposure from a return-seeking focus to a cash flow matching mandate that enhances liquidity, removes interest rate risk, secures the promised benefits, while also extending the investing horizon for the alpha portfolio that will have a significant exposure to equities and alternatives.
Letting your winnings ride in Las Vegas may occasionally prove fruitful, but it shouldn’t be the approach used to manage DB pension plans. After this incredible performance year, plans would be wise to take some chips off the table and finally begin to manage their plan’s assets versus plan liabilities. Everyone will sleep better at night knowing that the promised benefits have been secured.