The following is an excerpt taken from Thomas Jefferson’s letter to James Madison. It reads, “I hold it that a little rebellion now and then is a good thing, and as necessary in the political world as storms in the physical…An observation of this truth should render honest republican governors so mild in their punishment of rebellions as not to discourage them too much. It is a medicine necessary for the sound health of government.” As we get set to celebrate our nation’s rebellion this Fourth of July, these words remind me how important it is in our pension/investment industry to challenge the status quo.
We’ve witnessed a significant decline in the use of defined benefit plans. Is this a good thing? I’ve written quite often that I believe that it isn’t, as we are asking untrained individuals to fund, manage, and then disburse a retirement benefit through a defined contribution-type fund with little know-how on how to accomplish this task. There are many reasons why DB plans have lost favor with pension sponsors, despite most American workers favoring them. One of the primary reasons has been the volatility in funded status and contribution expenses, which have resembled a ride on a roller-coaster. I believe that this has been brought about by the continuing focus on “achieving” a return on asset assumption (ROA) as opposed to the promise made to the plan participant (secure plan benefits or liabilities)… this is the reason that the plan exists in the first place.
Fortunately, despite this funding issue for many public fund plans they continue to provide these important retirement vehicles to their workforce. But will they be able to continue? Perhaps, but a change in how they are managed must be implemented. The “rebellion” that I encourage starts with a return to pension basics. It calls for a commitment on the part of everyone involved in pension management to focus first and foremost on the plan’s funded ratio (assets/liabilities) and funded status (assets – liabilities) to drive asset allocation and investment structure decisions.
Since every plan’s liabilities are unique, no generic index is appropriate for this evaluation. Each plan must have a routine (quarterly) review of how assets are performing relative to their liabilities. Once the plan’s liabilities and cash flows have been modeled the allocation of assets can be done and monitored. But unlike today’s strategy of having asset allocation focus on the ROA we recommend that the plan’s assets be bifurcated into beta and alpha buckets. The beta portfolio will consist of fixed income assets whose objective is to cash flow match (defease) and fund the plan’s benefit chronologically in a cost efficient manner with acceptable risk. The alpha bucket (the growth portfolio) will be invested in a variety of investment options that can now grow unencumbered since they are no longer a source of liquidity.
The defeasing of assets to liabilities is a strategy currently used by insurance companies and lottery systems. More importantly, it is how DB pension systems were run prior to the adoption of a return-oriented focus. The time is now to return to pension basics. To paraphrase Jefferson, a little rebellion now and then is a good thing, and as necessary in the investment industry as storms in the physical! Are you ready to join us in this quest?