The US Federal Reserve has just released a report stating that inflation is running “hotter” than expected. That probably won’t come as a surprise to anyone buying nearly anything today. So, what happens to your fixed-income portfolio should we get continuing inflation that ultimately leads to higher rates? Well, if your pension plan is invested in a traditional fixed income product managed to a generic index, your bond portfolio’s principal will decline in value by 1% for every one-year of duration and every 1% increase in yields. Invested in a 5-year duration strategy, your portfolio will decline by 5% should interest rates back up 1%. Given where interest rates are your fund’s total return isn’t going to be protected much through income. We’ve been in a protracted bull market environment for US bonds since roughly July 1982. Fixed income managers and their clients have benefited tremendously from this tailwind. Is the bond party nearing its conclusion?
Plan sponsors of pension plans need fixed income if for no other reason than to have the cash necessary to meet monthly benefit and expense needs. Is there an alternative to sitting in a portfolio that will likely suffer principal and total return losses? There sure is! A portfolio of investment-grade corporate fixed income cash flow matched to your plan’s liabilities and expenses will provide significant protection from interest rate risk, as both the assets and liabilities will move in lock-step with one another. Actuarial projected benefits and expenses are future values which are not interest rate sensitive. By cash flow matching liabilities with bonds, you have eliminated interest rate risk which is by far the dominant risk in bonds.The Ryan ALM cash flow matching model (Liability Beta Portfolio™) is a corporate bond portfolio skewed to A/BBB+ securities. This LBP will outyield liabilities when discounted using ASC 715 rates of AA corporate bonds. This will produce some Alpha by the difference in yield (+/- 50 bps).
Furthermore, the cash flow matching portfolio (CDI) provides additional benefits. Importantly, because your cash flow needs are now taken care of for some period of time – we recommend 10-years – the non-bond assets (alpha assets) can now grow unencumbered, as they are no longer a source of liquidity. Studies have shown that the reinvestment of dividends is a major contributor to the S&P 500’s return over time. In fact, some studies that I’ve seen allocate 50% to 60% of the return coming from dividend reinvestment over periods greater than 20 years. In addition, both the funded status and contribution expenses should be more stable given this approach.
A pension plan’s asset allocation should be dynamic. It should be driven by the plan’s funded status and projected liabilities and not the return on asset assumption (ROA). There has been terrific progress made by many pension systems as a result of out-sized performance during the period since the Great Financial Crisis. It would be truly devastating to have those wonderful gains lost because we remained complacent thinking that yesterday’s great results were likely to happen once again. Now is the time to convert your fixed-income exposure from an allocation that will work against your fund should rates rise to one that insulates your portfolio against this great risk. Oh, and as rates rise, the CDI investment strategy gets to reinvest excess income at higher interest rates. That’s another benefit to adopting this approach. Call us. We’ve written the book or at least the chapter on CDI (Frank Fabozzi’s latest book).