No one’s crystal ball is any clearer than the next person’s. Sure, there are investors who are more disciplined, experienced, perhaps brighter, and luckier, but no one has a true knowledge of what awaits. Given this reality, market pros often, and correctly so, warn about trying to market time major moves within asset classes. Each of those decisions needs two right calls – the getting out and just as important, the getting back in – in order to capitalize. This ability is rare, and it can be expensive, as moving assets in the cash markets can have a high opportunity cost.
For years, we at Ryan ALM have encouraged plans to adopt an alpha/beta approach to managing pension assets for the reason that market timing is challenging, to say the least. Sure, we’ve been encouraging plan sponsors and their asset consultants a little more aggressively at this time to adopt our strategy but not because we have any greater clarity on the future direction of markets, but because we know from history that what goes up eventually goes back down. Pension plans are enjoying an improved funding position. As we’ve said, it would be sinful to see the great work/improvement wasted.
In proposing a new approach to asset allocation we are admitting that we have no idea about the future behavior of markets – bonds or equities. Using our Cash Flow Matching (CDI) approach creates an improved liquidity profile that will insulate the portfolio from having to liquidate alpha assets (non-bonds) during periods of turbulence. Furthermore, the alpha assets now have time to grow unencumbered while they potentially wade through rocky markets, such as the one we are in right now. Earlier this week we wrote about the 39-year bull market in bonds (began in 1982). Are we at the end of this extraordinary period of time? Who knows, but I like the bet that we are much more likely to see rates rise than fall further from these levels.
In a rising rate environment, total return-oriented bond products will likely suffer principal losses sufficient to produce a negative annual return. Given this possibility, use bonds for their cash flows and specifically to match asset cash flows with liability cash flows (benefit payments). In this case, assets and liabilities will be carefully matched (future values) producing a relationship that eliminates interest rate risk, which could be substantial during the next bear market.
Cash Flow Matching is a tried and true portfolio strategy that currently supports both lottery systems and insurance companies. It was once how pension plans were managed in the U.S. This “sleep well at night” strategy should be used at all times, as using bonds for liquidity purposes makes far greater sense than sweeping dividends from equity portfolios that could potentially reinvest those dividends at higher projected growth rates. You also don’t want to be searching for liquidity in an environment when everything correlates to 1 and liquidity disappears, such as that which we experienced in 2008. Don’t try to time the market. Adopt an all-weather strategy that will make your pension plan much more efficient to manage. Remember, the primary objective in managing a DB pension plan is to SECURE the promised benefits at both reasonable cost and with prudent risk.