This Doesn’t Make Sense – Now What?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Earlier today I published a post titled, “This Doesn’t Make Sense”, in which I questioned the current market action for US equities (especially large-cap growth stocks) given the great uncertainty associated with the Russian invasion of Ukraine, rising interest rates, decades high inflation, oil prices exceeding $113/barrel, supply chain issues that continue to cause delays, and equity valuations that remain stretched. Several regular readers of this blog provided positive feedback on the post (thank you), but many others asked the question: “Now what?” It is a great question that deserves an appropriate response.

As Ron Ryan and I have stated on many occasions, the primary objective in managing a DB pension plan is to SECURE the promised benefits in a cost-efficient manner and with prudent risk. It is NOT a return objective (ROA). Given this goal and the current economic environment, it would behoove plan sponsors and their consultants to quickly migrate from traditional total return focused fixed income into a cash flow matching strategy in which bonds are used for the certainty of their cash flows (income and principal) to match and fund liability cash flows (Liability Beta Portfolio™). In a rising rate environment, total return bond programs will generate negative returns. If a 1% real return were to be achieved (historically bonds produce 1-2% real returns above inflation) in this current fixed income environment, a 6-year duration bond would generate a return of -35% or worst.

Once a cash flow matching strategy has been implemented, your bond allocation will move in lock-step with the fund’s Retired Lives Liability. This strategy eliminates interest rate risk, as you are now defeasing a future value that is not interest-rate sensitive. Ideally, the allocation should provide 10-years of benefits and expenses coverage (improved liquidity management). If achieved, you have now built an expanded investing horizon (a bridge over troubled waters), for the remainder of your assets (Alpha assets) to grow unencumbered.

Most public pension systems (and multiemployer plans) have dramatically increased their plan’s exposure to risky assets during the last couple of decades as bond yields fell. That strategy has certainly created the potential for more return, but it has guaranteed more volatility and higher costs. In addition, it has impacted liquidity as many of these strategies are locked up in funds that have 10-12 year lives. Creating a bifurcated asset allocation of liquidity assets (Beta)  and growth assets (Alpha) that secures the promised benefits, improves liquidity to meet those benefits, extends the investing horizon for the plan’s alpha assets to work through choppy markets, while also eliminating interest rate risk for the portion of assets that are defeased seems like a most prudent strategy to adopt given all of the uncertainty within our capital markets. This recommendation isn’t knee-jerk! It is an asset allocation model with a long and successful history! Putting in place an asset allocation structure that provides the necessary protections WHEN markets go awry is fundamental to the success of DB pension systems. For too long we’ve played the return game. Very few plans are well-funded. Isn’t it time for a return to pension basics?

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