By: Russ Kamp, Managing Director, Ryan ALM, Inc.
“The Lost Decade”, a phrase originally used to describe Japan’s economic performance during the 1990s, has been recently showing up in story after story in the financial press. In fact, Stifel’s chief equity strategist, Barry Bannister, has said that investors should prepare for the likelihood of a lost decade ahead with returns of 0% in the US stock market from the end of 2021 through the end of 2031. This of course follows a decade when the S&P 500’s compounded annual rate of return was more than 13% during the 2010s. We’ve had a number of booms and busts for decades which isn’t surprising given that regression to the mean tendencies is very prevalent in our markets.
Furthermore, with the prospect of an aggressive US Federal Reserve raising interest rates to combat the current unrelenting inflation you have the potential to have the US bond market possibly generating similar results as those predicted by Bannister for US stocks. Given the focus of Pension America on the return on asset assumption (ROA), you have a formula for disaster when two major asset classes each have the possibility of generating annualized returns below long-term expectations. In addition, a rising rate environment has the potential to harm the US real estate market which has seen housing and rental costs soar since 2018.
Given this potential scenario, are pension plans soon to witness funded ratios that plummet, and contribution expenses accelerate upwards? Quite possibly. Is there anything that can be done to mitigate these potential outcomes? Sure! First, let us share some possibly good news. Given the US accounting rules (GASB) that permit plan sponsors (and their actuaries) to use the plan’s ROA as the liability discount rate, changes in the economic or market present value of a public pension plan’s future liabilities are hidden from view. The 39-year bull market in bonds that may have recently come to an end crushed pension funding, as liability growth far outpaced asset growth during that timeframe. If we are to experience a rising rate environment, the economic or market present value of those future promises will fall. Given the average duration of pension liabilities of roughly 12 years and you have the potential for “returns or growth rate” to be quite negative for pension liabilities.
In a rising rate environment that has the economic present value of future liability payments falling, asset growth doesn’t have to achieve the ROA. For every 1% rise in US rates, the impact on the average pension plan (with a 12-year duration) would have liability economic growth fall 12% before the yield is added back in. A zero percent return on the plan’s total asset portfolio would look amazingly good relative to negative liability economic growth. However, this potential scenario doesn’t mean that plan sponsors should do nothing. In fact, restructuring one’s asset allocation in anticipation of a potential lost decade is a must. We highly recommend bifurcating the plan’s assets into liquidity (beta) and growth (alpha) buckets.
The liquidity bucket is going to be the plan’s bond exposure. In a rising rate environment, traditional return-focused bond programs with long maturities are going to get hurt. Convert return-seeking fixed income into a cash flow matching strategy that uses bonds for their cash flow generating capability (both principal, income, and cash flow reinvestments). These asset cash flows should be optimized to match and fund the plan’s liability cash flows. Importantly, this strategy will eliminate interest rate risk (since it is matching liability future values) for that portion of the portfolio that is optimized. Once that step has been completed, your pension plan’s alpha bucket will enjoy an investing horizon that has been extended.
This buying of time is an important investment tenet. Allowing the alpha bucket (non-bonds) to grow unencumbered is critical, as market performance may be quite choppy as we look 10-years out. One doesn’t want to force liquidity where it may not naturally exist, especially given that America’s public pension systems have moved significant assets into private markets during the last couple of decades. This strategy is like a bridge over troubled waters. We witnessed very challenging equity markets during the first decade of this century. Unfortunately, the equity market declines were coupled with a significant fall in US interest rates. This combination proved to be crushing for Pension America’s funded status. Perhaps our pension systems will suffer less of a hit in this next environment if rates rise substantially and liability growth falls. Don’t close your eyes to this potential reality. Measure, monitor, and manage your plan’s liabilities much more frequently than the current practice of seeing those promises only once per year, at most.
Hi Russ. If P/Es return to 15, the 2020s will be a lost decade. Crestmont Research reports that low P/Es have historically occurred when we have high inflation & when we have high deflation. In other words, high P/Es need zeroish inflation to sustain.
Zeroish is not a likely scenario given all he stimulus! Hope that you are doing great, Ron, and thanks for the comment.