By: Russ Kamp, Managing Director, Ryan ALM, Inc.
What is the value of time? When it comes to investing, time can be a wonderful tool. When you have a long time horizon, you can seek out investments that have the greatest potential for long-term success. Importantly, you can invest in the knowledge that you can wait out any short-term downturn. Unfortunately, our pension industry has morphed into a “what have you done for me last quarter” mentality. Quarterly reviews measure recent performance differences relative to generic indexes as if they are meaningful. One stock or one bond performing badly can create an underperformance that isn’t reflective of the manager’s long-term capability, yet we scour these performance books each and every quarter as if they were Gospel looking to glean an insight that will provide us with a reason to keep or terminate a manager/strategy. How silly!
As a result, we have created an atmosphere in which a majority of managers have become benchmark huggers, yet they still charge active management fees. What has this wrought? Persistent underperformance on the part of active managers on a net of fees basis. Furthermore, these products ride the rollercoaster of uncertainty given the significant beta exposure to the index benchmark. As we possibly (likely) enter a new investing environment brought about by rising US interest rates, does maintaining a quarterly focus help or hurt pension systems? We’d unequivocally state that having a short-term focus is absolutely the wrong approach.
Don’t despair, for there is a way for Pension America to achieve both short-term (liquidity) and long-term goals. Instead of having ALL of the assets focused on achieving a return on asset (ROA) assumption, bi-furcate your portfolio into liquidity and growth buckets. The liquidity bucket will consist of bonds, and only bonds, whose cash flows of principal, income, and re-invested income, will be used to match net liability cash flows chronologically (after contributions). This “bucket” will provide all of the liquidity necessary to meet benefits and expenses for as far out as the allocation can fund. The good news: as rates rise the cost to fund those benefits gets lower allowing the plan sponsor to either cash flow match more payments or allocate fewer resources to secure the promised benefits.
The remaining growth assets now have an extended time horizon in which to grow unencumbered, as they are no longer a source of liquidity. Furthermore, these assets should be given a wider range from which to operate. Constraining products to narrow benchmarks reduces the efficiency of investing, as the information ratio is a function of the forecasting ability of the strategy and the breadth of the universe from which they are choosing their portfolio holdings. Unconstrained portfolios that now have perhaps as much as 10-years to operate should provide more stable returns as they are no longer tethered to a beta benchmark subject to normal market cycles.
As we have stated many times, defined benefit plans need to be preserved and protected. But approaching the problem in a similar fashion to how we’ve done so for the past 40-years is silly. We’ve all benefited from the significant wind at our backs as interest rates collapsed. Today those winds are blowing directly into our faces and it isn’t a fun feeling. Buying time should permit you the opportunity to invest very differently. If done successfully DB plans should be able to weather this storm.