By Russ Kamp, Managing Director, Ryan ALM, Inc.
Asset allocation decisions shouldn’t be taken lightly, and a long-term structured approach should prove superior over time compared to trying to “time” the market with dynamic shifts that can be costly and lead to regret as markets quickly snap back. For plan sponsors and their advisors who were fortunate to establish a long-term asset allocation in the early 1980s that had decent exposure to fixed income, you captured an incredible trend of falling inflation and US interest rates. You almost didn’t have to do anything else as the nearly four-decade rally made most of us look very smart.
You don’t often have the chance to capture a trend (paradigm shift) of this magnitude and when you can, it is likely prudent not to waste the opportunity. So, I was taken aback when I read something in P&I today when a member of a pension staff declared that “big macro trends are UNLIKELY to impact our strategic asset allocation decisions”. If the big trends don’t, then when? For those that might not remember, the last four decades of falling rates and inflation were preceded by nearly 30 years of rising rates! Did rates rise and fall consistently during each of these bespoke periods – NO. But nothing ever does. Having the ability to participate in a trend that favors a certain path is nothing to take lightly.
Calendar year 2022 was challenging for fixed-income managers, as rising rates played havoc with bond returns (BB Agg -13%). There is no greater ongoing risk to bonds than interest rate increases – none! US interest rates continue to rise as inflation remains stubbornly high (6.4% annualized through January 2023). The Fed is not likely done with increases in the Fed Funds Rate. If that is true, bonds will continue to be hurt. Why sit back and let this trend harm your bond allocation and ultimately your plan’s funded status. Inaction is as much a decision as action.
There is a fixed-income strategy that has been around for more decades than you can imagine. Cash Flow Matching (CFM) is a defeasement strategy that insulates your plan from the uncertainty of US interest rates, by carefully matching bond cash flows (Interest and Principal) with the ongoing benefits and expenses of the plan. You are funding and matching future values which are not interest rate sensitive. Since CFM will outyield liabilities, it will also outperform liabilities in present value growth. Rates go up – no problem, as liability growth is negative. US interest rates fall, again no problem as asset growth will mirror but outgrow liability growth. Not only are the assets and liabilities now working in conjunction with each other, but your plan has also dramatically improved the liquidity necessary to meet the monthly payments.
I don’t know with certainty where inflation will be in 3-5 years and as a result, I don’t know where US interest rates will be. I SUSPECT that they will be higher than they currently are, but I’m not willing to make investment decisions based on a guess. Eliminate the uncertainty. Use your bond allocation to SECURE the promised benefits while eliminating the onerous effects of rising rates.