By: Russ Kamp, Managing Director, Ryan ALM, Inc.
I have been thinking about producing a post on uncertainty for a while. An email that just came across my desk pushed me to finally write something on the subject. You would think that someone who has been in the investment industry for 41+ years has accepted that uncertainty is just part of the job. I haven’t, and I’m constantly looking for ways to minimize uncertainty to the greatest possible degree.
As textbooks explain, our minds actively work to reduce uncertainty as much as possible. We all want solutions — answers to our questions and problems. When the answers aren’t apparent, we find it difficult to stop ourselves from obsessing over the uncertainty. The impact of these uncertainties seems to magnify during periods of great stress (market dislocations). For most of us, uncertainty can feel very uncomfortable. It sure does for me.
Yet, those of us in the pension arena continue to exacerbate uncertainties, by focusing on a return objective (ROA) that doesn’t guarantee success in lieu of focusing on the true objective of managing a pension, which is to secure the promised benefits at a reasonable cost and with prudent risk. Why? Insurance companies and lottery systems discovered long ago that defeasing liabilities was the surest way to reduce risk and achieve the desired objective. They don’t cobble together a collection of asset classes with the hope that the combination will somehow achieve that return objective. No, they take a present value (PV) calculation of what the future value promise (FV) looks like and they fund that obligation with certainty. No games!
The email that hit my desk today was titled “Expect Uncertainties”. As I stated earlier, anyone who has spent any time in this industry appreciates that there are uncertainties. If there weren’t then pension plans would be fully invested, 401(k) balances would be robust, and the customers would have yachts instead of just a few hedge fund managers. Managing against a return objective is fraught with peril. There is a plethora of risks that contribute to the uncertainties. Perhaps there is no greater risk right now than the impact of inflation on our markets going forward. What will the Fed do? How will their decisions impact public and private markets? Will there be a pivot and if so, what will the magnitude be, and will it be timed appropriately or will it be premature? Inflation is just one risk. There are countless others that can create uncertainty.
Is there anything that a plan sponsor can do to significantly reduce this uncertainty? Must they continue to live with these uncomfortable feelings? Yes and no. As we’ve discussed on many occasions, the FOMC’s interest rate increases have played havoc on markets and nerves, but the spike in rates has also created wonderful opportunities to SECURE the promised benefits while reducing the uncertainties associated with investing in the markets. How comforting would it be for managers of pension systems, the sponsors that help fund them, and the participants that are counting on receiving a promised benefit to know that a significant portion of the uncertainty has been eradicated?
Don’t continue to focus your energy on allocating ALL of the pension plan’s assets to return-seeking products. Split the assets into a liquidity bucket and a growth bucket. The liquidity bucket will have all of your investment-grade bonds providing the necessary cash flow to meet the projected benefits and expenses through both the interest and principal cash flows, while the growth bucket will consist of all non-bonds that now can grow unencumbered with the purpose of meeting tomorrow’s liabilities. The cash flow matching (CFM) strategy will eliminate the uncertainty of where the cash will come from to meet benefits and expenses. Furthermore, the CFM portfolio will remove the uncertainty of interest rate risk since future values are not interest rate sensitive.
If uncertainty makes you uncomfortable, adopt a CFM strategy that can significantly reduce uncertainty by securing those promises. You and everyone else associated with that pension plan will surely appreciate the reduction in one’s level of stress.