By Russ Kamp, Managing Director, Ryan ALM, Inc.
There was an article in today’s WSJ that addressed the issue of transparency among hedge funds, private equity, and private debt offerings. There are a plethora of institutional entities imploring the SEC to require greater disclosure. Not surprising that this objective is being met with harsh criticism from the targeted investment firms. I’m all for more transparency and disclosures and the idea that performance is going to be hurt by enhanced reporting doesn’t carry water in my opinion.
That said, I am much more interested in the following paragraph that was embedded in the article: “Many pension plans are having a hard time meeting their payout obligations to members, the result of decades of underfunding, benefit overpromises, and unrealistic demands from unions. This year’s simultaneous decline in stocks and bonds has only made matters worse. To compensate, many pension plans are increasingly putting their money into private-market investments like hedge funds, private-equity funds, and private debt funds.” Do we really believe those are the primary reasons for poor pension funding where it exists? Furthermore, do we really believe that investing greater and greater sums of money into HFs, PE, and PD will be the Holy Grail to full-funding success? I certainly don’t!
Sure, there have been some entities that haven’t fully funded that annual required contribution, but many funds have met those obligations. Aren’t benefits, as well as other plan provisions, part of a negotiation process? Since when do unions make demands on their own without a counterparty involved in the process? No, the biggest contributor to poor funding among some pension systems has to do with not having the right objective in place. Our industry is enamored with the idea that achieving a target return solves all problems. It doesn’t. Given this unhealthy pursuit, it isn’t surprising that plans and their advisors are allocating more money to these private alternatives. Just remember that too much money into any asset class can significantly diminish future returns.
If generating a return is not the primary objective then what is? It is the SECURING of the promise that has been made to a plan participant that guarantees a certain payout each and every month in retirement until death. Meeting that objective is the only reason why that plan exists. Given that reality, it becomes obvious why that promise needs to be secured in such a fashion as to significantly reduce funding volatility. There is no reason to blame the size of the benefit or the union’s demands. Once that benefit has been agreed to the process becomes very simple as B+E=C+I, where contributions (C) and investment gains (I) and the existing corpus must be sufficient to meet the promised benefits (B) plus the expenses (E) necessary to meet those benefit payments.
With greater and greater emphasis on investments to drive success, we get potentially greater variability in a plan’s funded status as markets and market returns are not linear. Pension systems need to spend more time understanding their plan’s specific liabilities and then managing plan assets versus those promises and not some generic asset-based index. The roller-coaster gyrations that traditional asset allocations follow lead to significant volatility in contribution expenses. Get off that roller-coaster. Put in place a bifurcated approach to pension asset allocation that will enhance liquidity to meet the promises while buying time for all the private investments to which plans have flocked. Bonds are NOT going to be return generators in a rising interest rate environment. I have no idea how high rates will go, but I do know that their trajectory is higher – the Fed told me and everyone else. Use your plan’s fixed-income cash flows to meet your plan’s liability cash flows. Securing the promised benefits for the next 10-years or so buys ample time for your alpha assets (non-bonds) to achieve their expected outcomes.
Pension plans are much too important to rely solely on markets to create success. Put in place an objective to secure the promised benefits that elevates the probability of success!