This is No Time to be Greedy

The WSJ’s Heather Gillers has published an article today highlighting the potential risk of a liquidity crunch due to asset allocation decisions that have significantly reduced both fixed income and cash, as more aggressive exposure to alternatives – private equity and debt, real estate, infrastructure, etc. – are pursued. We’ve seen this scenario play out before, and it wasn’t pretty, as E&Fs were forced to liquidate less liquid investments in alternatives to fund their spending needs during the 2007-2009 Great Financial Crisis (GFC). That activity exacerbated the selling pressure and lead to the development of secondary markets for many of the alternative investment categories. Are we nearing a similar liquidity cliff?

According to Heather and several sources including both Boston College and Boston Consulting Group, fixed income allocations have fallen on average from 33% to 24% within the public fund universe, while average cash reserves are <1% today. The thought that fixed-income assets could be a source of liquidity when equity investments were under pressure was a very reasonable assumption during the last 39 years of a bull market for bonds. However, the next equity market crash may be driven by inflationary pressures forcing US interest rates higher. In that case, all bets are off as to the ease by which bonds can be sold and cash raised!

The WSJ article quotes Ash Williams, the recently retired and renowned (rightly so) pension officer for Florida’s Retirement system, who stated “finding a strategy that can accomplish what bonds once did, providing yield in good times and accessible cash in bad, is “not a problem with an easy solution.”” We agree that using fixed income as a total return vehicle is the wrong use for bonds in today’s environment. However, we disagree that there isn’t an easy solution – sorry, Ash. Bonds should be used for their value… the certainty of their cash flow – period! A cash flow matching investment (CDI) would allow for plan sponsors to use less fixed income, while dramatically improving the liquidity to fund benefits and expenses while buying time for non-CDI assets to grow unencumbered.

Bifurcating the plan’s assets into beta (liquidity) and alpha (growth) assets ensures that the liquidity necessary to meet monthly benefit payments is readily available without having to force liquidity during turbulent market environments. The CDI implementation will use roughly 80% fewer assets to meet the projected benefits than a traditional bond portfolio, as the funding of benefits and expenses comes from yield, principal, and unused reinvested income. This is a much more efficient asset allocation implementation than the current practice of sweeping cash from wherever it can be found. It allows all of those alternative investments to grow unencumbered as they are no longer a source of liquidity. An additional benefit includes the elimination of interest rate risk on the portion of the portfolio that is being defeased through CDI, as cash flows are funding future benefits which aren’t interest-rate sensitive.

The primary objective in managing a defined benefit plan is to SECURE the promised benefits in a cost-efficient manner and with prudent risk. Putting all of your eggs in an alternative bucket and hoping to find liquidity when it is needed doesn’t seem to fit this definition. Equity markets are expensive through the lens of any traditional valuation. Searching for liquidity during difficult markets may prove more challenging this time and it may be necessary sooner than one thinks.

It’s Happened Before!

Are you thinking that another major equity market decline isn’t possible? That we are once again entering into a new paradigm (remember 1999) casting all previous ideas on market fundamentals out the window? If yes, I implore you to think again! Market fundamentals still matter. Sure, value is always in the eye of the beholder, but eventually value does in fact matter. It is difficult to identify today any asset class exhibiting cheapness or fair value when looking at the landscape of potential investments for pension plan sponsors and their advisors. Please don’t forget the significant damage that was inflicted on pension plans and E&F’s during the Tech Bubble bear and the Great Financial Crisis when the bull markets went poof! Market declines of roughly -48% and -52%, respectively, were generated.

We recently pointed out the fact that in both of those bear markets the S&P 500 registered a low at the bottom of the bear markets near 760. Given the S&P 500s current value, a -50% decline would bring the S&P 500 to a price of 2,265. Should a retest of the lows of the last 20-years be in the cards, the return would be roughly -83.1%. Come on, Russ, when have we seen declines of that magnitude? Well, students of the markets don’t have to go back too far to remember that the NASDAQ declined -76% when the tech bubble burst. Also, as the chart below highlights, the S&P 500 fell nearly -85% in 1932. I can just hear the roar from the crowd chanting the mantra once again that “it is different this time”. Maybe, but maybe this will prove once again to be another chapter in the normal cycles of equity market performance.

Reuters Graphic

I bring this concern to your attention because pension America – private, public, and multiemployer – have benefited tremendously from the equity market rally since the bottom achieved on March 9, 2009. Please don’t continue to subject this wonderful improvement in funding to the whims of the markets. I have no clue when the next correction will come, but I do know that one will come. Based on the market’s current valuations, I don’t think that the impact will be tamer than the usual bear market experience, which has produced an average -37% correction in the previous 20 bear markets! Ouch! Take risk off the table, ensure that you have the proper liquidity necessary to meet benefits/expenses during the downdraft by building a cash flow matching portfolio to meet those projected outflows, as traditional bonds will not preserve capital in a potentially rising interest rate environment. This strategy will allow your equities and other risk assets the time necessary to work through any turbulent market environment.