By: Russ Kamp, Managing Director, Ryan ALM, Inc.
As most investors appreciate, trying to time the markets can prove to be a fool’s game. We know that timing the tops, bottoms, and dips is incredibly challenging and often leads to excessive turnover coupled with transaction costs that can erode potential value-added. As a result, it is best to remain in the equity markets through thick and thin, but does that mean you do nothing? Of course not. The graph below only goes through August 2019, but it dates back to 1970 and clearly demonstrates the impact on the total return to the S&P 500 when missing just a couple of handfuls of trading days.
First, the plan’s investment policy statement (IPS) must clearly highlight a targeted allocation for equities (S&P 500 in this case) with an appropriate range above and below that target used for rebalancing purposes (+/- 5%?). The graph above highlights the impact of an all-or-nothing strategy, which pension systems would likely never engage in, but they should bring discipline to the asset allocation process by taking profits when equities have demonstrated enough outperformance relative to other asset classes to have the allocation reach the upper band. Equally important is the realization that stocks will provide value over the long term. Forcing a buy decision at the bottom of an allocation band, although it may not be easy, is the right decision in the long run.
That said, we have a tendency in our industry to seek liquidity wherever it can be found in order to meet the required monthly benefit payments and expenses. This often leads to assets having to be sold when enough liquidity cannot be found. Unfortunately, this may lead to selling equities near the bottom of their market cycle instead of buying them at that point. One way to avoid this unfortunate occurrence is to put in place an asset allocation strategy that divides the assets into liquidity (beta) and growth (alpha) buckets that each have a specific role within the portfolio.
In our model, the liquidity bucket uses investment grade fixed income to meet all of the plan’s cash flow needs. Bonds are the only asset with a known semi-annual cash flow (interest payment) and terminal value at maturity (par) which is why bonds have always been used to defease liabilities (pensions, lotteries, NDTs, OPEBs, and insurance companies). This liquidity bucket will be used to meet all of your ongoing liability cash flows as long as the allocation lasts. We recommend sustaining a 10-year allocation, if possible, by back-filling (rebalancing) the bond cash flow matched portfolio on an annual basis.
Creating a liquidity bucket will permit the alpha assets to grow unencumbered. There will be no forced selling of these assets during periods of challenged liquidity. During market downturns similar to what we are currently experiencing, there will be no temptation to sell, as you’ve built a 10-year horizon for your equities to wade through the troubled waters. Importantly, your fund gets to reinvest the dividends back into the equity market instead of using them as a cash proxy. Studies that we’ve highlighted previously suggest that the S&P 500 derives a significant percentage of its total return from dividends and the reinvestment of those dividends (as much as 48% on a 10-year moving average).
Having all of your eggs (assets) in an asset allocation basket singularly focused on a return on asset (ROA) assumption, as our industry continues to do, has created volatility of returns but no guarantee of success. We believe that the primary objective in managing a DB pension plan is to secure the promised benefits in a cost-efficient manner and with prudent risk. It is not the achieving of the ROA. Split your assets into two buckets. Allow the liquidity bucket to take care of all your funding. Doing so will allow you to sleep better at night knowing that you have the participants’ benefits covered and you’ve now bought time for your equity assets to grow unencumbered. It is a win, win!