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.

Where Is The Disconnect? Which Americans?

Americans Feeling Better About Household Finances — Fed Survey

The above is a title from a WSJ article that appeared today. Based on the title, one would think that the average US adult is doing fairly well, and in fact, “a total of 65% of respondents in the Fed’s 2014 Survey of Household Economics and Decision making said they were “living comfortably” or “doing okay,” up from 62% in the 2013 survey, the central bank said Wednesday. In fact, “Some 29% in 2014 said they expected their income to be higher in the next year, up from 21% a year earlier.”

That all sounds rather positive until one pulls back the curtain on the true detail.  “For many Americans, household finances remain fragile: 47% said they wouldn’t be able to cover a $400 emergency expense or would have to borrow money or sell something, and 31% said they went without some form of medical care in the last year because they couldn’t afford it.”  I find it truly outrageous and disconcerting that forty seven percent of responders couldn’t meet an unexpected $400 medical emergency!!  I find it perplexing that 65% can claim that they are doing at least okay if some percent of them couldn’t come up with $400 to meet an unexpected expense.

We continue to read in the financial press how quality jobs are being created and that the unemployment rate is once again nearing “full employment”. But what doesn’t seem to get the same air time is that we have nearly 93 million age-eligible workers on the sidelines.  Among those working, there is a significant % that are forced to work multiple part-time jobs just to get by, and many of our full-time workers are in a position of underemployment given their skill set.

As you know, we are not going to see a strong economic recovery without getting an increase in demand for goods and services.  However, with this much potential demand on the sidelines, we aren’t going to see our corporations investing in plant, equipment, and inventory, likely reducing further employment gains.

Lastly, it was reported that 31% of non-retirees said they had no retirement savings or pension.  If we want to be able to manage our workforce through a normal life cycle, we need to once again find retirement vehicles that actually help employees save so that they can retire. Defined contribution plans are glorified savings vehicles. DB like plans need to be re-introduced so that we can actually retire our employees with the financial means to remain active participants in our economy.

I am outraged, by the results from this survey, and you should be, too. We are creating an environment that continues to favor only a select few, and they certainly don’t have the ability to prop everyone up.  There will be grave economic and social consequences as a result of our inability to get everyone participating in this economy!