Tag Archives: Asset allocation

04.18.24
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What’s the Motivation?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

There appears in the WSJ today an article stating that pension plans were pulling “hundreds of billions from stocks”. According to a Goldman analyst, “pensions will unload $325 billion in stocks this year, up from $191 billion in 2023″. We are told that proceeds from these sales will flow to both bonds and alternatives. First question: What is this estimate based on? Are average allocations now above policy normal levels necessitating a rebalancing? Are bonds more attractive given recent movements in yields?

Yes, equities have continued to rally through 2024’s first quarter, and the S&P 500 established new highs before recently pulling back. Valuations seem stretched, but the same argument could have been made at the end of 2023. Furthermore, US interest rates were higher heading into 2023’s fourth quarter. If bond yields were an attractive alternative to owning equities, that would have seemed the time to rotate out of equities.

The combination of higher interest rates and equity valuations have helped Corporate America’s pensions achieve a higher funded status, and according to Milliman, the largest plans are now more than 105% funded. It makes sense that the sponsors of these plans would be rotating from equities into bonds to secure that funded status and the benefit promises. Hopefully, they have chosen to use a cash flow matching (CFM) strategy to accomplish the objective. Not surprisingly, public pension plans are taking a different approach. Instead of securing the benefits and stabilizing the plan’s funded status and contribution expenses by rotating into bonds, they are migrating both equities and bonds into more alternatives, which have been the recipients of a major asset rotation during the last 1-2 decades, as the focus there remains one of return. Is this wise?

I don’t know how much of that estimated $325 billion is being pulled from corporate versus public plans, but I would suggest that much of the alternative environment has already been overwhelmed by asset flows. I’ve witnessed this phenomenon many times in my more than 40 years in the business. We, as an industry, have the tendency to arbitrage away our own insights by capturing more assets than an asset class can naturally absorb. Furthermore, the migration of assets to alternatives impacts the liquidity available for plans to meet ongoing benefits and expenses. Should a market correction occur, and they often do, liquidity becomes hard to find. Forced sales in order to meet cash flow needs only serve to exacerbate price declines.

Pension plans should remember that they only exist to meet a promise that has been made to the participant. The objective should be to SECURE those promises at a reasonable cost and with prudent risk. It is not a return game. Asset allocation decisions should absolutely be driven by the plan’s funded status and ability to contribute. They shouldn’t be driven by the ROA. Remember that alternative investments are being made in the same investing environment as public equities and bonds. If market conditions aren’t supportive of the latter investments, why does it make sense to invest in alternatives? Is it the lack of transparency? Or the fact that the evaluation period is now 10 or more years? It surely isn’t because of the fees being paid to the managers of “alternative” products are so attractive.

Don’t continue to ride the asset allocation rollercoaster that only ensures volatility, not success! The 1990’s were a great decade that was followed by the ’00s, in which the S&P 500 produced a roughly 2% annualized return. The ’10s were terrific, but mainly because stocks were rebounding from the horrors of the previous decade. I don’t know what the 2020s will provide, but rarely do we have back-to-back above average performing decades. Yes, the ’90s followed a strong ’80s, but that was primarily fueled by rapidly declining interest rates. We don’t have that scenario at this time. Why assume the risk?

04.12.24
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The Truth Will Set You Free!

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Managing a pension plan should be all about securing the promised benefits at a reasonable cost and with prudent risk. I believe that most plan sponsors would agree, yet that is not how plans are managed, especially public and multiemployer plans that continue to pursue the return on asset assumption (ROA) as if it were the Holy Grail. I’ve written quite a bit on this subject, including discussing asset consulting reports that should have the relationship of plan assets to plan liabilities on page one of the quarterly performance reports.

We know that pension liabilities are like snowflakes, as there are no two pension liability streams that are the same given the unique characteristics of each labor force. Furthermore, most pension actuaries only produce an annual update making more frequent (monthly/quarterly) updates more challenging. Would plan sponsors want a more frequent view of the liabilities if they were available? I think that they would. Again, if securing the promised benefits are the primary objective when it comes to managing a pension plan, then plan sponsors need a more frequent view of the relationship between assets and liabilities.

Why is this important? First and foremost, the capital markets are constantly moving, and the changes impact the value of the plan’s assets all the time. But it isn’t just the asset-side that is being impacted, as liabilities are bond-like in nature and they change as interest rates change. We’ve highlighted this activity in both the Ryan ALM Pension Monitor and the Ryan ALM Quarterly Newsletter. However, accounting rules for both multiemployer and public plans allow a static discount rate equivalent to the plan’s ROA to be used that hides the impact of those changing interest rates on the value of a plan’s liabilities and funded status.

What if a more frequent analysis was available at a modest cost. Would plan sponsors want to see how the funded status was behaving? Would they want that comparison available to help with asset allocation changes, especially if it meant reducing risk as funding improved? I suspect that they would. Well, there is good news. Ryan ALM, Inc. created a Custom Liability Index (CLI) in 1991. The CLI is designed to be the proper benchmark for liability driven objectives. The CLI calculates the present value of liabilities based on numerous discount rates (ASC 715 (FAS 158), PPA – MAP 21, PPA – Spot Rates, GASB 67, Treasury STRIPS and the ROA). The CLI calculates the growth rate, summary statistics, and interest rate sensitivity as a series of monthly or quarterly reports depending on the client’s desired frequency.

The above information is for an actual client, who we’ve been providing a CLI for 15+ years. This client has elected to receive quarterly reviews. They’ve also chosen to see the impact on liabilities for multiple discount rates, including a constant 4.5% ROA, which could easily be a pension plan’s ROA of say 7%. As you will note, the present value (PV) of those future value (FV) liabilities are different, and they could be dramatic, depending on the interest rate used. In this case, the AA Corporate rate (5.48% YTW) produces a funded ratio of 56.7%, while the flat 4.5% rate increases the PV liabilities thus reducing the funded status by more than 20%.

Using Treasury STRIPS as the discount rate produces the lowest funded ratio of 33.7% or 23% lower than using the AA Corporate discount rate.

With this information, plan sponsors and their advisors (consultants and actuaries) can make informed decisions related to contributions and asset allocation. Most plan sponsors are currently blind to these facts. As a result, decisions may be taken without having all of the necessary facts. Pension plans need to be protected and preserved (Ryan ALM’s mission). Having a complete understanding of what those future promises look like is essential.

You’ve made a promise: measure it – monitor it – manage it – and SECURE it…   

Get off the pension funding rollercoaster – sleep well!

10.02.15
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Weakening Jobs Growth To Further Pressure DB Plans

Given the news from this morning regarding US job growth (only 142,000 jobs added and revisions down in the previous two months), it would not surprise us to see US interest rates continue to fall.  If in fact this happens, DB plans’ funded ratios and funded status will continue to weaken. As we’ve reported on numerous occasions, plan liabilities, although discounted at the ROA, do not grow at the same rate as assets.

Liability growth has far outpaced asset growth in the last 15 years, and the asset allocation mismatch that exists between a plan’s assets and liabilities continues to be dramatic.  With most everyone expecting interest rates to rise, fixed income exposures have been reduced and bond durations shortened. A combination that continues to weigh on plan performance.

We continue to believe that weak global growth will keep interest rates low for the foreseeable future, and as such, fixed income exposures should be increased and reconfigured to meet near-term liabilities.  I will be discussing this concept / strategy at the upcoming FPPTA conference on Tuesday in Naples, FL.

Plans continue to focus almost exclusively on their fund’s ROA, but the liability side of the equation needs some attention, too, especially given the prospects for continuing global economic weakness.  In this environment, a plan will not close it’s funding gap through outperformance relative to its ROA.

06.30.15
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Market Volatility Giving You The Woollies?

I’ve witnessed many market declines during my more than 33 years in the investment industry, and I would be lying if I told you that I called the beginning, end, and ultimate magnitude of any of the sell-offs.  Market declines are part of the investing game.  But just knowing that isn’t enough, as unfortunately, they can have a profound impact on retirement plans and retirement planning, both institutional and individual, as they impact the psyche of the investors.

It is well documented how individuals tend to buy high and sell low. The market crash of 2007 – 2009 drove many individuals out of equities at or near the bottom, and many of those “investors” have kept their allocations to equities below 2007 levels. It hasn’t been that much better for the average institutional investor either.  We are aware of a number of situations (NJ for one) that plowed into expensive, absolute-return product at the bottom of the equity market only to see that portfolio dramatically underperform very inexpensive beta, as the equity markets have rallied since March 2009.

In some cases, the selling “pressure” was the result of liquidity needs, which lead to the tremendous explosion in the secondary markets for private equity, real estate, etc. in 2009.  The E&F asset allocation model, made so famous by Yale, was the undoing for many retirement plans, as the failure to secure adequate liquidity exacerbated market losses. Who knows whether the turmoil in Greece will lead to their exit (expulsion) from the Euro, but there is certainly heightened fear and volatility in the global markets? Are you currently prepared to meet your liquidity needs?

As we’ve discussed within both the Fireside Chats and on the KCS blog, the development of a hybrid asset allocation model geared specifically to your plan’s liabilities, can begin to de-risk your plan, while dramatically improving liquidity.  The introduction of the beta / alpha concept will provide plan sponsors with an inexpensive cash matching strategy that meets near-term benefit needs, while extending the investing horizon for the less liquid investments in your portfolio. By not being forced to sell into the market correction, your investments have a greater chance of rebounding when the market settles.

Traditional asset allocation models subject the entire portfolio to market movements, while the beta / alpha approach only subjects the alpha assets to volatility.  But, since one doesn’t have to sell alpha assets to meet liquidity needs given that the beta portfolio is used for that purpose, the volatility doesn’t matter. Don’t fret about Greece and its potential implications for the global markets and your plan. Let us help you design an asset allocation that improves liquidity, extends the investment horizon for your alpha assets, and begins to de-risk your plan, as the funded ratio and status improve.

06.11.15
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The latest Iteration of the “High School Dance”

It has been a very long time since I was in high school, and as a result, things may be different today.  But, what I remember about my high school days and the dances at Palisades Park, NJ, were that the boys stood on one side of the gym and the girls stood on the other.  Occasionally a couple of girls would dance, but there was little fraternizing among the boys and girls.

Well, I get the same sense about the management of DB pension plans today, as I did at those dances a very long time ago.  It seems to me that we have on one side of the “gym” assets and on the other side is liabilities, and never the twain shall meet.  As a result, DB plans haven’t found their rhythm and there is no dancing!

We get periodic updates from a number of industry sources highlighting how the funded status is improving or deteriorating.  But we don’t seem to get a lot of direction on how we should mitigate the volatility in the funding of these extremely important retirement vehicles.  I can say with certainty that it isn’t striving to achieve the ROA.  That’s been tried, and DB plans continue to see deterioration in their funded ratios.

For too long, the asset side of the pension equation has dominated everyone’s focus, and as a result, a plan’s specific liabilities are usually only discussed when the latest actuarial report is presented, which is on a one or two year cycle.  This isn’t nearly often enough. We suggest that the primary objective for the assets should be the plan’s liabilities, and that every performance review start off with this comparison.  However, in order to get an accurate accounting of the liabilities one needs a custom liability index (CLI).

In order to preserve DB plans we need assets and liabilities dancing as one. Without this, DB plans face a very uncertain future. Are you ready to bring both parties to the dance floor?

06.10.15
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Next 10 years Could Really Challenge Your ROA Assumption – Are You Ready?

According to Standard & Poor’s Institutional Market Services, which polled 679 defined benefit plan sponsors, the median return on asset (ROA) assumption is 7.56%, down slightly from 2013.  How realistic is this objective?  According to Rob Arnott, sponsors will have a very difficult time in the near future meeting this objective. Arnott gave investors a gloomy forecast for medium-term returns at the Inside ETFs Europe conference recently, and urged the audience to think of a new way to attack the ROA challenge.

According to Arnott, “10-year forward-looking expected returns are unanimously low.” He is predicting that Core fixed-income stands at 0.5 percent real returns as well as long-dated inflation linked bonds. Long Treasuries will go barely above zero. U.S. equities are 1 percent above inflation, and small-caps also give 1 percent, despite their yield of 1.8 percent.

Furthermore, the “Growth of earnings and dividends over and above inflation is 1.3 percent, not the 5 percent or more that Wall Street wants us to believe,” said Arnott.

Importantly, these real return expectations are before fees, which for many active strategies would “eat” most of the potential gain. Arnott’s research found that the U.S. top-quartile active manager pockets 0.9371% of the “alpha” and only passes on 0.0629% on to the client.

The plan sponsor quest to meet the ROA challenge has also produced exceptional volatility.  In the next 10 years, volatility is likely to remain at these levels or increase, but it seems that the return won’t be there to compensate for that extra volatility.  Importantly, we believe that liability growth is likely to be flat to negative during the next 10 years as interest rates rise, so a more conservative asset allocation may accomplish a sponsor’s funding goal.

We would suggest that a plan sponsor focus more attention on the plan’s liabilities to drive asset allocation decisions.  However, in order to accomplish this objective, the plan needs to have greater transparency on their liabilities.  Receiving an actuarial report every one or two years will not suffice.  In order to gain greater clarity, we would suggest that plans have a custom liability index (CLI) produced. The CLI will use various discount rates, and will provide a view with and without contributions factored in.  The CLI is provided on a monthly basis.

As a reminder, the only reason that a DB plan exists is to fund a benefit that has been promised in the future. Knowing how that benefit is changing on a regular basis should be a goal of every plan. We stand ready to provide you with the tools necessary to gain greater transparency on your plan’s liabilities, since it doesn’t seem that plan’s will win the funding game by generating outsized returns in the next decade.

05.01.15
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KCS May 2015 Fireside Chat – Do You Know The Answer?

We are pleased to share with you the latest edition of the KCS Fireside Chat series.

Click to access KCSFCMay2015.pdf

This article is the 34th in our series.  In this piece we explore whether or not the US Federal Reserve is likely to raise interest rates in the near-term – the $64,000 question.

The uncertainty surrounding this action continues to challenge DB plan asset allocation decisions.  Level to falling US rates will continue to harm DB plan funded ratios.

We hope that you find our insights thought provoking.  Please don’t hesitate to reach out to us with any comments and / or questions, or if we can be of any assistance to you.

03.19.15
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My plan was up 10% in 2014 – Was that Good?

We frequently receive updates in our email in-boxes about various pension funds and their returns in 2014, and not surprisingly the numbers vary quite a bit.  According to Wilshire’s TUCS comparisons, the average public pension plan was up 6.76% in 2014. However, we’ve seen some funds reporting returns closer to 10%.  It seems to us that a plan did better the more traditional the plan’s asset allocation, meaning more equities and fixed income, and less in alternatives, particularly hedge funds.

In most cases the announcement of a total return was hailed as good or bad depending on how it did relative to the plan’s return on asset assumption (ROA).  However, is that really the true objective? If a plan generated a 10% return and its ROA was 8% (49% of public plans have 8% as their ROA) it was reported as a great year.  However, what did the plan’s liabilities do in 2014? Since most sponsors and consultants assume that liabilities grow at the ROA, they would likely assess that 2014 was good on both the return and liability front.  Unfortunately, they would be wrong.

With the precipitous decline in US interest rates continuing through much of 2014, the average defined benefit plan had its liabilities grow more than 15% in 2014.  Given this fact, I’d say that any return that didn’t exceed liability growth was a poor year, with the average public pension (6.8%) doing quite poorly versus liability growth.

Can you imagine if you were playing a football game without a scoreboard? Let’s assume you are in the fourth quarter and you’ve scored 27 points.  How do you play your offense or defense? Do you get more conservative or aggressive? You don’t know, do you? Exactly! Well, this is how Pension America is playing the game.

A significant majority of DB plans only get a look at their liabilities every 1-2 years, and the results are usually presented with a 3-6 month lag.  It is quite difficult to have a responsive asset allocation when you don’t know whether or not you are winning the pension game versus your liabilities, just as it is impossible to play football if you don’t know how your opponent is performing.

At KCS we place liabilities and the management of plan assets versus those liabilities at the forefront of our approach to managing DB plans. Pension America has seen a significant demise in the use of DB plans, and we would suggest it has to do with how they’ve been managed. Focusing exclusively on the asset side of the equation with little or no regard to the plan’s  liabilities has created an asset allocation that is completely mismatched versus liabilities.  It is time to adopt a new approach before the remaining 23,000+ DB plans are all gone!

04.16.14
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U.S. Treasury STRIPS – The Naked Truth

At KCS, we have been sharing ideas with plan sponsors to reconfigure their existing fixed income exposure into an enhanced asset allocation framework that might just stabilize a plan’s funded status and contribution costs.  The motivation has been driven by the fear of rising interest rates.  Unfortunately, this fear has provided the impetus for many of our friends in the industry to shed exposure to domestic fixed income programs.  Stop!

Despite the near unanimous expectation that rates have to rise from these “historically low levels”, the fact is that interest rates have actually fallen rather significantly year to date.  In fact, the U.S. 10-year Treasury Bond has seen its yield fall by 37 bps (as of 4/15).  The KCS crystal ball is no clearer than that of any other market participant, so why “guess” where rates are going.

We think it would be advantageous for plan sponsors to reconfigure their existing fixed income exposure to include a separate, lower risk portfolio that matches near term benefit payments for the next 5-7 years depending on the current funded ratio of the plan and projected future contributions. This strategy will improve the plan’s liquidity, while extending the investing horizon for less liquid assets that we would use to support their active portfolio.

We have recommended that the lower risk portfolio be invested in U.S. Treasury STRIPS to match benefit payments.  However, that instrument’s name raises more questions than answers, and has often turned potential users off before the conversation really heats up.  We are here today to say that STRIPS, although misunderstood, are actually low risk, useful fixed income securities.

STRIPS is an acronym for “separate trading of registered interest and principal securities”. Treasury STRIPS are fixed-income securities, sold at a significant discount to face value and offer no interest payments because they mature at par, which is why they are so good at matching projected cash flows. Backed by the U.S. government, STRIPS, which were first introduced in 1985, offer minimal risk and some tax benefits in certain states, replacing TIGRs and CATS (…retired to the zoo?!) as the dominant zero-coupon U.S. security.

If you are concerned about your plan’s funded status, the direction of interest rates and / or the current composition of your fixed income assets, call us to discuss a new path forward. We are here and ready to help you!

03.26.14
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TIme for a New Gameplan?

TIme for a New Gameplan?

As we touched upon in our January, 2013 Fireside Chat, the Private, Public and Union pension deficit in America exceeds $4 trillion, when assets and liabilities are marked to market. Since 1999, pension asset growth has significantly underperformed liability growth and the return on assets (ROA), causing increased contribution costs and a national pension crisis. The true objective of any pension plan is to fund their liabilities (benefit payments) at low and stable contribution costs –with reduced risk through time.

Do you need a new game plan? We’ll explore the asset allocation issues sponsors face and offer solutions for underfunded plans.