Katy Burne of Dow Jones Newswires reports that pension funds have a bit of a problem. They are falling further and further behind on their obligations. They don’t want the volatility of stocks and they don’t like the yields offered by bonds. The ugly details are summarized below:
The median expected return on assets in U.S. pension plans:
Last year’s median expected return on assets among U.S. pension plans of the Standard & Poor’s 1,500 index was around 8%, according to consultancy Mercer.
The problem:
Pension funds are in a bind over how to achieve the sorts of returns they have been used to, given the pummeling stocks suffered during the financial crisis and expectations that interest rates will languish near zero for a protracted period.
Their solution:
Companies that recently set about de-risking their portfolios include retailer J.C. Penney Co. (JCP) and technology company NCR Corp. (NCR). In April, NCR announced it would change its 40% allocation into bonds to 100% by the end of 2012.
This makes perfect sense, right? After all, there is no risk in longer-duration bonds…
Milliman’s annual pensions study shows the average equity allocation has fallen more than 15% over the past three years. “This represents the movement into longer-duration bonds and hedging instruments to de-risk their investment portfolios,” explained John Ehrhardt, principal and consulting actuary at Milliman.
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From a pension-fund accounting perspective, there actually is very little “risk” in longer-duration bonds. Which you would know, if you had some familiarity with the rules that govern pension funding. The accounting perspective, along with the funding rules, create both a desire to match assets to liabilities from a cash flow perspective and a strong preference for fixed income investments (both actual and synthetic) over equities. Property and casualty insurers also face the same dilemma.
While you and I, who are not institutions, may feel that embracing the volatility in pursuit of higher compounding rates, and that these institutions are retarded for investing the way they do, we are not under their constraints and, in their position, we would have powerful incentives to behave the same way they do.
We might state the normative perspectives that “the rules are MUBARed” or “Darn the incentives, just compound at a maximal rate and let the chips fall where they may!”, the positive perspective is that there is a REASON they invest differently than we do.
The fact remains that pension funds tend to do the wrong thing at the wrong time. We’ve referenced several of those studies on our blog. They got heavily into real estate and private equity just in time to get whacked. Now risk parity portfolios are in vogue and many pensions-egged on by consultants-have increased their bond allocation and then leveraged it. In their view, this is de-risking because they can reduce their equity allocation and the portfolio’s expected standard deviation. But what is the standard deviation on fixed income rises from here? Despite the fact that there is an incentive to own fixed income from a funding perspective, most pensions have traditionally had 60/40 type allocation, all because they needed equities to hit their return targets. I guess we will have to wait and see how “de-risking” and risk parity investing work out in the future. Maybe it will work out better than tactical asset allocation, but color me skeptical.
I agree that pension fund allocators allow their emotions to influence them i.e. “do the wrong thing at the wrong time.”
Reminder, though, when you carry your bonds at amortized cost, your fixed income return has a zero standard deviation.
Funny how the accounting for something influences your opinion of its risk, isn’t it?
I agree with you that pension funds would be better off completely divorcing their assets from their liabilities, pursuing absolute returns in a systematic fashion, and funding their allocations when necessary. Barring that, they should at least be RE-risking when underfunded and DE-risking only when firmly on the glidepath. However, they’ve looked at the pros and cons and by and large decided otherwise.
Is this the model testing that you propose? I don’t see how your models wouldn’t have made it worse.
http://dorseywrightmm.com/downloads/mi_articles/DWA%20Mgr%20Insights%202010%20Q2.pdf
Linda,
See link below for a longer-term perspective:
http://www.dorseywrightmm.com/downloads/hrs_research/Asset%20Class%20Rotation.pdf
More educational material for you about how insurers and pension funds invest, from Chubb’s recent conference call.
“Q: Would something need to happen to make equities more attractive investments, and does the NEIC have any thoughts on that matter?
A: Well, we have a certain amount of our portfolio already invested in equities. We have about a little bit more than $1 billion in public equities. We’ve got about $2 billion in alternative investments. The way we view that is there’s a certain amount of our portfolio that we are comfortable investing in risk assets. Will you see that number go up periodically? Maybe, but you’re not going to see it go up dramatically. I don’t think we’re ever going to go hog-wild into equities.
A: You should remember, too, that unlike a pension fund, in equities if you’re an insurance company, you incur a significantly higher capital charge than fixed income munis. So, you not only have to earn more; you have to earn significantly more.”
So although we agree that pension fund allocators allow their emotions to influence them i.e. “do the wrong thing at the wrong time,” you have to understand that your suggestion of embracing “a tactical asset allocation approach that shifts exposure to those asset classes that have the best relative strength” faces significant regulatory and de facto regulatory (rating agency) headwinds.
Sorry about the copy-paste above having messed-up HTML, it included symbols around the names of the speakers that WordPress interpreted somehow as style tags. Maybe you could edit it? It’s supposed to be a question from Joshua Shanker and answers from Richard Spiro and John Finnegan, followed by comments from me.
You are conflating two different things. Andy’s original blog post was directed to pension funds (i.e., “Dear Pension Funds”). Pension funds do not have to take risk-based capital reserves for different kinds of assets. The issues that apply to Chubb in the Q&A above do not apply at all to pension funds. In fact, Chubb’s response says “unlike a pension fund” that they have to take risk-based reserves. Embracing a tactical asset allocation approach makes perfect sense for a pension fund-there are no regulatory or de-facto regulatory rating agency headwinds. Insurance companies are a different matter, but Andy didn’t mention insurance companies. You’ve got them linked together somehow in your post, but they are two different animals.