In November 2009, I questioned if the pension industry is an example of ‘The Peter Principle’ in action. In other words, has the pension industry been promoted to its own level of incompetency? My conclusion was no, due to the very difficult and prolonged landscape presented by low interest rates for defined benefit pension plans. As much as you may hear about liability-driven investing, pension liabilities are actually paid by investment-driven results.
Currently, we continue to see shifts in the ‘asset allocation versus manager structure’ debate. The ‘manager structure’ side continues its path of using non-market directed investments such as real estate, infrastructure, private equity and other types of alternatives. While the governance aspects of these types of investments are more challenging to pension committees and trustees, these investments are slowly but surely becoming more mainstream.
The gravitation back towards asset allocation through the concept of ‘dynamic asset allocation,’ has become an interesting trend. This effectively means changing your strategic asset allocation on a more regular basis based on one of two fundamental bases:
1. Active tactical asset allocation model – this approach relaxes the rebalancing and control ranges (minimum and maximums for each asset class) typically used by pension funds in Canada. Based on certain economic factors (you are taking a page from the investment manager’s playbook here) temporary adjustments to the long-term strategic asset allocation can be made to reflect prevailing market conditions. These adjustments take the form of additions to or deductions from the strategic asset allocation for each asset class. Adjustments may be made in several ways including:
• when the Fund’s actual distribution of assets has drifted outside the normal control ranges, rebalancing may be postponed when the actual position falls within the control range around the ‘adjusted’ asset distribution; or
• when the adjustments are significant and evidence for significant differences in relative market valuations is strong, then the pension committee/ trustees may decide to switch assets from one portfolio to another, in order to move towards the adjusted asset distribution.2. Dynamic asset allocation model – advocates of this approach believe that the traditional approach of maintaining the same asset allocation, regardless of the economic environment, the funded status of the pension plan or the financial strength of the plan sponsor is no longer appropriate. The traditional static approach does not sufficiently address the ‘tail risk’ associated with the asset allocation and the avoidance of ‘ruin. Tail risk describes the worst performance a portfolio could potentially experience over intermediate time intervals. Ruin is the level below which the plan sponsor cannot afford to sink (i.e. where funded ratios are so low that they trigger additional contributions that the plan sponsor cannot afford). Plan sponsors are in the best position to avoid ruin when they fully understand and properly manage tail risk. In general, pension plan governance does not facilitate quick decisions. Consequently, dynamic asset allocation generally requires plan sponsors to pre-approve certain strategies. For example, plan sponsors can identify funded status trigger points that automatically reduce the risk budget and/or modify the asset allocation.
The two models outlined above are not dramatic leaps from the current governance protocols used by pension committees/ trustees in terms of investment policy but these approaches do clash with plan sponsors’ historical reluctance to deviate from the ‘herd.’ Regardless, it is important to analyze the asset classes and the evolution of asset allocation investment tools so that plan sponsors can understand the potential risks and rewards.
The case for a Capital Markets Safety Board
In my September 2009 submission, I wrote about systemic risk and the efforts of mainly regulatory bodies to manage and mitigate the catastrophic form of this risk. The highlight of the article was the concept proposed by Professor Andrew Lo of MIT’s Sloan School of Management to create a truly independent ‘Capital Markets Safety Board’ whose role would be akin to that of the National Transportation Safety Board (NTSB). The article also discussed the apparent shift from the historical emphasis on asset allocation to a better balance between asset allocation and manager structure (i.e., benefits of creating a more diversified portfolio than just “asset allocation, asset allocation, asset allocation”).