Pension funds may be about to experience the second perfect hundred year storm in this decade. With Canadian stock markets already down this year and central banks reducing interest rates to support a soft economy, the conditions experienced in 1999-2001 appear poised to re-occur. (This combination hurts pension funds since asset values fall while discounted liability “values” increase.)
Ryan Labs Asset Management maintains metrics on indicative funded ratios for a typical U.S. pension fund. These declined from 139% to 73% from 1999 to 2002 and after climbing back to 89% in 2006 have now fallen to 80% at the end of February 2008 from where they are continuing to head south.
What should pension fund sponsors be doing to address these challenges? Other Online Expert Panel columnists have proposed new plan design—a core benefit level which is truly guaranteed and an optional benefit level which depends on market conditions and fund performance. This allows the investment manager to reconsider the investment strategy, with a core portfolio to meet the core benefits and a more risky approach being taken with the “surplus” assets (akin to the insurance industry model). As funded ratios decline, plans need to be de-risked so as to ensure that the core benefits are secure.
Fund sponsors who have adopted a liability-driven investing (LDI) approach should be well positioned to weather the storm and guarantee the core benefit at a minimum. For the others, there may still be time to adopt a more defensive stance.
Fixed-income strategy needs to move away from pure duration “bets,” risky at the best of times but particularly when interest rates and funded ratios remain low. While the last few years have been bad times to assume credit risk in fixed-income portfolios, now is the time for bold investors to explore (with eyes wide open) alternative fixed-income strategies. Admittedly the credit debacle appears to be far from over, but the margins available on good “names” may soon reach a high water mark again.
As for the rest of the portfolio, while it may be too late to exit public stock markets, there are still opportunities to select the right sectors for frothy periods (traditional defensive stocks as well as energy and commodity bets in light of global trends). Alternative assets may also be returning to more reasonable valuation levels for an entry point opportunity. Additionally the value of manager skill (alpha) tends to peak when the going gets tough. These turbulent times are ideal for experienced investors who know how to ask the right questions, cut through the bafflegab and insist on transparency and good investment process.
Surprisingly, many traditional investment managers have failed to recognize the market trends in client demands, so this period may also see some shifting of market share among these providers as well. To return to the storm analogy, bad weather conditions separate the “day sailors” from the serious competitors.
For DC plan members, plan sponsors should be vigilant for the popular “buy high, sell low” investment strategy. While this disease can also affect experienced institutional investors, it almost never fails to find a bull’s-eye with those who fall asleep when markets are calm, then awake with a compelling need to take some decisive action. Educational notes should remind members of investment platitudes like long time horizons, mean reversions, and herd mentality.
A final word of caution on LDI: while it is tempting to batten down the hatches and lock in a “matching” strategy at times like these, it is important to remember that the only perfect hedge is in the emperor’s garden in Japan. Active management need not mean taking action, but it does mean being proactive by taking ownership and accountability for results. Here’s to smooth sailing!