That esteemed financial guru, Yogi Berra, once said, “You’ve got to be very careful if you don’t know where you are going, because you might not get there.”
I have it on good authority that Berra was referring specifically to pension fund investing when he made this comment, which would explain why so many defined benefit pension plans have arrived at a precarious funding position and why some don’t seem to know how they got there.
If you look at the objectives contained in the investment policy. You may find something like, “To achieve the highest possible return commensurate with a prudent level of risk.” This objective is so vague that it has no practical purpose. Since the best definition of “risk” for a pension fund is the extent to which the fund’s objectives may not be achieved, having “risk” in the objective leads to a circular definition.
We need to define investment objectives that are specific, realistic, and flexible.
Be specific
The goal of the pension fund is to pay for the pensions. We know how much money we have today (our assets) and we know how much money we are likely to need (our liabilities), both when we come to pay the pensions in future (going concern) and if we needed to settle up right away (solvency). So we have the specific financial information upon which to base our plan.
Defining the fund objectives in terms of parameters such as funded status, cash flow requirements and the effect on the sponsor’s financial statements permits us to monitor the plan on an ongoing basis, and to continuously assess the best way to manage the money to achieve these objectives. The focus should then shift from ‘is our manager above median’ to ‘are we meeting our objectives.’
Be realistic
Once we have determined where we are today and where we need to get to in future, we need to map out the best route to get there. Our route is dependent upon investment return expectations. The return that should be assumed is what the markets will give us, nothing more.
Actuaries have traditionally included a provision for adverse deviation (PAD), lowering the discount rate slightly to be conservative. But there appears to be a desire to augment the discount rate by assuming that we can all achieve a higher return than what the markets give us. The discount rate is boosted by an assumption that our active managers can beat the markets and add higher return, or through the magic of rebalancing and diversification, or through loading up on alternative asset classes. It is great if these or any other approaches achieve a higher return for us in future; we call this an experience gain from investments. But to assume this success in our planning before it happens is equivalent to adding a PWT (provision for wishful thinking).
A realistic assessment of expected future investment returns may lead to some tough, but very necessary, decision-making regarding the need to raise contributions or lower benefit levels. Being realistic means dealing with these issues sooner rather than when it is too late.
Be flexible
Plans need to be able to be changed in reaction to changing circumstances; and the asset mix defined by the plan objectives should be dynamic rather than static, because the funding measures and other parameters are continuously changing. This is in contrast with the classic ALM approach, where these parameters are quantified, a plan is developed, a static asset mix is determined, and nothing is changed until the next ALM several years later.
If we are managing asset mix relative to fund objectives, for example, rather than an immutable target of x% in fixed income, we might say that we will have x% in fixed income when the funded ratio is y%, and for every increase of Δy% in funded ratio, fixed income will increase by λx%.
So rather than spending time listening to your investment manager drone on about the impact that decreasing coffee production in Columbia is going to have on domestic insurance stocks (because nobody drinks more coffee than those guys), perhaps more time could be spent by the committee reassessing the investment objectives and monitoring progress relative to those objectives. After all, when it comes to pension funding, without a proper road map we are unlikely to get to where we need to be. And where we end up instead might not be pretty.