'Boots for everyone'
An Englishman was the hero in New York city at the second Pension Forum organised by Ryan Labs, an American research organisation and the proprietor of the Liability Index. In front of a few dozens pension fund managers and advisers gathered at the Plaza Hotel for a couple of days last month, the Boots Company’s head of corporate finance John Ralfe was introduced as the example to follow for all DB (defined benefits) pension schemes. “Boots for everyone” was indeed one of the slogans of the conference, where Rafle explained why last year he decided to move all the £2.3bn (E2.6bn) of the UK company to a 100% AAA long dated sterling bonds portfolio.
That was the right move, according to Ronald Ryan, president of Ryan Labs, which for many years has been advocating bond portfolios as the only effective way to reach DB pension funds’ goals.
It makes no matter that for the first quarter of 2002 US pension fund assets outperformed the growth of liabilities: “The single most positive development in the land of pensions in nearly two years”, as Ryan puts it. The problem is that pension funds’ managers still do not understand that their current asset allocation depends on myths and a rear-view mirror attitude (to look at past performances as a guide to the future) and it does not guarantee they will be able to pay the promised retirement benefits.
All the conference was focused on this issue. Returns on pension funds’ assets must be compared with the growth of their liabilities, measured as high quality zero-coupon bonds whose pure value matches the liabilities payment amounts and whose maturity matches the liability payment dates. Based on these assumptions, Ryan Labs has elaborated the Liability Index as a proxy for the average pension fund’s liabilities, with an average duration of 15.5 years. Because of the last two years’ deep decrease of interest rates to the lowest yields in modern history, the value of liabilities has grown dramatically: +25.96%t in 2000 and +3.08% in 2001. On the other hand pension funds’ assets – 60% in American equities, 5% in international equities, 30% in bonds, 5% in cash according to the average model – have lost 2.59% in 2002 and 5.40% in 2001. The combined results mean a negative difference of 28.46% in 2000 and 8.48% in 2001: a real threat to the future of US pension funds and their corporate sponsors.
The first 2002-quarter has been more positive. Interest rates have started increasing again and so the Ryan Labs Liabilities Index has declined by 2.80%, while all four asset classes have produced positive returns: +0.28% the Standard&Poor’s stock index, +0.57% the MSCI international equities index, +0.09% the Lehman aggregate bond index, +0.36% the Ryan Cash Month bill index. The total return has been 0.29% that added to the reduction of liabilities equals a positive increase of 3.09% of pension funds’ value.
That is not enough to solve the many problems US DB schemes face. Not only they do not understand that assets versus liabilities is a relative game and must be monitored very frequently – not once a year, but each day, month, quarter – to check if the fund is well balanced, but they still rely on return on assets (ROA) assumptions way too high. The average pension fund, for example, assumes that the Standard&Poor’s index is growing at a 9.2% pace a year, which looks quite unrealistic to most experts. It’s true that current accounting rules allow companies to smooth the difference between assumed and real returns over 15 years. But the negative 2000 and 2001 gaps represent already a heavy drag on companies’ earnings through 2015 and the situation may worsen.
The solution proposed by Ryan Lab is first to tailor a liability index for each pension fund, according to its active and retired members’ situation. Next step is to build a bond portfolio that is indexed to its liabilities so that it perfectly matches them, lowering risks and costs to a minimum, removing volatility from the corporate sponsor’s earnings and contributions.
One big question is unanswered: what if really all US DB pension funds follow Ryan Labs strategy? What will the impact on the US economy be? So, during the last few years European countries have been trying to go towards the US model: a “virtuous” circle among “public companies-stock markets-investors (especially institutional ones like pension funds)”, where the risk-taking attitude was the key. What will happen if pension funds stop being large players in this circle?