The whole investment strategy of US defined benefit (DB) pension funds must be re-thought. Otherwise, they and the companies that sponsor them risk bankruptcy – or at least serious financial trouble. The alarm is being raised by Ryan Labs, a research organisation based in New York and the proprietor of the Liability Index.
The index is a proxy for the average pension fund’s liabilities (average duration of 15.5 years). It is elaborated according to the rules set by the Financial Accounting Standards Board (FASB): each liability must be priced as a high quality zero-coupon bond whose par value matches the liability payment amount and whose maturity matches the liability payment date. “The economic present value of pension liabilities is extremely interest rate sensitive,” according to the special study ‘Pension Alert!’, just released by Ryan Research. “Since recent interest rates have rallied to some of the lowest yields in modern history, the growth in present value of liabilities has been enormous”.
“The problem with most DB plans is that their asset allocation models do not compare the value of assets with the value of liabilities, so they are not aware of the current deficit problem,” stresses Ronald Ryan, president of Ryan Labs.
The ‘alert’ is based exactly on this comparison. On one hand, there is the performance of the average US DB pension fund portfolio, whose asset allocation is 5% cash, 30% bonds, 60% domestic equities, 5% international equities. The returns of this portfolio were: 28.7% in 1995; 15.2% in 96; 23% in 97; 21.4% in 98; 13.7% in 99. Then they dropped with the downturn stock market: -2.5% in 2000 and
-16.6% in the first nine months of 2001. But, the absolute return does not mean anything without acknowledging the growth of liabilities, which was higher than assets’ return in 1995 (+41.2%), in 2000 (+26%) and in the first 2001 nine months (+5.8%), due to the rise in bond prices with the decrease of bond yields.
What DB pension plans should pay attention to, according to Ryan Labs, is the difference between portfolio’s returns and liabilities’ growth – the two numbers should match. If portfolio’s returns are better, the fund has a surplus, but if liabilities grow quicker, the fund is in danger of a deficit. This is happening right now with 2000 having been “the worst pension year in history” with pension assets underperforming pension liabilities by about 28.5%, more than twice the previous worst year of 1995 (-12.5%). The negative trend continued in 2001 (underperformance by 16.6% in the first nine months).
“Moreover, since December 1988, the cumulative total return difference of pension assets minus liabilities is 0.84%… no value added. It is hard to believe that an asset allocation, heavily skewed to equities (which enjoyed the greatest bull market in American history), could not significantly outperform a low yielding, high quality liability portfolio over 12 years and nine months. Perhaps, traditional asset allocation models and asset management strategies need rethinking!,” says the ‘Alert’.
Indeed, this is the solution proposed by Ryan Labs: “Only a bond portfolio matched to liabilities provides the least volatility solution”. Ronald Ryan elaborates on this: “During the last 20 years or so, US pension funds have been caught by the asset allocation fever. They’ve been trying to optimise their surplus, investing in equities, which are thought to outperform bonds in the long period. But equities do not match liabilities and when they underperform, they also create big deficit problems. The surplus optimisation is not the right message. Pension funds should go back to defeasance, dedication and immunisation strategies, which were adopted in the 1970s and early 1980s, when interest rates were very high”. Ryan refers to mathematical models using 100% bond portfolio to match liabilities: “It’s the only way for companies to be comfortable with their pension liabilities. Otherwise, they must take into account to pay higher a contribution, when interest rates’ volatility affects their plans”.
Some investments in equities, or alternative assets like real estate, can be considered either if a pension fund runs a surplus or, at the opposite, if it has accumulated a significant deficit and doesn’t know how to fix it. In the first case, however, “the surplus should be isolated and treated as a separate portfolio, with a distinct objective and policy constraints. Liabilities should not be funded here, hopefully,” according to ‘Pension Alert!’.
In the UK, the Boots group’s pension fund has already dramatically switched all its investments into bonds, points out Ronald Ryan, who believes this is the right path and should soon be followed in the US.
Ryan’s ‘alert’ and recommendations will be discussed at a New York conference, in April 7 and 8. No doubt, it will be a lively discussion.