A favorite story of mine is about the father who buys his young son his first bat and ball. Excited, the boy races outside, throws the ball up in the air and swings but misses. Again and again the boy swings and misses the ball. Seeing his son's failed attempts from a window and feeling his own anguish, the father is compelled to go out and console his son. As he walks up, the boy turns to his dad with a surprising big grin on his face and, in an excited voice, exclaims: "Nice pitching, huh, Dad!"
I was reminded of this story by a news article that has drawn a lot of attention, "Liabilities' growth hurts funds" (Pensions & Investments, Feb. 5, page 2). The story questions how well pension plans really fared in 1995 considering liabilities for many plans probably rose by more than the 20% plus growth in assets. The bull market in assets was evidently more than matched by a "bull market" in liabilities. Suddenly, winners are being made to feel like losers. Should we be smiling or agonizing?
A case for long-term bonds?
Ron Ryan of Ryan Labs, cited in the story, and some others see plan sponsors missing the ball and argue for portfolios with longer-maturity bonds to better match liabilities. Assets will then move in tandem with liabilities, thereby minimizing swings in unfunded (or overfunded) liabilities caused by interest rate movements. In their world, consultants - always an easy target - and money managers are to blame for a misguided short-term focus on market indexes.
His perspective is an valid one, but not lost on plan sponsors or consultants. Past circumstances have caused some sponsors to change focus and emphasize the liability-matching opportunities with bonds. The first time was in the early 1980s when interest rates on Treasury securities were at double-digit levels.
Many corporations turned their backs on equities in favor of "dedicated" and "immunized" bond portfolios to match cash flows with benefit payments. With future benefits locked in at these high rates, sponsors easily convinced actuaries to increase interest rate assumptions and eliminate cash contributions. The hostile takeover environment at the time even persuaded companies to go a step further and terminate plans that were then overfunded at these higher interest rates.
FASB's influence
The second occasion was 1988 when, for the first time, the Financial Accounting Standards Board required companies to report unfunded liabilities in their financial statements and to use market-based interest rates in calculating liabilities. These new accounting rules attracted chief financial officer attention to pension asset management, in most instances for the first time, and increased the use of long bonds and derivative-related strategies to manage the company's accounting exposure to unfunded liabilities. Some companies entered into derivative "collars" to lock in asset gains and protect their funded status.
A third occasion was in 1990, when the Pension Benefit Guaranty Corp. first published its list of 50 corporations with the largest unfunded pension liabilities. I can speak from personal experience that CEOs hate being on that list and some make it a corporate objective to get off it.
For companies on, or close to being on that list, asset/liability management is an important factor in managing pension assets.
In fact, increased accounting and regulatory scrutiny has had an impact on overall corporate asset allocation strategy. While public pension funds have been rapidly increasing their equity allocations during the 1990s, corporate equity allocations have stayed approximately the same despite the bull market. And, these asset allocation surveys do not include terminated benefit plans now backed by insurance company bond portfolios.
Why sponsors avoid long-bond strategies
But, for the most part, Mr. Ryan is right. Most plan sponsors have not embraced long bond strategies for their defined benefit plans. There are two good reasons.
The first is that plan sponsors really are long-term oriented and impressed by the logic and past evidence that stocks will outperform bonds, both short and long maturity, over extended periods of time. They are willing to tolerate some calendar volatility in asset values and unfunded liabilities to lower long-term pension contributions and thereby increase shareholder value or reduce the taxpayer burden, in the case of public funds. They also understand that the long Treasury bonds needed to match pension benefits often appear to sell at premium prices and lack the incremental yield found in mortgages and corporate bonds.
Yes, pension bond portfolios are probably too short in maturity, as Mr. Ryan claims. But the maturity of the bond market is a compromise between buyers and issuers. As the leading provider of capital to these markets, pension funds help determine the makeup of the bond indexes, rather than being slaves to them.
The second reason sponsors hesitate to embrace liability-matching bond portfolios is that liabilities are influenced by inflation as well as interest rates - and bonds are a terrible hedge against inflation. Interest rates did fall dramatically in 1995, causing liabilities, the discounted value of future benefits, to rise. However, interest rates are likely to be falling because the market expects lower inflation and lower inflation will likely lead to slower salary growth and lower future benefits. Consequently, higher liability values from lower interest rates may be offset by lower salary growth for a sizable fraction of a typical plan's liabilities - 60% by our estimation.
Of course, changes in salary growth expectations are not as easy to see as interest rate changes and by habit we seem to forget what we don't easily see. Except for very mature pension plans, liability-matching is considerably more difficult than it at first appears.
Most dads know it takes both a good pitch and a good swing to be successful. So also with managing pension assets; sponsors need to keep an eye on liabilities as they endeavor to maximize shareholder value through long-term, diversified, equity investment strategies.
