Asset-liability management back with a twist
Asset-liability management is back.
Unlike the 1980s, when such strategies first came into vogue, this time pension executives are eschewing dedicated and immunized bond portfolios and are casting about for other solutions.
While experts say many large plan sponsors are convinced they need to extend the duration of their bond portfolios to better track their liabilities once long-term interest rates kick back up, others are proposing alternative approaches, ranging from overlays on the entire pension fund to specific equity investments.
So far, however, few pension executives have gone down this road.
But many pension executives, particularly at publicly held companies, never want to get caught again between the pincers of falling stock markets and declining interest rates.
Pension funding levels have collapsed through a combination of plummeting stock markets - the Standard & Poor's 500 index fell 42.4% from its peak close of 1527.46 on March 24, 2000, through Dec. 31, 2002 - and long-term interest rates, which are starting to rebound now but had plunged to 46-year lows. The upshot: 89% of Standard & Poor's 500 corporate defined benefit plans were underfunded at the end of 2002, lowering their average funding ratio to 83% from 104% in 2001, according to Wilshire Associates, Santa Monica, Calif.
A growing consensus is that pension executives have been poorly served by focusing on maximizing returns while ignoring pension liabilities. Instead of trying to find the right point on Harry Markowitz's efficient frontier, they should be trying to better match pension assets against liabilities, say a growing number of pension experts.
"The thinking was that by adding equities to the liability stream, which looked like long-only bond exposure, you would generate outperformance in the long term, which had to be good for the pension fund. But how long is the long term?" asked Chris Campisano, director of equities for the $8.6 billion Delta Air Lines Inc. pension fund, Atlanta.
"In the intermediate term, you get asset and liability performance that are de-linked. A three- to five-year period with these being de-linked can put you out of the game," he explained.
Ronald J. Ryan, president of Ryan Labs Inc., New York, said state lotteries, many of which are bound by law to invest in government zero-coupon bonds, should provide a model for pension funds.
"A pension fund should be just like a lottery. Match the assets to the liabilities and go to bed. Why are you playing games?" said Mr. Ryan, who manages bonds against customized liability indexes for pension clients.
Experts say pension executives have been managing assets against the wrong benchmark.
"Basically, the depreciation in equity markets and the decline in interest rates we've seen over the last several years have caused some pretty significant deterioration in pension funding," said Kurt Winkelmann, managing director and co-head of global investment strategies at Goldman Sachs Asset Management, New York.
"For a lot of people who were comfortably funded before and weren't thinking all that much about the liabilities, this environment has forced them to rethink what their true benchmark is," he said. The real benchmark, he said, is the ability to pay benefits.
In the 1980s, asset-liability management and "surplus optimization" techniques flourished as the result of new accounting rules. Many large pension funds, particularly among airlines, automotive companies and banks, adopted immunized and dedicated bond portfolios. While immunized strategies had targeted returns, dedicated bond portfolios matched expected cash flows, usually for retiree liabilities. But wholesale portfolio changes are expensive, interest rates are at a low, and earlier portfolios were later unwound as interest rates declined.
Now, managers are touting different solutions to help pension executives smooth volatility in their funding levels and avoid having underfunded pension plans depress company stock prices.
Here are some of the ideas being floated:
c Increase the bond allocation at the expense of stocks. The extreme example was Nottingham, England-based Boots Co. PLC's 2001 move to a 100% bond portfolio for its pension fund. But experts warn this approach is very expensive because bonds typically return less than stocks, and bond prices will fall when interest rates come back up.
c Switch to a longer-duration benchmark. Some pension funds have shifted from traditional indexes, such as the Lehman Brothers Government/Corporate bond index, to a longer duration index, such as the Lehman Long Government Credit index. But "that seems to be the wrong way to go, based on regression to mean," said Christopher P. Dialynas, managing director at Pacific Investment Management Co., Newport Beach, Calif.
What's more, "even the longest-duration index may not be long enough for many pension plans," Mr. Winkelmann said in a paper co-written with three other Goldman Sachs officials.
c Extend the bond-portfolio duration. Much discussed but little adopted, sources say many pension executives plan to extend the duration of their bond portfolios to better match their liabilities. The problem: Pension executives would be betting on today's low interest rates and likely ensuring higher pension contributions down the road.
"Ultimately, I think long bonds is the right answer for a pension plan; it gets you more in line with the liabilities, it manages in the surplus space," said Michael Hall, senior consultant, Frank Russell Co., Tacoma, Wash.
"Most believe you should be running with long duration," said Michael Peskin, principal in the global pensions group of Morgan Stanley, New York. But "everybody also believes interest rates are going up, so this is a bad time to do it," he added.
c Hire a duration completion manager. This approach, advocated by Goldman Sachs' Mr. Winkelmann, applies an overlay onto the entire pension portfolio, using swaps and other derivatives.
Pros: Underlying managers and benchmarks are undisturbed, avoiding expensive changes. Plus, the fund continues to rake in alpha from equities, real estate, international and other investments.
Cons: There is some counterparty risk from swaps, and interest-rate futures are limited to specific maturities and are subject to cash calls. Goldman officials advocate a core position in the swaps market, supplemented by futures.
c Invest in other securities that more closely match liabilities, such as Treasury inflation-protected securities or stocks in certain sectors, such as utilities and financial stocks, suggested officials at Barclays Global Investors, San Francisco. Value stocks also provide a better fit for liabilities than growth stocks, said Gerry Rocchi, chief executive officer of BGI, Canada, Toronto.
c Pick specialized equity strategies. Officials at Manning & Napier Advisors Inc., Rochester, N.Y., say they have devised an equity strategy that consistently outperforms the S&P 500, especially when both the stock market and interest rates are falling.
By investing in viable companies with high yields - around 12% on a pre-tax basis - and strong free cash flows, the Manning Yield Stock Portfolio had an average annual return of 2.86% during the past three calendar years, compared with -14.54% for the S&P 500. From 1988 through 2002, the model returned 14.02%, vs. 11.47% for the S&P 500, net of fees, based on back-testing.
With an average duration of 15 years compared with 22 to 23 for the S&P 500, Jeffrey S. Coons, co-director of research at Manning & Napier, said the strategy bridges the duration gap between bonds and traditional equities.