Pension shortfall: Solving for the missing 2%

Pension plan sponsors face significant challenges. Retirement obligations continue to increase, and the two major equity market setbacks in 2000 and 2008 have produced widening funding gaps. So what does the future hold? Will their plans be able to reliably achieve their stated return objectives?

Unfortunately for plans relying solely on traditional equities and fixed income, the prospects look grim. Our analysis suggests these plans will likely experience a 2% shortfall per annum over the next seven to 10 years.

Public and private pension plans rely on formal return targets to match their funding requirements against the present value of estimated future retirement benefits. Return targets for U.S. public pension funds typically range between 7% and 8.5%, with a median target of about 8%, according to Wilshire Associates. For our analysis, we chose a slightly more conservative rate of 7.75%.

Plans also are required to revisit their target return assumption periodically. For example, in March 2012 CalPERS, the largest U.S. public pension plan, voted to reduce its return target to 7.5% from 7.75% to reflect diminished forward market expectations. As pension funding gaps continue to widen, other plans around the country have begun to follow suit.

Although CalPERS' proposed reduction of just 25 basis points might appear minor, the impact on state and local funding levels, plan contributions and total benefits could equate to a very meaningful $167 million per year. With this in mind, it is easy to see why a potential 2% per annum shortfall has potentially large and serious consequences.

There are numerous accepted approaches used in forecasting investment returns. For our analysis, we scrutinized a variety of methods and ultimately chose the Grinold and Kroner model to forecast equity returns. This model estimates future annual equity returns based on factors such as inflation, dividends and earnings growth. Our resulting analysis yielded a forecast of 7.39%, which falls slightly above or in-line with those of well-known market pundits.

For purposes of comparison, John Bogle, the founder of Vanguard, claimed 7% as a reasonable estimate for stock returns over the next decade. The more bearish Jeremy Grantham from GMO forecasts a more somber 5.6% for U.S. large-cap stocks over the next seven years. Furthermore, methods with a reliable 50-year track record of using normalized 10-year earnings to forecast forward returns currently project approximately 6% returns over the next decade. To predict fixed-income returns, we surveyed corporate bond and Treasury yields across various maturities and risk profiles, ultimately producing a composite fixed-income return expectation of 3.25%.

We then blended these three asset classes of equities, fixed income and cash into a portfolio weighted at 61%/36%/3% respectively, a ratio intended to approximate that of a traditionally oriented public pension plan. The resulting portfolio yielded a forward annual return of 5.69% per annum, which represents a 2.06 percentage point shortfall relative to a 7.75% annual return objective.

While our bottom-up return forecast approach might be new to some, the conclusion that traditional investments alone are insufficient is not especially insightful. Many, if not most, pension plan executives already have concluded this for themselves, and are actively allocating to alternatives like private equity, venture capital, real estate, commodities, hedge funds and managed futures.

For these investors, the question is not whether to include alternatives, but how much? Our prior analysis allows us to revisit this question armed with an estimate of how traditional investments will likely perform over the intermediate term. Because most investors already know how much they invest in alternatives (10%? 20%? 30%?), let's back-solve to find the implied return required from these alternatives to achieve 7.75% portfolio returns per annum.

For example, the plan sponsor with a 20% allocation to alternatives (and with the remaining 80% of its portfolio invested at the same traditionalist ratios) and a 7% per annum forward equity return expectation, is implying that its alternatives investments must return 17% in order to achieve an overall portfolio return of 7.75%.

While investors can decide for themselves which investments they would like to include in their alternatives allocation (hedge funds? commodities? real estate?), this exploration serves as a reminder that one's alternatives allocation strategy must be linked to the achievement of performance goals.

For example, in an environment of low-yielding traditional investments, a modest allocation to alternatives might be placing unrealistically high performance expectations on one's alternative investments. Instead, plans may be better served by committing a larger allocation to alternatives with more modest, yet achievable, performance expectations.

Plan trustees are increasingly mindful not only of returns, but also of the return efficiency of their combined investments through measures like return-to-risk and non-correlation. For example, while leveraging a plan's exposure might initially appear to add return, the accompanying volatility could actually lower the plan's probability of achieving its terminal wealth goals.

Perhaps the two most wealth-destructive shortcomings exposed by the recent financial crisis were the correlation convergence among investments that previously were considered to be different, and the need for investments capable of offering tail risk protection during crises. So glaring was this, that many investors openly questioned the validity of their asset allocation models, with many concluding that changes were indeed required. We analyzed this issue in greater depth ourselves in a prior white paper titled “Diversification: Often discussed, but frequently misunderstood.”

Fortunately, there are at least two established investment strategies that address both return production and diversification/tail risk protection: global macro and managed futures. Both have a tendency to contribute returns while at the same time reducing portfolio volatility by harnessing both long and short capital flows during periods of volatility, tail risk price momentum and correlation convergence, converting sources of risk into sources of return and dampening overall portfolio volatility.

Equities and fixed income traditionally have formed the backbone of most plans' portfolios, but low yields and tepid forward equity forecasts now require plan sponsors to seek out alternative sources of return in order to help maintain their plans' funding ratios.

As these investigations into alternatives persist, many plans will be pleasantly surprised to learn of the depth and variety of investment strategies available to help them construct more resilient and diversified portfolios.

For example, hedge funds historically have delivered equity-like returns, but at about half the volatility of long-only equities. Because of its inherent non-correlation characteristics, managed futures can often be added to provide return and potentially lower overall portfolio risk at the same time. Real estate and private equity can change the risk-reward characteristics of income and growth, further diversifying public capital market investments.

Of course, the handful of alternative strategies cited here is unlikely to represent a complete solution. By providing meaningful return, diversification and volatility suppression at times when portfolios need them most, however, the proper blend of alternatives will assist in addressing the primary investment challenge of our time.

Chris Keenan is the senior managing director, director of strategic marketing at Welton Investment Corp.