Public funds should take good look at liability matching
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April 15, 2013 01:00 AM

Public funds should take good look at liability matching

Taking a lesson from insurance companies could help plans move to a healthier place

Chad L. Strean and Lina Komanduri
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    Two very good recent books about pension finance, “State and Local Pensions” by Alicia Munnell and “Pension Finance” by Barton Waring, touch on the many daunting challenges faced by public pension systems.

    These challenges include funding gaps, revenue shortfalls, required contributions, statutory changes and aggressive return assumptions. The authors also discuss optimal asset allocations within pension funds.

    One conclusion reached by both authors is that the liability-matching principle is not frequently used in pension portfolio construction and is, therefore, a fundamental problem in pension fund investing. Significant allocations to equities are evidence of the violation of this matching principle. Public plan equity allocations averaged approximately 50% as of 2009 (the most recent year of full data in the Public Plans Database of 126 state and local pension plans produced by the Center for Retirement Research at Boston College).

    Pension liabilities are bond-like obligations in that the promise of payment on a defined benefit pension plan is similar in profile to borrowing current compensation from employees to pay them back in the future in the form of pension benefits. Consequently, pension payouts are very similar in profile to deferred annuities. However, deferred annuity products offered by major insurance companies are primarily backed by fixed-income products. Our most recent data indicate that major life insurance companies, typically the biggest originators of annuities, have fixed-income allocations of approximately 75% while, according to a recent Pensions & Investments survey (Nov. 29, 2012), fixed-income allocations for U.S. public pension plans are approximately 27%. Given the similarity in profile of annuity products and pension benefits, it is surprising there is such a disparity in the composition of the portfolios.

    Corporate pension plans already have progressed from the liability-matching principle to full risk transfer. The momentum in pension buyout transactions, including the recent General Motors Co. transaction, might be the start of the sea change in approach by corporate plan sponsors. As sponsors such as GM enter into pension buyout transactions, these pension plans transform into group annuities managed by large insurance companies. As mentioned above, insurance companies manage annuities with fixed-income assets to match their liability. Is it just a matter of time before more public pension sponsors embrace this matching principle?

    The primary hurdle between public pension funds and liability matching is the statutory rate structure in public funds. Unlike corporate pension discount rates that are based on historical averages of corporate bond yields, public funds use a fixed statutory rate. With the median rate remaining at 8% and the market experiencing the lowest interest rates in modern history, the statutory rate seems unattainable without taking excessive risk in exchange for high returns.

    The rate is also problematic, as Ms. Munnell points out, because it gives a false sense of security with respect to funding levels. Many plans negotiated more generous benefits when funding levels were at or above 100% based on the 8% discounting. These plans are now significantly underfunded after the market crisis and face a steeper hill to climb with increased benefit payments and a lower return market environment.

    While an 8% statutory rate in this environment might invite excess risk into a portfolio, we are also concerned about the way pension funds look at expected returns on their assets vs. realized returns while trying to optimize their portfolios. Fundamentally, the expected return on a bond is simple — the yield to maturity. The realized return for a bond portfolio that is held to maturity is the yield to maturity of the bonds less any losses given default. The expected return on equities, however, is significantly more complicated and requires estimates of real earnings growth, inflation, dividend growth and price/earnings multiple projections. Not only is it more difficult to project equity returns, but also returns on equities are much more volatile than all of the major fixed-income asset classes (including high yield). In determining pension asset allocations to meet a statutory return, pension funds should consider the likelihood of realizing the expected return as opposed to simply modeling the expected return.

    Asymmetric investors

    Pension plan sponsors, akin to bond investors, are asymmetric investors who have significant downside and limited upside in that they run huge risks of underfunding if they do not meet expected returns. In addition, funded status volatility and unexpected pension contributions are a major concern for sponsors. Given the significant equity allocations in pension portfolios, funded status volatility spiked and funding ratios plummeted during the significant stock market declines of 2002 and 2008. With the benefit of hindsight, higher fixed-income allocations would have significantly cushioned the blow.

    The reality for public pension funds is that lower discount rates and increased allocations to fixed income would lower reported funding ratios dramatically. These lower funding ratios would likely reflect what many analysts and experts believe is economic reality. Lower funding ratios might also be a positive catalyst to bring all stakeholders to the negotiating table in order to address long-term pension fund challenges. Funding problems in the pension market are exacerbated if addressed only on the asset side of the equation without exploring the benefit side; although it is a political minefield. Excess risk in a portfolio to make up for a funding gap and an unrealistic statutory rate does more harm than good.

    We expect the debate will continue as to whether to structure a pension portfolio with optimal asset allocations by maximizing expected returns using modern portfolio theory or to structure pension portfolios with liability-matching assets. We believe pension funds should try to immunize their liabilities as best they can regardless of statutory rates. We also believe there will be a natural migration toward the liability-matching principle now used by insurance companies as governed by their regulators. As in the corporate pension market, we expect to see more pension funds that have a “hedged portfolio” (immunizing some portion of their pension liability) along with a “risk seeking” portfolio (including equities). We believe this is healthy as it brings focus to the liability-matching principle. While there are many changes that must be made to improve the public pension system in the U.S., liability-matching portfolios with significant fixed-income asset allocations are a good start on the road to long-term pension health.

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