Commentary: The Fed's new mandate – target an equity rate of return

The Federal Reserve's about-turn in monetary policy in January, after the equity market swoon in the fourth quarter, showed that even Jerome "Straight-Talking" Powell joined his predecessors Alan "Irrational Exuberance" Greenspan, Ben "Taper Tantrum" Bernanke, and Janet Yellen in falling prey to the wiles of the equity market. The Fed should give up the pretense that it is focused on just unemployment and inflation and publicly acknowledge that the equity market matters. Heck, it should go one step further and make the lives of many pension funds much easier by explicitly stating that it is targeting a rate of return. It would clean up a lot of the chaos, mistakes and inefficiencies in managing pension funds. The fact that defined benefit plans were overfunded in the late 1990s and are now well below full funding is evidence of the havoc monetary policy has had on retirement security.

Professor Robert C. Merton and I argued that traditional monetary policy, by trying to increase absolute wealth (i.e., "boosting the stock market") of investors through lower interest rates did great damage to retirees and pension funds. In short, by lowering interest rates, the Fed raised the value of retirement liabilities of both DB plans and DC accounts by more than they raised the value of assets, thereby making pension portfolios worse off because the funded status, or "relative wealth," declined. This move, in turn, caused these funds to have to "save more" through additional contributions, taking precious resources away from consumption (of individuals saving in defined contribution plans), investment (of companies sponsoring defined benefit plans) and government spending (from government entities sponsoring pension plans). By backing off interest rate increases in 2019, and even potentially lowering them by 50 basis points this year, it runs the risk of exacerbating its original sin and further worsening relative wealth in DB and DC plans.

To take a step back, typical pension plans make forecasts of expected returns of equities and other assets, and then establish a long-term asset allocation (with a target expected return) to which they adhere to over many years. The expected return on equities and the full portfolio is invariably, if not always, a positive number and in range of 7% to 10% a year. The fact that our ability to forecast expected returns is poor at best and wrong in direction at the worst has not changed behavior one bit over the last 20 years. Further, despite the inability to forecast returns, most, if not all investors, naively and regularly rebalance back to this "optimized portfolio" in the mistaken belief that this is good portfolio management.

Many private equity managers talk privately about being massively outbid on deals, suggesting that weak forecasts of equity returns are driving more money into the private markets and causing a bit of a bubble. Missing consumer price inflation is rearing its ugly head in (private) asset inflation — a movie we have seen before. In an additional twist, most pension plans are now in a "net cash out" situation — namely, payments on benefits exceed receipts from contributions, which means they have to periodically liquidate assets and loading up on illiquid assets starts to pinch.

When the equity market swoons as it did in the fourth quarter of 2018 through the Fed's actions, it causes enormous pain. The realized return of the pension portfolio is negative, forcing new savings and contributions from individuals, companies, and state and local governments that missed their expectations, further disrupting operations. Corporate pension fund chief investment officers have been told by their treasurers to derisk the pension plan — in plain speak, the treasurer does not want to be on the next earnings call reporting how the pension plan needs additional contributions when eager investors want dividends or share buybacks or new investment plans. Higher contributions to pension funds diverts resources from schools, safety personnel and essential services. Furthermore, naive rebalancing policies that take pension plans back to their original "optimized mix" are an exercise in futility because rebalancing to a target level of equity when equity returns are negative is further exacerbating the pain.

Instead, if the Fed announced its annual equity return target (much like it does on unemployment and inflation), pension plans and the overall economy might greatly benefit. First, the entire exercise of setting expected returns and optimal portfolios would be simplified and the precision of the realized return to the expectation greatly improved. A fund targeting a high expected return could be 100% in equities; one with a lower expectation could blend in some bonds or cash. Second, these same funds could go largely passive and save on paying high fees, and improve liquidity, with potentially better and more predictable outcomes than currently achieved. This would obviously impact compensation and employment in the financial services industry, but the greater good might be worth striving for. Corporate treasurers, individuals and government entities could plan much more efficiently how they hope to get their pension plans back to full funding (and then ideally immunize these cash flows) and other areas of the economy might benefit from not having resources diverted away from them.

Essentially, if the market, at some point in a year, was running above (or below) its target annual rate of return, funds should intelligently rebalance their portfolios by selling (or buying) equities because maintaining an equity overweight (or underweight) is not sensible. Just the threat of the Fed intervening to achieve its target equity return will improve pension plan investment behavior. Current operations, however, attempt to get the portfolio back to some arbitrary weight without any focus on the target return, often with disastrous consequences as in 2008. In this fashion, the market would potentially self-correct with the knowledge that if it does not, the Fed could intervene and adjust liquidity from the market by trading equities outright.

Gone are the days when central banks stayed away from the stock market that such a recommendation would be blasphemy. The Bank of Japan and the Swiss central bank are active participants in equity markets, and the Fed balance sheet has lots of non-traditional assets, so why not go the extra step and use equity purchases and sales to achieve financial stability? No more crazy distortions of relative wealth from massaging interest rates to improve absolute wealth — interest-rate and equity-market management would be easily separated.

In summary, central bankers have tried to pretend that they are not beholden to the stock market, but 2018-'19 appears to have peeled back the curtain once and for all. Let's give up the pretense and make life much simpler for pension fund investors and also set an annual equity target, which would allow every pension plan, and related sponsoring entity, to clearly plan how to manage its fund and other core activities. The current distortion from wildly gyrating markets does nobody any good. It's time to change the "Powell (Greenspan, Bernanke and Yellen) Put" to the "Pension Put."

Arun Muralidhar is co-founder of Mcube Investment Technologies LLC in Great Falls, Va. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.