September 30, 2013
Like an America’s Cup sailboat with the wind at its back, pension funds have been cruising forward in 2013, riding the performance asset rally as interest rates have crept up over the course of the past nine months. As the third quarter ends, there is nary an area of complaint for pension funds. Performance assets are up, liabilities are down, and the difference between the two is meaningful. Funding ratios are up significantly, pension plans are moving upwards on onwards from the ICU, and the Dow is on it’s way to 100,000. Sound familiar?
The traditional asset allocation has outperformed RL PPA liabilities by 17.09% YTD. The S&P 500 has led the way with a 17.90% YTD return, while PPA liabilities have declined in value by –8.40%. The asset allocation model return of 8.69% has resulted in asset versus liability YTD outperformance of 17.09%. The RL model asset allocation returns over the past 12 months have outperformed liabilities by 17.56%. The RL PPA Index, with a liability duration of 14.08 years, as of September 30, 2103, and priced on an equal weighted basis, widened by 59 basis points YTD, going from 3.22% to 3.81%. RL PPA funding ratios have improved over the past nine months from 67% to 79%.
Chief Seattle famously said that “All things are connected…” While the wise Chief was talking about man’s impact on the Earth, going on to say, “Man did not weave the web of life, he is merely a strand in it. Whatever he does to the web, he does to himself,” his words resonate in the pension landscape. All pension investment decisions are connected, not only directly to the plan’s funding ratio, but to corporate and public finance decisions, to shareholders/stakeholders, to plan participants, and to the taxpayer via the PBGC.
So in a year where pension funding is up significantly, where performance assets have rallied, and having spent the past few years fighting off the left tail funding events related to the Credit Crisis and Great Recession, how can a plan sponsor connect investment decisions to pension health, investment decisions to plan sponsor health, and investment decisions to the benefit of shareholders and stakeholders? While those plans that have implemented LDI in some degree or another have a head start in overall risk management, numerous plans still have big duration mismatches and big correlated interest rate bets. These plans are exposing themselves to the whims of the capital markets, and just as they can be a tremendous source for strong returns, they can also quickly revert to the mean.
For a plan that has seen their funding ratio improve, as we head into year-end the next round of quarterly meetings represent a perfect time to pause and take a breath. It is a great time to assess how the current asset allocation is connected to potentially further growth in funding ratio, or if the markets turn, the potential exposure to left tail risk. Just as a plan sponsor would not embark on a strategic growth initiative without understanding the connection of the plan with potential results, investment committees have an opportunity to assess the potential results of reducing interest rate risk and surplus volatility. Connecting asset allocation with pension liabilities and risk capacity, while developing a plan for future funding triggers will only help in avoiding volatility and the pain that comes with it.