In today’s world, the decision on how much equity to hold in a pension fund is not easy. Most plan participants are many years away from retirement. Moreover, retired participants are living longer and so the “average dollar” saved in pensions won’t typically be spent for many years. As such, pension fund asset allocations often include hefty doses of equities – the average corporate plan holds a little over 60%.1 Seems reasonable—conventional wisdom says that the inevitable stock market “storms” can be weathered in order to earn outsized returns with such a long horizon on the sponsor’s side.
Unfortunately, there are two sides to the pension coin: assets and liabilities. Liabilities—how much the pension owes to its participants—are calculated every year, just like asset returns. To determine the amounts needed today for future retiree payments, plan sponsors calculate the present value of estimated future payments using a discount rate equivalent to current interest rates. Given that the amount needed today will be smaller if you can earn 10% than it would be if you could only earn 5%, future liabilities are less cumbersome with higher interest rates than with lower interest rates. Any portfolio that rises when interest rates fall (and liabilities grow) helps the pension plan sponsor minimize its risk. For this reason, investments that on average rise in value when interest rates fall (i.e., bonds) are excellent hedges to pension liabilities.
With this brief primer in mind, it is no wonder that 2000-2002 was labeled the perfect storm for pensions—heir equity-centric assets fell considerably while their liabilities skyrocketed in the wake of plunging interest rates. With diminished funded ratios and regulatory changes like the Pension Protection Act of 2006, many plan sponsors are now seeking strategies to more closely match their assets to their liabilities. This has spawned a variety of Liability Driven Investment (LDI) strategies designed to introduce more interest rate exposure—and therefore more liability matching behavior—into pension plan asset allocations. Regardless of the rate of adoption of LDI strategies, pension plans are still likely to allocate significant sums to equities to access their higher expected return potential. We, therefore, believe it important to better understand the role of equities in the asset liability puzzle.
A recent study by IPM of Sweden2 examined the performance of the Research Affiliates Fundamental Index (RAFI™) approach versus that of a capitalization-weighted approach to assessing each equity portfolio’s interest rate sensitivity and liability hedging characteristics in the United States, Japan, Sweden, and Europe. The results show that in the U.S. market, RAFI displayed a higher correlation to government bonds (0.32 versus 0.23) and a longer empirical duration (3.6 years versus 2.5 years) to bonds than the S&P 500.3 However, unlike most interest rate sensitive stock portfolios with their large bank and utilities positions, RAFI earned a materially higher return than the S&P 500. Similar results were found in other markets.
Higher returns and better asset/liability matching? Hard to believe but intuitively these results make sense. Recall that RAFI holdings and weights are selected using a blend of fundamental measures of firm size—sales, cash flow, book value, and dividends paid. In doing so, RAFI is able to break the return drag associated with a capitalization-weighted strategy that always overweights overpriced stocks and underweights underpriced stocks.
The intuition is enhanced by looking at Figure 1, which shows RAFI performance in various economic environments.
Let’s look at the recession period, which is typically a tough time for pension plans. In a recessionary period, RAFI produces an average annualized return of 6.8% versus 3.0% for the S&P 500 Index, or a premium of 3.8%, which is significantly better than the strategy’s overall advantage of 2.1% for all environments. So at a time when liabilities are rising (because interest rates typically fall due to slow demand) and the ability to fund them is falling (because corporate earnings—the source for plan contributions—are lower), RAFI produces larger excess returns than the capitalization-weighted alternative. At the same time, RAFI still generates a meaningful excess return during the good times, unlike defensive and conservative equity portfolios.
These results suggest that a partial cure to the pension woes can be had by shifting pension equity portfolios from capitalization-weighted indexes to a RAFI approach.
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1. Independent Consultants Cooperative (ICC) Corporate Universe Median Allocation as of 9-30-06.
Courtesy of Wurts & Associates.
2. Djehiche, Boualem and Jonas Rinné. 2006. “Can Stocks Help Mend the Asset and Liability Mismatch?” Working paper, IPM Informed Portfolio Management AB Stockholm.
3.Duration is a measure of price sensitivity to interest rate movements. For small interest rate changes, the duration is the approximate percentage that the value of the asset will fall/rise for a 1% increase/decrease in interest rates.