Sadly, the silver lining of higher discount rates vanished—in a hurry—in November. A back-of-the-envelope calculation indicates things got much worse. The 60/40 portfolio “only” lost 3%, but interest rates declined significantly. For example, the BarCap Aa Corporate Long Bond Yield dipped from 7.75% to 6.93%; the drop in Treasury yields was farther and faster. A lower discount rate means a higher net present value for liabilities. Assets down and liabilities up translated to a “guesstimated” funded ratio of 81%.
How could pensions be hit twice by a perfect storm in the same decade? After 2002, plan sponsors that wanted to immunize some portion of their portfolio were confronted with paltry long-term rates making a move to LDI prohibitively expensive in the eyes of decision makers. About the same time, the mega endowments, with their uber-diversified and alternatives-heavy portfolios, were held out as the best way to earn materially higher returns with significantly less volatility than the old “60/40” model pension portfolio. That’s the reason, despite all of the talk about LDI and an acute awareness of asset/liability mismatches, pension tracking error to a liability index remained very wide.
At the time, pension leaders didn’t consider LDI an important strategy. In fact, a study conducted by CREATE, a UK-based think tank, showed that LDI finished 12th when pension sponsors were asked which asset classes will best meet their funding needs over the next five years.2 Emerging markets equities, portable alpha, private equity, high-yield bonds, and real estate all were believed to be a better solution than LDI. Indeed, the “Yale Effect” had taken hold and pensions were well on their way to building sizeable alternatives allocations.3 If the alternatives delivered their promises of higher returns and moderate volatility, then the pensions would not need to worry about their liabilities—or so they believed.
But alternatives haven’t been immune to the take no prisoners market of 2008. As an example, hedge funds— measured by the HFRI Global Hedge Fund Index —were down 22.3% year-to-date through November 2008. REITs, as a proxy for real estate, were down 45.9%. And the true extent of the carnage in private equity won’t be known for a few years.
So what to do now? We believe there’s hope for increasingly distressed pensions. The forward-looking opportunities, however, require investment committees to reassess their priorities along four key criteria:
- Shift Risk Focus to Liabilities. Many interest sensitive bond categories offer lower tracking error to liabilities and, consequently, more stable funding for pensions. Figure 2 gives the traditional risk and return chart a twist by displaying current yields on the vertical axis and tracking error to a liability index on the horizontal axis. In a liability framework, long Treasuries show up as the low risk asset class, but also offer the least yield today. Next come core bonds (as measured by the Lehman Aggregate) and TIPS. Investment-grade corporate bonds offer yields in the 8% range, similar to many plans long-term return on asset assumptions, but with significantly less mismatch to liabilities than equities. Equities show a far larger tracking error to liabilities of 23%. Liability-focused investors, looking for a bit more return juice, will find credit categories like emerging market bonds or high yield much more efficient in asset liability framework.4