Pension Fund Critics: Stop Griping About Underperforming the 60/40 (and Start Focusing on Fiduciary Duty)

Want an audience? Criticize public pensions.

Lately we see article after article criticizing public pensions (especially the big ones) for their poor performance relative to a naive strategy - the popular 60/40 mix of the S&P 500 and the Aggregate Bond index. The facts seem to show that this simple, passive strategy had earned higher returns than many pension fund portfolios which use complex asset classes that promise higher returns, but which bring several problems, including a lack of transparency, illiquidity and high fees for active management. This has surprised and disappointed investors. The case against the pensions seems irrefutable, right?

Not so fast. While the critics may be right on this factoid of who won the total return horse race, they may be missing the point of why pension funds invest, and what measure of performance is most relevant. What good is it to be an expert archer if you're aiming at the wrong target?

Why Do Pension Funds Invest?

We need to get this question right before seeking answers. Why calculate the wrong performance measure?

The fiduciary responsibility for those in charge of pensions is to fund future payments to beneficiaries with as little risk of failure as possible. With that in mind, what makes more sense:

• Investing in a portfolio concentrated in equity, or...
• Pre-funding the liabilities with matched-maturity bonds ?

The second option is preferable, but it may not be affordable.

"Cash matching" always costs more, and so it may be necessary to pre-fund (i.e., "defease") only some of the liabilities and invest the remainder of the assets for growth. You essentially "own the short end of the curve" as part of your bond strategy.

What better time than now to invest in a short annuity of guaranteed investments to fund the most pressing payments? The yields available on the next five years of payments are in the range of 5.5% to about 4.5% which is extraordinary reward for zero risk. Remember that "risk" is in the context of the mission, as it relates to funding the liabilities. It's NOT about asset volatility.

This approach brings the added benefit of increasing the risk tolerance for the growth assets backing the remaining payments, including concerns around their illiquidity.

The Right Pension Performance Measure

What does beating an asset benchmark tell the plan sponsor about success in meeting the fiduciary responsibility of funding the benefits? Sadly, this tells us nothing regarding "mission failure." Should we call it "success" if we beat the asset benchmark, but lag the growth in the liabilities over that period? (The answer is "no...")

The traditional focus on benchmark-relative performance of the assets - rather than a concern for funding the liabilities - is one reason that pensions are underfunded. Strong returns do increase the portfolio's capital, but when the liability values rise faster, the underfunding worsens. Active managers often get bonuses while the beneficiaries fall behind in funding, all because plan sponsors focus on portfolio statistics rather than the task at hand.

We Were Down This Road Before

Think back to the period ending in 1999, when equity markets experienced extraordinary (i.e., "unsustainable") valuation growth, and pension portfolios were at a surplus relative to the value of their liabilities. This was the opportunity of a lifetime, because 95% of the current value of the liabilities could have been pre-funded with 75% of the assets invested in zero-coupon Treasury bonds; the remainder could have been invested in a liquid equity index. This strategy would then be rolled forward every year. This was not a matter of timing the market; it was a fiduciary decision NOT to expose beneficiaries to unnecessary market risk.

The result? Strong surpluses became significant deficits over the next decade. During this time of deterioration in funding levels, those focused on beating asset benchmarks continued measuring their success in implementing their strategies, as funding levels continued to decline. Only government mandates through the Pension Protection Act ("PPA") caused plan sponsors to begin focusing on their fiduciary duty to fund the liabilities.

Are We There Yet?

We have seen the rise of so-called "Liability-Driven Investing" (LDI) that is guided by each pension plan's funding ratio. But instead of cash-matching liabilities to take risk off the table, this approach simply matches price sensitivity of the assets invested in bonds to the price sensitivity of the liabilities. This minimizes price risk for some of the liabilities, while ignoring the massive tracking error between the liabilities and the growth investments.

Using current market assumptions, the equity portion of a pension portfolio presents between 12% to 15% "funding gap risk" relative to the liabilities in any given year. With the majority of the pension portfolio invested in growth assets (global equity and alternative investments) the potential funding gap the plan faces is substantial.

Care For Some Performance Attribution?

Back to the initial gripe: "The big pension funds were beaten by the passive 60-40 portfolio!"

The question is: "Why?"

Let's consider the following:

• Risk matters. Did the portfolio reflect lower volatility and/or market risk? If so, we should expect lower returns.
• There's a structural component to the plans' relative performance; it's a "strategic allocation effect" from holding a different set of market exposures. This is the main driver for the level of overall risk and the pattern of that risk.
• There may be a tactical asset allocation effect.
• Each of these structural aspects is evaluated in terms of its effect on performance. Hopefully, a more complex asset strategy outperforms a simpler, passive strategy after accounting for relative risk. If not, then the plan sponsor should act on this important insight.
• What remains is an "active residual" that is often called a "selection effect;" this is attributed to the managers assigned to each portfolio segment. Net of fees, there should be a clear benefit in terms of risk-adjusted active returns and total returns to justify the expenses of active management.

We see four sources of relative performance when comparing the fund to a benchmark. Until we have completed a proper performance attribution analysis, we are in no position to criticize pension fund performance. Simply comparing the returns of a portfolio and a naive index is more like an uninformed "Monday morning quarterbacking" than a valid criticism of a significant part of the investment market.

Moving Forward

Investment management is by definition a forward-looking activity. We have no ability to predict future events, but we are required to make well-reasoned decisions about where to allocate capital (asset allocation) and how to execute on our plan (investment selection.) These decisions can be implemented actively, passively or with a mix of both.

The performance results of the past may inform on what has worked, but this remains a matter of judgement. The best we can do is to provide a rigorous and thorough evaluation through risk-adjusted performance attribution and then apply these insights to future decisions.

So, what about that 60/40 strategy?

Let's be fair-minded and even-handed about this; we're not letting the 60/40 off the hook as the "go to" strategy. That might work for an individual who is detached from the investment markets, but those working with client assets already understand that diversification beyond a pair of familiar indexes is required as a best practice. The 60/40 reference might serve to create a catchy headline, but it doesn't serve the duty to fairly evaluate investments.

Using current market expectations, we can see the benefits from increasing diversification. We begin with varying allocations between equity, bonds and alternative investments, starting with a 50-50 mix of bonds and growth (i.e., equity and alternatives) and ending with an all-growth strategy.

This provides three insights:

• Naive "S&P plus Agg" is the least-effective asset allocation; there is substantial benefit from including smaller stocks, adding Treasuries to increase yield curve and diversification, while adding a bit more credit risk premium via high yield;
• "Going global" provides substantial benefits, both in terms of higher risk-adjusted returns and even greater rewards for taking on more volatility risk;
• Adding alternatives completes the diversification effort.

This is a snapshot of what performance attribution provides in answering the question "Why" pension plans may have underperformed a passive approach to a simple benchmark. Armed with those insights, a plan sponsor is better prepared to take appropriate actions.