Obligation-based Asset Allocation for Public Pension Plans

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1 Obligation-based Asset Allocation for Public Pension Plans Market Commentary July 2015 PUBLIC PENSION PLANS HAVE a single objective to provide income for a secure retirement for their members. Once the benefits have been designed to accomplish this, the single objective becomes an important obligation to pay the promised benefits to their members. This obligation defines everything that public plan fiduciaries and their advisors do, and the investment strategy is no exception. However, sound public policy suggests that an additional objective be considered: How will the impact on other stakeholders be minimized while ensuring retirement security for members? Public plan investment strategies are naturally focused on generating as much return as possible, but risk must be considered as well. Risk should be defined relative to the obligation to pay the promised benefits with the least impact on stakeholders such as taxpayers and creditors. 1 The term impact is not a precisely defined notion, but it will encompass some combination of funding cost and risk. Pension plans enjoy two luxuries that can help them to achieve those objectives a welldefined financial obligation and a long-term horizon. These advantages can be exploited to maximize return in the most risk-efficient way. The purpose of the obligation-based approach described in this paper is to take the right type of risk in the most effective manner possible. The Basic Approach Let s start by imagining a very simple pension plan that promised to pay a single amount to one individual one year in the future. If our single payment pension promise was for $100,000, and we could earn a 3% low-risk fixed income investment for one year, it would be quite reasonable to put aside $97,000 today in order to secure the payment promised one year from now. This would meet the overriding objective of securing the payment and would also have minimal potential impact on taxpayers or creditors. An alternative would be to put $93,000 into a mixed portfolio of investments, including equities, and expect that we are likely to have the money we need in one year. One might argue that this reduces the impact on stakeholders by lowering the expected cost today. However, one could easily experience negative returns on this type of portfolio over such a short time horizon, resulting in the potential need for additional contributions to meet next year s obligation. This risk is part of the impact on stakeholders. Evan Inglis, FSA, CFA Senior Vice President, Senior Actuary Nuveen Asset Management, LLC David R. Wilson, CFA Managing Director Head of Institutional Solutions Group Nuveen Asset Management, LLC 1 In addition to plan members, taxpayers and creditors, stakeholders might also include politicians, organizations that insure public debt, and others. NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

2 Now let s consider another simple pension payment obligation a $500,000 payment due in 40 years. Securing such a promise is not nearly as simple as the first one we considered. There are few, if any, bonds available that would secure this payment in the same way that we were able to with the payment one year in the future. Thus, there is significant reinvestment risk related to the yield that will be available on bonds into which the initial investment is rolled over. In addition, the $500,000 expected payment will change over time due to actual wage growth, mortality experience, unexpected changes in the workforce, and other factors. bond that matures in 20 years in the future that yields 5%. The longer bond secures the payment with less risk. FIGURE 2 Reinvest at new rate = reinvestment risk 5-year bond 5-year bond 5-year bond Lock in higher rate for full period 20-year bond 5-year bond Payment Objective Payment Objective FIGURE 1 Equity Bonds Focus equities on longer-term obligations that are less certain and harder to match with bonds 40 years Equity Bonds 5 years Less predictable obligation More predictable obligation Many investors prefer shorter maturity bonds to reduce volatility related to changes in market interest rates 2. However, an investor that is focused on securing a future payment obligation need not worry about changes in value due to changes in interest rates. Even if the market value of a longer bond is more volatile on an asset-only basis (e.g. the value of a 20-year bond is more volatile than the value of a 5-year bond), it is less risky if it is more likely to secure the promised payment (i.e. on an asset / liability basis). 3 As shown in Figure 1, because very long-term commitments can t be locked in, it may make sense to take more investment risk in pursuit of higher returns. There are several reasons for this, including: If recent equity returns are lower than expected, increases in costs can be addressed over a longer time period. Equities are very likely to outperform bonds over longer timeframes. Although some experts argue that equity risk does not decline with longer time horizons, this is a matter of debate and perspective. (see call-out box on time diversification ) Over time, equity returns should reflect inflation and economic growth which in turn are related to wage growth and inflation-linked COLAs that impact the size of benefits. The uncertainty in the future payment serves to diversify equity risk when assets and the obligation are viewed together. The right kind of fixed income for longerterm obligations Now let s imagine an obligation to pay $200,000, 20 years from now. We can buy zero-coupon bonds that will secure such a payment with little risk. If we did so, what maturity would we choose? We could choose to use 5-year bonds (let s say they currently provide a yield of 3%) and plan to purchase new bonds every five years. This introduces uncertainty about the return that we will achieve, as shown in Figure 2. Instead, we could use a 2 The longer bond will also usually have a higher expected return because of the term premium 4 associated with longer maturity bonds. This is one of the luxuries of the long-term horizon that a pension plan enjoys term premiums can be captured without paying for them with volatility risk as shown in Figure 3. FIGURE 3 What are interest rates made of? Real risk-free rate + Expected Inflation + Term premium Pension plans can earn this premium without worrying about volatilty Thus far, we have implicitly assumed the use of zero coupon bonds to match directly with expected payments. While Treasury STRIPS are available for this purpose, it is typically preferable to use higher-yielding credit bonds, taking advantage of the illiquidity premium in the spread above Treasuries. The illiquidity premium is the yield over and above what is needed to compensate for potential defaults and is another premium which long-term investors take advantage of effectively. 5 Credit bonds 2 The sensitivity of bond prices to interest rate changes is called duration. 3 Some investors will feel that when rates are very low it is wiser to assume that rates will rise and invest in shorter duration bonds until they do. It s important to realize that this approach includes reinvestment risk and also sacrifices return until such time as rates do rise. 4 A term premium is additional yield on longer term bonds 5 Because a pension plan has relatively predictable payments and does not need to worry that members will demand payment of their benefits at any time, illiquidity risk is a relatively minor risk in a pension portfolio.

3 will generally pay coupons, but it is quite possible to create a portfolio of credit bonds that will align well with a future payments for a typical pension plan. Putting it together Three key concepts have been described: Fixed income investments can secure predictable pension payment obligations effectively; The potentially higher, more uncertain returns associated with equities may be better aligned with longer-term, more uncertain payment obligations; and Fixed income investments may be matched with the payment obligation to maximize return and minimize risk. A pension plan is just a series of payment promises similar to the ones described earlier. The near-term payments for retirees are quite predictable and easy to secure with little risk while longer-term payments are uncertain and may vary with factors like economic growth and inflation. Based on these concepts, one can visualize a glidepath for any single annual pension payment promise, as shown in Figure 4. A higher allocation to equities is aligned with payments many years in the future and this allocation is gradually adjusted as the payment date comes closer. The path is not locked in when the approach is initiated it evolves as the expected benefit payments and market conditions change. Over time, the payment amount becomes more certain, which makes aligning assets with payments easier. At the same time, adjusting contributions in response to unexpected returns becomes more challenging as the timeframe decreases. The gradual change from equities with higher expected returns to bonds that target the payment obligation allows for better risk reduction while maintaining higher potential returns. FIGURE 4 Benefit Payments: A Hypothetical Plan Inactive Active Years Until Payout LDI FOR CORPORATE PENSION PLANS The obligation-based approach is similar in concept to liability-driven investing used by corporate pension plan investors, but has significant differences as well. Corporate plan liabilities are measured with market interest rates and their risk framework is driven by this liability measurement. The fundamental tenet of corporate pension derisking strategies is to align the duration of the assets with the duration of the liability. The liability measurement guides the corporate plan asset allocation and makes it relatively easy. The liability measurement approach used by public plans is not so directly applicable to investment allocation decisions. Public plan liabilities are also different because they are often more affected by inflation and wage growth. However, the time horizon of expected payments does provide important information to use when designing an investment strategy. More predictable payments Easier to match with assets Less predictable payments Liability is equity diversifier Asset Allocation 100% 80% 60% 40% 20% 0% Fixed Income Equity Years Until Payout The plans above do not currently exist and are hypothetical strategies for illustrative purposes only. See notes on hypothetical illustrations under important considerations at the end of this report. Source: Nuveen Asset Management 3

4 For a pension portfolio as a whole, such an approach would gradually adapt the asset allocation as the demographics of a plan evolves more bonds and less risk would emerge as the plan population ages. As the retiree population grows, so would the bond allocation. This has the important effect of minimizing demographic leveraging, a concept which is described below. Demographic Leveraging of Pension Risk As a pension plan population ages, the number of retirees increases and the liabilities for the plan grow. More significantly, the plan liabilities grow relative to the size of the plan sponsor. Liabilities that grow relative to the plan sponsor s revenue represent a kind of leverage that increases financial risk for the plan sponsor and its stakeholders. Leverage exists because there are liabilities that are not related to the productive assets of the plan sponsor. As illustrated in the table below, the same asset allocation is riskier for the plan sponsor with an older plan that has many retirees and larger liabilities than it is for the plan sponsor with a younger, smaller plan. Demographic leveraging of investment risk in a hypothetical pension plan (dollar figures in $MM) Young Plan Mature Plan Liability for active members $1,000 $1,000 Liability for terminated employees $200 $500 Liability for retirees and beneficiaries $300 $1,000 Total liability $1,500 $2,500 Assets $1,350 $2,250 Funded Ratio 90% 90% Starting Deficit $150 $250 Assets after -10% return $1,215 $2,025 Funded ratio 81% 81% Increase in deficit $135 $225 New Deficit $285 $475 Tax revenue $1,000 $1,000 Deficit as percent of tax revenue 28.5% 47.5% The plans above do not currently exist and are hypothetical strategies for illustrative purposes only. See notes on hypothetical illustrations under important considerations at the end of this report. Source: Nuveen Asset Management In the illustration, two hypothetical government plan sponsors with the same active employee populations, pension funding ratios, and tax revenues are compared. The only difference is that one has a higher percentage of retirees in their pension plan in effect, the plan is older since more former employees have retired and are receiving benefits. The illustration shows the impact of a -10% investment return on the plans. Since the liabilities and assets are much larger for the older plan, the unexpected investment losses have a greater impact. Funding the larger deficit from the same amount of revenue could be a problem the consequence of leverage when things don t go right. The leveraged situation for the older plan calls for a lower risk investment strategy. Plan sponsors may want to consider the objective of fully funding and hedging the pension obligations for retirees and other former employees. If these obligations are kept continually funded and hedged, the leveraging impact described above will be largely eliminated. Even if the liability grows faster than the local economy and tax base (e.g. when the public services are downsized) pension risk will kept at a manageable level. When this portion of the liability for inactive members is funded with a well-matched portfolio of assets, this potentially destructive leverage is mitigated. Aligning specific asset allocations with specific payments that result in the glidepath described above will cause the asset allocation to naturally evolve to lower risk as a plan ages. Retiree populations will end up aligned largely with matching bonds, reducing the demographic leveraging effect. Implementation There are various methods for determining an asset allocation that aligns effectively with specific payment obligations. One straightforward approach is to design different allocations for retirees and active members. A more sophisticated method would determine allocations for each individual year s payment obligation. There are a number of factors to consider when aligning assets with pension payment obligations. Some payments are fixed, some are sensitive to inflation, and some will grow with wages. All of these factors have implications for aligning asset classes effectively with payment obligations. Different investors will have different views of the potential returns available in the markets and these views will be reflected in the obligation-based asset allocation. The funded status of the pension plan, the plan sponsor s financial health, and the size of the pension plan relative to the plan sponsor s revenue are other factors that may influence perspectives on how much risk to take 4

5 in the portfolio. The purpose of using an obligation-based approach is not to reduce risk, but to take risk in an effective manner. Any initial obligation-based allocation will be adjusted as time goes on. The plan population will evolve and the pension payment profile will evolve with it. As views on the equity markets and bond yields change, the ideal asset allocation will also change. The plan s asset allocation should be revisited at least annually as new actuarial information becomes available and changes in the financial markets are assessed. Other asset classes Any asset class can be worked into an obligation-based portfolio. A fundamental concept of any approach to investing is that an asset class must provide a higher expected return relative to the lowest risk asset. The matching bond payment is the lowest risk asset in a pension context. Therefore the expected return on any other asset must be higher, or the portfolio has taken on uncompensated risk. This critical concept is not apparent with other approaches to asset allocation, but becomes obvious with an obligation-based approach. One way to incorporate assets beyond stocks and bonds is to create an excess-return portfolio consisting of the desired assets that have expected returns above the matching fixed income portfolio. The full portfolio will consist of two pieces excess-return and matching fixed income. Then a glidepath can be created to evolve from the excessreturn assets into the targeted fixed income. Conclusion Obligation-based investing allows a pension plan to use any amount of risk in a portfolio, but strives to take that risk in the most effective manner. It results in these important advantages: Risk reduction is effective and predictable when it is accomplished by using bonds that target the specific maturities of promised pension payments. The potential for higher returns from risky assets is aligned with payments which are harder to match with assets, thereby seeking return in the most risk-effective way. The potential for demographic leveraging of pension investment risk is reduced by gradually decreasing equity exposure and increasing the allocation to matching bonds as payment obligations come nearer. These achievements are made possible by the two strategic luxuries that pension plans enjoy. For one, the well-defined and relatively predictable nature of the required pension payments provides a useful risk framework. In addition, the long-term nature of the obligation allows the plan to capture term and illiquidity premiums with little related risk. If you re investing pension assets, it would be a shame to not take advantage of the well-defined obligation and the long time horizon. TIME DIVERSIFICATION Time diversification is the idea that risk decreases as the time horizon increases, such that equity investments make more sense for investors with longer time horizons. For many investors this is intuitive, but there is a theoretical argument against this idea. When investors are assumed to be typically risk averse and when equity returns are assumed to be independent of each other, it can be shown that equity risk increases over time (Kritzman, 1994 FAJ). It is certainly worth being aware of the theoretical argument against time diversification. It is also worth understanding the evidence for mean reversion in equity markets and the behavioral preferences of investors which may support the concept of time diversification. Reasons to question the classic argument against time diversification include: Evidence of mean reversion in markets (Blanchett, Finke, Pfau, 2014 Advisor Perspectives) Risk aversion may be lower over longer time horizons (Jaggia, Thosar, 2000 Journal of Psychology and Financial Markets; Olsen and Khaki, 1998 Financial Analysts Journal) 5

6 For more information, please consult with your financial advisor and visit nuveen.com. RISKS AND OTHER IMPORTANT CONSIDERATIONS This report is for general information purposes only and represents the opinion of Nuveen Asset Management, LLC. It is not intended to be a forecast or guarantee of future events or results, and it should not be considered investment advice of any kind. Information was obtained from sources we believe to be reliable, but are not guaranteed as to their accuracy or completeness. This report contains hypothetical information for illustrative purposes only and is not intended to depict any Nuveen Asset Management portfolio or strategy. This report contains numerous assumptions. Different assumptions could result in materially different results. The resulting analysis of this report contains no recommendations to buy or sell specific securities or investment products. All investments carry a certain degree of risk, including possible loss of principal. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager. This report does present a hypothetical strategy for illustrative purposes only. This hypothetical does not reflect actual performance results of a product currently or previously managed, and should not be relied upon for investment advice. Hypothetical performance does not reflect the deduction of fees and expenses, which would reduce performance in any actual client account and any assumptions and/or methodologies are not guaranteed. Nuveen Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen Investments, Inc. GPE-PENSION-0715P 9146-INST-Y-07/16 Nuveen Investments 333 West Wacker Drive Chicago, IL nuveen.com

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