Investment Benchmarking In The Post-PPA World

INVESTMENT BENCHMARKING IN THE POST-PPA WORLD 

 

 

INVESTMENT BENCHMARKING IN THE POST-PPA WORLD 

 

 

INVESTMENT BENCHMARKING IN THE POST-PPA WORLD

The Pentegra Defined Benefit Plan for Financial Institutions' primary investment objective is "to preserve principal and provide at least an adequate return to meet benefit payments to present and future retirees". The Plan's other objectives are to minimize year to year volatility in contributions in different markets by minimizing the volatility of the funded ratio; and to seek over time to reduce employer contribution rates.

In the post-2006 Pension Protection Act (PPA) world, our basic investment policy has not changed. How we get there-our investment strategy --- as well as the metrics by which we measure our performance versus a benchmark --- has evolved in the PPA environment.

What is an investment benchmark? It is a specifically-defined collection of assets considered representative of a given investment market, aggregated to produce a market standard by which a fund or portfolio's performance is evaluated over time. An important criterion for a benchmark to be effective is that it be appropriate to the current investment structure and environment.  To be useful, a benchmark should also be able to be invested and be accurately measurable.  That is, it should be clearly defined and investors who use it should be able to reasonably transact in the assets within the benchmark.  It should also contain assets that can be periodically priced with a comfortable degree of accuracy on a consistent basis.  In short, a good benchmark should provide a fair and rational basis of comparison for investors to judge the performance of all investments in a broadly-defined market as well as the relative performance of active managers within the same market.

KEY CHANGES RESULTING FROM THE PPA

Before the PPA, defined benefit pension plans valued their liabilities based primarily on actuarially assumed rates. The key assumption was a single discount rate to calculate the present value of the projected future liability cash outflows. The higher the assumed rate, the lower the present value of liabilities.  A higher discount rate assumption was generally justified by using long-term equity market returns. Therefore, a stock index such as the S&P 500 Index was the preferred benchmark used for pension plan returns. If there was an allocation to bonds, the Barclays Capital US Aggregate Bond index was often used as a secondary benchmark. While useful as a direct comparison between the stock and bond markets and the rate of return plan managers generated on assets, these benchmarks are broad-market performance indicators with a  meaningful but loose, systemic correlation to the funding cost of pension liabilities.  They are not necessarily specific to the needs of pension plan investors.  For example, these benchmarks did not factor volatility of plan liabilities or funded ratio risk since the assets and liabilities were actuarially smoothed.

As a result of PPA, liabilities are marked to market based on either (1) a corporate spot yield curve calculated each month by the US Treasury based on debt securities rated A and better or (2) on the 24 month average of three segments of this bond yield curve. The yield curve segments are comprised of three maturity intervals: 0-5 years, 5-20 years, and 20+ years. Consequently, under PPA, actuarial valuation results are tied to current capital market returns and volatility, especially to changes in longer term interest rates - a change deemed more appropriate to the risks facing pension plans. The new PPA rules have incented pension sponsors to rethink large allocations to equity investments in favor of longer duration fixed income since changes in PPA yields can create volatility in the present value of liabilities.

Good benchmarks must now be sensitive to volatility in the liabilities and the DB Plan's funded ratio. The primary market benchmark for the Pentegra Defined Benefit Plan is the Barclays Capital US Long Term Credit Index, as this index is most closely correlated with the growth and duration characteristics of the Pentegra DB Plan's PPA liabilities. A companion, customized benchmark (which is shown in the quarterly DB Plan Investment Performance Update), is the "Plan Liability Return Based on PPA Yields (Plan Liability Return)".  This metric applies the monthly PPA yields to the Pentegra DB Plan liabilities to estimate the monthly growth (or decline) in the present value of liabilities. The Plan Liability Return provides a measure as to how well the return in Plan assets compare to the growth of Plan liabilities.

The change to PPA-defined liability valuation motivates pension managers to adjust investment strategies that were previously designed to simply outperform the broad-market indices.  The focus in a post-PPA world must be even more acutely trained on the characteristics of liability cash flows and the cost of funding them.  This means a greater focus on long-term interest rates, and on investment strategies that mitigate the risks of funding ratio shortfalls as long-term interest rates fluctuate.  This does not mean that stock market and bond market performance are no longer relevant - only that market performance must be considered more thoroughly in the context of the effect on long-term interest rates.

SUMMARY

Implementing its post-PPA strategies have lowered the Pentegra DB Plan's exposure to the equity market and increased the duration of the Plan's assets through increases in long-term fixed income and swap positions.  Increased fixed income duration is expected to reduce the exposure of the Plan liabilities to yield curve changes. The Plan's performance benchmarks (Barclays Capital US Long Term Credit Index and Plan Liability Return) have reflected these strategies by incorporating a market based,  long-duration fixed income and Plan liability focus. Going forward, the Pentegra DB Plan will continue to evaluate its benchmarks as it develops greater refinement of its liabilities.

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