Pentegra :: Pension Investing 101

Pension Investing 101

Pension Investing 101

PENSION INVESTING 101 - IT'S ALL ABOUT ASSET/LIABILITY MATCHING

It has become increasingly clear that market performance has an important effect on the funded status of a defined benefit program. The recent combination of a bear stock market coupled with falling interest rates has had a devastating effect on many pension funds, depleting surpluses and resulting in increased employer funding requirements. But while the investment environment has a direct effect on funding requirements, pension investing is not an arbitrary process of chasing market returns. Pension investing is more a process of matching assets to liabilities, with the ultimate objective being to pay retirement income. With that in mind, a plan's investment policy should be structured to invest plan assets in such a way that will meet these benefit obligations.

HOW IS AN INVESTMENT POLICY DEVELOPED?
Pension funds can invest in many different types of investments-most typically fixed income, i.e. bond investments, and equities. The nature of a plan's investments depend in large part on the demographic make-up of its pension liabilities and investment objectives of the plan.

A defined benefit pension plan is essentially a contract that an employer has with its employees to provide future compensation in the form of retirement benefit payments after the employees retire. As such, a defined benefit pension plan is like a bond in that it is a debt obligation consisting of a series of future payments. Generally, these future payment streams can be attributed to three types of pension liabilities: a retired lives liability, a deferred vested liability, and an active lives liability.

The retired lives liability is made up of employees who have retired and are currently receiving benefits.  The deferred vested liability represents employees who worked for the employer long enough to become vested in the plan but are no longer with the employer and not yet receiving retirement benefits. The active lives liability represents what is currently owed to the "working" employees, or the retirement benefits these employees have accrued to date. Recognizing these different demographic components is significant, since each group has a different level of certainty and time horizon associated with it that will determine the types of investments that the plan should hold to meet its benefit obligations.

EVOLUTION OF PENSION INVESTING
While a pension plan can be equated to a debt obligation like a bond, most plans have invested in a far greater mix of investments than bonds alone. As inflation rose during the 1960s and 1970s, companies found that rising salaries and low fixed-income returns made funding pension plans rather expensive. They turned increasingly to investment in equities to attain their actuary's return and lower the eventual cost of their pension plans. More sophisticated plans began to diversify by investing funds in, for example, real estate, venture capital and mortgages. By the 1980s, pension plans were investing in "non-traditional" investments such as hedge funds and even direct ownership of private companies.

However, with the inception of the 2006 Pension Protection Act (PPA), pension plans were forced to refocus on the characteristics and potential volatility of their pension liabilities and contributions. Under the PPA, plans are required to mark both their assets and liabilities to market, while permitting significantly less smoothing of assets and liabilities than prior to PPA. Liabilities are discounted using a contemporaneous yield curve based on A and better bonds. This yield curve is calculated monthly by the US Treasury. Matching the duration of assets and liabilities (where duration is the sensitivity of a bond or liability stream's value to changes in interest rates) has increasingly become the focus of pension plans, so as to minimize the volatility of the funded ratio (assets divided by liabilities) and to minimize the volatility of contributions. This has therefore resulted in a re-emphasis on fixed income as a means of matching the duration of assets and liabilities.

PENTEGRA'S UNIQUE INVESTMENT APPROACH
One of the many benefits of Pentegra's multiple employer pension program-the Pentegra Defined Benefit Plan for Financial Institutions-is the level of investment sophistication and asset/liability modeling that our multiple employer structure affords our clients.  By commingling the assets of hundreds of clients nationwide, we are able to leverage the buying power of a $2.3 billion dollar pension fund to offer significant economies of scale.

The Plan also affords access to sophisticated investment management strategies and some of the top investment managers in the world-well beyond the scope of what a single employer plan could offer on its own.

Ultimately, our ability to pay benefits is what drives the Plan's investment policy. The primary objective of the investment program is to preserve principal and to provide at least an adequate long term return so that the principal plus return are sufficient to meet the benefit payments to present and future retirees.

The second objective is to seek to minimize the year to year volatility in contributions in different capital market environments by minimizing the volatility of the funded ratio. The Plan's third objective is, over time, to reduce contributions below normal cost requirements so that employer contribution rates can be minimized over time. It is this focus that forms the basis for the Plan's investment strategy, particularly in managing asset allocation relative to liabilities.
To achieve the Plan's overall investment objectives, a major emphasis is placed on risk management. Therefore, plan contributions are invested on a commingled basis in a portfolio that is broadly diversified among both asset classes and investment disciplines.  The Plan's investment portfolio consists primarily of fixed income and equity investments. Post-PPA, the Plan has been reducing the difference in duration between its assets and liabilities in order to manage volatility in its funded ratio. To accomplish this, the Plan has lowered its equity exposure and lengthened the duration of the fixed income assets in the Plan.

Investment in equities provides potential capital appreciation and growth of income through dividend increases. This growth can help offset the impact of salary-based benefit accruals of active employees on future liabilities. The Plan's equities portfolio consists of U.S. large and small cap portfolios, international equities and protective equity strategies.

Protective equity strategies focus on risk management and use non-leveraged derivatives, such as equity linked notes and options, to mitigate the downside volatility of the portfolio's equity exposure.  Essentially, protective equity strategies skew equity returns, giving up returns in excess of 12% to 15%, in exchange for reducing the amount of potential loss. As these types of investments offer lower downside risk exposure in lieu of potential higher returns, a larger allocation can be made to equities including protective strategies than could be made to equities alone.

Risk management is also the driving force behind the Cash Flow Match portfolio, one of the major elements of our fixed income allocation. The Cash Flow Match portfolio is a high-quality bond portfolio structured to match the future cash inflow from coupons and bond maturities against future cash payouts for benefits to current retirees and beneficiaries.

In addition to increasing the duration of its fixed income allocation, the Plan has used interest rate swap overlay portfolios to synthetically lengthen duration.  This strategy allows the Plan to receive the return on instruments of varying maturities in return for paying a short term LIBOR rate.

In summary, implementing its post-PPA strategies have lowered the 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 duration is expected to reduce the exposure of the Plan liabilities to yield curve changes. Going forward, the Plan is also developing greater refinement of its liabilities in order to achieve fuller matching of the capital market characteristics of its assets and liabilities.

Pension investing is an evolving process. Risk management has changed over time and will continue to change with new tools, techniques, and investment vehicles. For more information on pension investing, or to discuss your pension program, contact Richard Rausser, Vice President, Consulting Services at rrausser@pentegra.com, or 1.800.872.3473, extension 415.