As we wrote in our recent post about minor hockey and pension funds, it’s not the absolute results that matter most, it’s the margin of victory. Unfortunately for pension funds, right now they’re a bunch of goals behind. In fact, the opposition (a.k.a. pension liabilities) scored a barrage of unanswered goals in 2008 and opened up a seemingly insurmountable lead.
This in-game coverage comes from the Deutsche Bank’s semi-annual “Asset Owner Survey.” As the chart from the survey below indicates, corporate pensions remain underfunded to the tune of 25%:
Things were even worse for public pension plans, which trailed liabilities by 35%. Naturally, declining assets were a key contributor to this problem. But as regular readers of this website know, the present value of future liabilities has been rising simultaneously as the discount rate used to bring those liabilities to the present shrinks. Making matters worse, some pension funds have been throwing in the towel on their dreams of 8.5% annualized returns.
One would think to turn this all around by somehow tying assets and liabilities together. But who wants to lock-in a funding gap of 25% or 35%? If the pension could only wait until returns – as well as interest rates – rose, the gap might close on its own. They could then lock together assets and liabilities and wipe their hands clean of the whole mess.
Deutsche Bank asked pension funds to consider this option in a roundabout kind of way. First, they asked survey respondents what funding status level they would require before liability driven investing (LDI) “makes sense.” They calculated the interest rates required to move pension funds from today’s funded status to the level at which pensions say they would lock-in funding status using LDI. As the chart below shows, most funds said it would take a rise in 30-year Treasury yields of rates of over 200 bps.
This estimate might be too conservative though. Following their own calculations, Deutsche Bank concluded that a 200 bp rise in rates “would bring the average S&P plans sponsor’s funded status from its current level of 74% to nearly fully funded.” (our emphasis added)
Saved! No, wait…unfortunately,the median consensus forecast is for rates to rise less than half of what’s needed by mid-2012. So pension fund might be waiting a long while for rising rates to cut liabilities down to size.
But the firm does have an interesting idea for those who are willing to give up any upside if rates go sky high (and liabilities fall commensurately). Sell a 30-year swaption that pays a premium now and that would lock together assets and liabilities if rates do get to a point where the funded gap shrinks to zero. You lose any upside beyond that. But who cares? At least your pension fund is still solvent. The pensioners probably won’t start a letter-writing campaign to complain about how you didn’t take on more risk…
There’s always the option of trying score a few more goals. And this is where the survey results get interesting. Deutsche Bank found that public and corporate pensions differed in their strategy to eke out a few extra points in returns over the next year. The chart below shows the percentage of respondents that planned to either increase (green) or decrease (red) their allocations to several asset classes over the next 12 months. As we have pointed out before, the perspectives of public and corporate plans seem to differ markedly. (click to enlarge)
In this chart, you’ll see that public plans seem to be more bullish on real estate than their corporate cousins. In addition, 0% of public plans said they would decrease allocations to various other alternative investment classes (e.g. infrastructure, commodities, or hedge funds). And only a few said they would cut back on private equity.
What’s most striking though are the last 2 bars “US Small Cap Equities” and “US Large Cap Equities.” This seems to reaffirm what Morningstar and Barron’s found when they surveyed institutions about the importance of alternative investments vs. traditional ones (see post). Over half of respondents to that survey said alternative would be “as” or “more” important than traditional investments over the next 5 years. Apparently a good call…
With hedge funds clearly still on the institutional agenda, the firm then asked respondents which hedge fund strategies they planned to allocate to next year. The following chart contains the aggregates data (public pension funds, private pension funds, and endowments/foundations). The report also breaks this out into public and corporate plans – showing that very few, if any, public pension plans aim to decrease allocations to individual strategies over the next 12 months.
It’s a good time to be a special situations, global macro, long/short credit/equity or distressed debt manager. Investors don’t seem to have quite the same level of enthusiasm for arbitrage strategies though. Still, even the less favoured strategies can expect to see “decrease” rates that are as low – or even lower – than those of the hot strategies.
The survey also covers fat tail mitigation strategies and a few other topics. So there’s plenty of stuff to mull over while you patiently wait for interest rates to rise.