Column: The Institutional Elephant

From aiCIOs November Issue: How investors are evaluating an equity-centric policy. 

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The elephant in the room for institutional investors is whether target return assumptions of over 8%—established in times of rosier equity risk premia—are achievable in the future. To posit that the median plan will reach 8% is, at best, greatly optimistic, especially in the “risk-on/risk-off” environment post-2008.

However, after what the industry has gone through over the decade, it is not surprising that fund sponsors are evaluating alternatives to the equity-centric policy standard.

How Low Can You Go?

Interest rates are at historic lows, but for plans approaching fully funded status, lengthening durations and increasing fixed income is high on the list of risk and volatility management.

A number of institutions have switched from an equity-biased asset allocation model to a liability-driven investment (LDI), risk-parity, or factor-based approach. Typically, addressing the asset/liability mismatch includes combining long corporate (10 years+) and government credit (two to three decades+) with options and derivatives to hedge certain exposures.

Large corporate and defined benefit (DB) plans are moving to LDI to reduce market and balance sheet volatility. Compared to their five-to-ten year brethren, multi-decade credit looks more like a liability than an asset.

Plans that are not fully funded—and there are many of them—potentially face significant risks if they lock in low yields now, since shorter duration bonds could improve their funded position should rates rise. According to Aon Hewitt (which by the way has one of the best apps in the industry, “HRevolution”), 86% of DB plans were underfunded as of January 2011.

While long duration bond funds are a possible solution, the strategy faces a number of challenges: the possibility to lock in losses by going long now, convincing trustees to approve the necessary portfolio changes, and the overall question of supply for long duration bonds in the marketplace.

How Long Can You Go?

The UK, driven by the depth of its pension market and regulatory impetuses, in 2005 started with a 50-year gilt. This summer, the UK’s debt management office reported sales of long-dated government bonds of £11 billion in under an hour (50-year gilts accounted for £4 billion), which prompted the chancellor to put forth the idea of a 100-year “Osborne bond” or a perpetual gilt, similar to bonds issued after the South Sea Bubble and WWI.

On the emerging front, Mexico—encouraged by the success of Rabobank and Norfolk Southern—issued 100-year debt at a 6.1% yield, while Peru post-2008 sold 40-year sovereign bonds. Often, such issues have been a result of specific requests. For pension funds, the longer, the better.

For the US markets, getting longer exposure has been an uphill battle.

Going beyond the existing 30-year offering, the discussion by the US Treasury to create 50- and 100-year bonds as a sensible thing to do in this environment is built around $2.5 trillion+ in possible demand in the next few years as a result of financial and pensions regulation.

The 2008 crisis forced the US government to issue $800 billion in Treasury bills, along with some $500 billion in short-term financing to deal with the financial crisis. Since then there have been efforts to transition to longer term financing with auctions of 10- and 30-year bonds, alongside 10-, 20-, and 30-year TIPS for a total of more than $2 trillion in various instruments with long maturities.

Still, the average maturity in the UK—close to 15 years—is three times longer than in the US.

As a result of the limited long-term supply, asset holders have been stacking up on long-term corporate debt instead of US Treasuries. 2012 is already a record year for 30-year corporate bonds. Halfway through the year, long-term corporate debt sales had already surpassed the $85 billion 2011 full year totals, capitalizing on the low-yield environment and institutional demand for alternatives to government debt. For example, the University of Pennsylvania issued $300 million in 100-year bonds at 4.64% (lower even than the California Institute of Technology last November) in a strategic move to take advantage of low borrowing cost.

So while LDI implementation and long duration bonds are a risk management solution for some well funded plans and a good way for corporations and schools to raise money, most institutional investors must first decide whether rates could potentially go lower or remain low, and then perform a balancing act of risk allocation, interest rate assumptions, and board education around new investment policies and implementation triggers. Moreover, as Callan Associates speculated in a recent risk parity research study, “Given the underperformance in the 1990s and the practical difficulties to implement a levered policy portfolio, it is unlikely that the levered risk parity approach would have survived at any major institution.”

And assuming this communication conundrum can be solved, good luck with breaking the news that future returns might be closer to 5% than 8%.

Daniel Enskat is Senior Advisor to Asset International and Founder of Enskat & Associates.