Public, Church Pension Plans Face Similar Challenges

Alternative strategy seeks to increase returns, improve funded status, avoid ‘death spiral.’

Public sector and church pension plan sponsors can use an alternative approach to investing that suit their “unique but similar financial challenges” by seeking equal or greater investment returns with less funded status volatility than conventional investment strategies, according to a white paper from asset manager River and Mercantile.

The white paper, which was written by Rivera and Mercantile Managing Director Thomas Cassara, said that difficulties facing both public and church plans included funding ratios less than 100%; high levels of annual cash outflows (such as benefit payments that are often more than 5% of the plan’s market value); and a limited ability or interest to significantly vary cash contributions each year.

However, the paper also said public and church pension plans typically have financial flexibility in how they can manage their pension obligations because they are able to use a liability discount rate that reflects the long-term expected return on plan investments. This, it said, results in lower, more predictable reported liability values. They can also establish relatively long amortization periods to pay back any underfunded liabilities, which provides more contribution stability, and they can smooth out investment gains and losses over a longer number of years.

Cassara wrote that most plan sponsors and trustees diversify their asset holdings over several asset categories, and will look to blend the allocation to create an investment strategy to meet or exceed their return objective, while controlling investment risk. In rising markets this has worked well, he wrote.

However, he said that because most plans have public and private equity holdings of well above 50% of assets, they are exposed to potentially big losses if a market correction or prolonged recession hits. Cassara cited a study by Wilshire that found that during the financial crisis, the level of funded status for state public plans went from an average of 92% funded in 2007 to 61% in 2009.

“Unfortunately, many of these plans had high benefit payments and expenses relative to contributions and investment income, creating a negative cash flow situation,” Cassara wrote. “These plans had to sell off assets during the crisis in order to raise cash to meet required benefit payments, and as a result, had fewer assets with which to participate in the subsequent market rebound.”

According to Cassara, an ideal investment strategy for these plans needs to address two key objectives. One is to improve the funded status of the plan while managing the ups and downs of the funded status volatility. The other is to avoid having the plan become underfunded to the point where it falls into a “death spiral” from which the only way to recover would be to significantly increase contributions and/or reduce future benefits.

Cassara writes that the objectives can be reached through a portfolio that has an underlying fixed income investment strategy made up of higher-yielding investment-grade securities, as well as equity derivatives, such as put options and call options, that provide contractual exposure to the equity markets, but in a way in which risk can be managed.

He said a combination of fixed income and synthetic equity derivatives can provide a higher likelihood of providing a plan a steady increase in funded status over time, meeting or exceeding the expected return assumption, net of fees and expenses, and mitigating the risk of a death spiral, especially during a market correction or recession.

“This portfolio stands in sharp contrast to other investment strategies that rely heavily on illiquid and ‘alternative’ asset classes, many of which have been in vogue since the Great Financial Crisis of 2008,” wrote Cassara. “With a goal of controlling volatility while still seeking to earn a sufficient investment return, typical mainstream investment strategies have struggled to meet plans’ objectives while tending to have a higher fee structure and less transparent investment management.”

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