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Fixed-income managers touting their expertise in liability-driven investing (LDI) would like nothing more than for American public pension plans and their trillions of dollars in capital to move en masse into duration-matching “solutions.” They will be waiting awhile.
“These public plans are set up to operate essentially in perpetuity,” says Keith Brainard, Research Director at the National Association of State Retirement Administrators. “An overarching objective of theirs is predictability and stability of cost, which affects the plan sponsors—who, in this case, are public entities that cannot sustain wild gyrations in the cost of their pension plans.” At first glance, the foundation underneath this line of reason—that public plans demand stability and hate volatility—will have LDI pitchmen drooling, for it is these two desires (along with regulatory catalysts) that drive LDI adoption at corporate plans the world over.
Not so fast, Brainard says. “These plans are scheduled to make their payments over decades, and they set up actuarial methods and processes, investment assumptions, and strategies on the basis of a long horizon. We could achieve what LDI seeks to promote, but one of the problems is that costs would go up. The sponsors would be forced to contribute more capital earlier, and investment returns would be significantly less. What these plans are doing is leveraging their perpetuity—across lives and generations—so as to not have cost and contributions skyrocket right now.”
Of course, LDI doesn’t inherently imply that an all-or-nothing approach is mandated. “The average allocation of a public pension to fixed-income and cash is about 30%—and these funds have to consider and anticipate their payment stream,” Brainard says. “That’s why they have these diversified portfolios that include a core fixed-income component.” There is no reason that some form of duration extension could not occur in this corner of the portfolio, he asserts. Some vendors have noted this opportunity, and are adjusting their products accordingly: Cutwater Asset Management, for one, touts products that de-risks a near-term set of liability payments—a quasi-LDI for public plans.
This quasi-LDI is likely the extent of LDI-inclusion in public plans for the foreseeable future. Like with corporate plans, no significant change will occur until regulation forces solvency and mark-to-market accounting of public pension liabilities. By one rule of thumb, pension liabilities rise 35% for every 1% change in the discount rate used to calculate them. With the average public plan assuming 7.64% investment returns, according to aiCIO’s inaugural Liability-Driven Investment Survey, on page 78, and the average corporate plan being forced to use a discount rate of somewhere around 5%, this would mean a change in liabilities of upwards of 100% if the former was forced to use the same accounting standards as the latter.
Besides a public outcry that would make the Tea Party movement look like a garden picnic, such accounting changes would also spark another crisis: an extreme shortage in long-duration bonds that would make LDI an even more expensive proposition in the short-term. This would be due to the simple fact that global pension liabilities dwarf global high-quality long-duration fixed-income offerings. LDI-utilizing pension plans and vendors are already complaining about the lack of long-duration bonds. If Washington told every state, county, and city pension plan that they must be solvent and account for pension liabilities in the same way that corporate plans currently do, saying that this problem would be exacerbated would be an extreme understatement. In this case, traditional fixed-income managers—currently enjoying an LDI inflow from corporate funds—may not be the beneficiaries: With so few long-duration bonds available, new adoptees of LDI would likely embrace swaps to immunize. Drool away, LDI vendors, but be aware of how this market may ultimately evolve—and adjust your businesses accordingly.