Fundamental to investment success is a clear objective. In many cases, institutional investors articulate this objective as a fixed investment rate of return (ROR), for instance 7%. But such an approach can overlook a fundamental aspect of institutional investing: Investment returns will ultimately be distributed as cash flows. Focusing on only the ultimate targeted return is insufficient if the investor wants to achieve its goals, as level of return is just one component. In this article, we look at the considerations an institutional investor should keep in mind and how a targeted return approach falls short.
There are many types of institutional investors, and each has different objectives to consider. On one end of the spectrum are frozen defined benefit (DB) pension plans, where there is a great deal of certainty as to when cash will be distributed. On the other end are endowments with a mission to support an organization long into the future but with an increasing cash payment requirement along the way. Ideally, the investment objective of an institution will reflect where that investor falls on the spectrum; it will also depend on the nature and timing of the payments that need to be made in the future and the ability of the institution to handle any shortfall.
Unfortunately, many institutions don’t seem to make this observation as part of their investment objective and, thus, their asset allocation process. For example, the vast majority of vested U.S. pension liabilities, both corporate and public, are not inflation-linked. Almost no corporate pension plans have cost of living adjustments (COLAs). The picture is more complex for public pension plans, but the majority do not have automatic COLAs. Because these liabilities are not inflation-linked, it can be counterproductive to invest in assets designed to respond well to inflation, such as bonds with relatively short maturities.
In fact, higher inflation would likely lead to higher interest rates. Higher interest rates, all else equal, should lead to higher future investment returns, making it easier to fund expected future cash flows. For most pension plans, inflation is an opportunity not a risk. It is deflation, coupled with lower nominal interest rates, that’s the key risk for most DB plans.
Conversely, endowments and foundations, as well as individuals, have a great deal of sensitivity to inflation, as their expected future cash outflows need to increase in real—i.e., after inflation—terms. Rising inflation is therefore an appropriate key risk for an endowment to try and mitigate. Therefore, it could be practical to see investments whose objective is to keep pace with inflation as part of an endowment fund’s strategy.
This one example demonstrates how there is no one-size-fits-all approach for institutional investors. Yet, when we look at the institutional investment landscape, we see, for example, many defined benefit pension plans, particularly in the public sector, that seem to invest with little or no regard to the fundamental nature of their liabilities.The simplest example of apparent misallocation by pension plans is how they treat fixed income. Most institutional investors view fixed income as an “off-risk” or “low-risk” asset class that provides diversification from equity returns. Many public DB plans use relatively short maturity bonds for their off-risk fixed-income allocations, but is this really the most appropriate off-risk asset?
As we mentioned before, it’s imperative to first understand the nature of future cash requirements to be able to hone in on the type of investment risk that should be in a given portfolio. As an example, pension plan cash flows will be paid many years in the future. These future cash flows can be met, in part, by investing in bonds that will mature when the cash is required. This means the true off-risk asset for a pension plan, so long as the future cash flow is not subject to changes due to inflation, is a portfolio of bonds invested to match a portion of a plan’s future expected cash outflows.
The shorter-maturity bonds that most public pension plans, and many corporate pension plans, invest in provide a reasonable amount of asset value stability as part of a diversified portfolio and won’t suffer too badly in an inflationary environment. But they provide a poor hedge against deflation, or even just “low-flation,” which leads to lower future expected investment returns—actually the key risk for most pension plans.
Many pension plan sponsors and their advisers have fallen into the trap of looking at traditional portfolio diversification metrics and have, in fact, failed to consider the investment problem they are trying to solve. Or, even worse, they may look to peers who may have very different liability profiles, to gauge whether they are investing properly.
This also can be clearly seen with regards to alternative asset classes such as hedge funds. Absolute return hedge funds typically target returns of cash plus 2% to 3%. When cash yields were 3% to 5%, these funds could produce decent top-line performance with low correlation to equities and bonds. However, when cash yields are below 2%, as they have been for most of the past 10 years, then these investments are challenged to be able to meet the investment return that most pension plans need—a requirement driven by how the value of pension liabilities will grow. Many plan sponsors were sold on these investments because of their seeming ability to provide diversification as well as positive returns, especially if interest rates rise. But most pension plans don’t need more return when rates rise—they need it when rates fall. Again, sponsors have been misled by portfolio allocation strategies that neglect to account for the fundamental nature of what the institution is trying to achieve.
It is no secret that investing well over the long term can be a difficult task. Unforeseen events will inevitably blow an institutional investor off track. However, the task is made easier when the correct path is taken at the outset. That path will largely be driven by having a thorough understanding of the cash flows to be paid in the future as well as how those cash flows may change in different economic environments. Some liability/cash flow risks such as inflation/deflation can be mitigated through the investment strategy, and some such as mortality cannot. Knowing the difference and the sensitivity to getting things right or wrong will go a long way to producing a better investment process—one that has a higher likelihood of producing a successful outcome. If institutional investors separate their stated investment objective from their future cash requirements—i.e., their liability profile—they do so at their own peril.
Ryan McGlothlin is a managing director in River and Mercantile (R&M)’s Boston office and leads the U.S. investment business. Michael Clark is a managing director in R&M’s Denver office and is the 2019/2020 president of the Conference of Consulting Actuaries.
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