Investment Return Expectations and Wishful Thinking

When it comes to strategy games, count me in. Bridge and Scrabble are two of my favorites except when it looks like I have little chance for victory. It's one thing to lose a hand or two but feel confident in a possible win. It's altogether depressing to know that recovery is unlikely. This happened a few days ago when my husband added an E, U, A and L to create a cluster of words that scored him sixty-seven points. Ouch. Even with lots of high point letters, I knew that besting his bonanza move was improbable. Each time we play, I begin on an optimistic note and hope for a favorable outcome until that moment when I know it's time to recast my calculations.

It's good to wish upon a star yet just as important to distinguish fantasy from fiction. That's why I was surprised to learn the results of a recent study of 400 institutional investors about their performance predictions. Carried out by State Street Global Advisors ("SSGA"), in conjunction with the research arm of the Financial Times, main takeaways from the "Building Bridges" study include the following:

  • Traditional asset allocation models may be unable to generate a long-term average rate of return of eleven percent, certainly without forcing buyers to take on more risk.
  • Forty-one percent of survey-takers expressed a preference for "traditional" classifications of asset exposures versus factor or objective-driven identifiers.
  • Eleven percent of those in search of closing "performance gaps" rank smart beta strategies as most important and 38 percent of institutional investors will employ this approach alongside other activities. "Significantly, three-quarters of those respondents who have introduced smart beta approaches found moderate to significant improvement in portfolio performance."
  • Enlightened decision-makers are finding it hard to get board approval of "better ways to meet long-term performance goals" and peer groups are slow to follow suit.
  • Eighty-four percent of pension funds, sovereign wealth funds and other asset owners believe that underperformance is likely to continue for one year.

As Market Watch journalist Chuck Jaffe somewhat indelicately points out in "An overlooked investment risk: wishful thinking" (May 18, 2016), long-term investors are daydreaming if they believe they can regularly generate eleven percent per annum. He quotes Lori Heinel, chief portfolio strategist at SSGA, as acknowledging the difficulty of achieving this number, given "a really challenging growth outlook, inflation environment, and a really challenging investment return environment." Notably, it was only a few weeks ago when the special mediator for the U.S. Treasury Department sent a letter to Central States Pension Fund trustees, denying a rescue plan in part because its 7.5 percent annual investment return assumptions were not viewed as "reasonable."

As I described in an earlier blog post entitled "A Pension Rock and a Hard Place," public pension funds, union leaders, taxpayer groups and policy-makers are navigating choppy asset-liability management waters. They are not alone. Corporate plans, endowments, foundations and other types of institutional investors are likewise challenged with getting to their destination and not crashing on the rocks. My unrealistic expectations might lose me a game. For long-term investors, there is serious money at stake and model inputs are being scrutinized accordingly.

Pension Plan Divestment and ESG Investing

In its quest to advise the City Mayor, Boris Johnson, about climate change, the London Assembly recently urged the London Pension Fund Authority ("LPFA") to rid itself of its carbon ("specifically fossil fuels") investments and allocate the proceeds to "responsible funds, which deliver appropriate returns to the taxpayer." They referenced the National Association of Pension Funds ("NAPF") and its recognition that institutions have a role to play in Responsible Investment ("RI") or what the NAPF describes as the "integration of environmental, social and governance (ESG) factors in the investment decision-making process and stewardship activities."

According to Chief Investment Officer, the LPFA, with assets in excess of 4 billion pounds sterling, replied, in a letter to its 80,000+ members, that it takes ESG investing seriously as a long-term vehicle, adding that its "key aim must be to ensure we can continue to pay your pensions as they fall due." Although this jumbo pension plan currently has "less than 1% invested in fossil fuels," it carved out space on the LPFA website to address the topic as follows: "Responsible investment factors, such as low carbon, may be relevant as an additional consideration. However, screening out stocks for investment/divestment on ethical grounds only is in conflict with the Board's fiduciary duty if the decision risks significant financial detriment to the fund."

The concepts of responsible investing and divesting are not new. Pension plans and sovereign wealth funds are a few of the many organizations that have been approached to jettison certain investments. Push back, when it occurs, is based on the notions that (a) entrenched shareholders can do a lot to effect change (b) divestment costs are high and/or (c) selling off a position could violate fiduciary obligations to beneficiaries. In "Selling out of fossil fuels no solution for climate change" (Financial Times, March 22, 2015), Anne Stausboll details the governance stance adopted by the California Public Employees' Retirement System to encompass "advocacy, engagement with companies and investing in climate-change solutions." As its CEO, she suggests that "Walking away by simply selling off assets through divestment will not help."

In 2007, I wrote about my interview with Maria Bartiromo, then CNBC senior anchor, on this topic of whether, how and when to divest. See "Is There Fiduciary Liability Attached to Divestment?" I offered four considerations as repeated below:

  • Selling an investment due to political pressures could end up costing "taxpayers and plan participants in the form of 'unexpected' transaction costs" which in turn could worsen sub-par funding levels;
  • Proceeds from any mandated sales could lead to lower returns than originally projected;
  • Fiduciaries may find themselves accused of breaching their duties unless they can adequately demonstrate the economic rationale for divesting; and
  • Plans, especially those with small staffs, could be overwhelmed with having to spend considerable time and money to get up to speed before making direct ESG type investments.

As with any investment action, there is never a free lunch. Every decision needs to be carefully reviewed.

Interested readers may want to check out the following items:

Deciding When to Tweak or Overhaul a Pension Plan

People in my family buy things to last. It doesn't always work out the way we want. For example, we can't watch internet movies through our television set because we have yet to upgrade to a newer box that has the technology to allow this to happen. However, sometimes it is better to upgrade, even if there is a short-term incremental cost to do so. I learned this lesson the hard way in recent weeks. Sick of an old laptop that constantly froze on pages with too many graphics and a printer that only worked when I cleaned the print head (and that became a frequent occurrence), I made a beeline to Staples. During my discussion with the technology salesperson, he agreed with me that the immediate outlay of buying new productivity tools would be a lot cheaper than upgrading with the purchase of a few parts. The speed, storage and ability to use newer versions of software were a few of the advantages we discussed.

Change can be a good thing or not. The concept of evaluating when to tweak plan design or asset allocation mix (or a host of other decisions), as compared to carrying out a complete overhaul, applies to retirement plans. Of course this assumes that it is even possible to modify. For a defined benefit plan that is grossly underfunded or a defined contribution plan that is set up to keep workers happy by offering a particular group of investments, reversing course could be problematic. On the flip side, a sponsor that can effect change that would be deemed advantageous by participants but does not take action could be accused of bad practices or worse. Keep in mind that lots of ERISA lawsuits allege actions that a fiduciary committee could have taken. The important thing is to be vigilant about what has to be done on an ongoing basis and respond accordingly,

At least some plan sponsors are taking heed of the need to review where things stand. According to a recent Aon Hewitt survey, 62 percent of polled 220 U.S. companies with traditional pension benefit offerings vowed to "adjust their plan's investments to better match the liabilities in the year ahead." Some respondents affirmed their intent to consider increased allocations to fixed income securities and hedging strategies, once their funding status improves. One out of eight companies queried are evaluating plan funding status as often as once per day. Click to download "2014 Hot Topics in Retirement: Building a Strategic Focus."

I have a t-shirt that reads "Change is good. You go first." It always makes me chuckle. Even when change is not warranted, it is important to demonstrate that at least someone has thought about risk factors and alternative ways to mitigate those identified uncertainties.Maybe the t-shirt should instead read "Assessing whether change makes sense is an important part of a fiduciary's responsibilities."

Institutional Asset Allocation

My comments about institutional asset allocation, along with those made by Mr. Ron Ryan (CEO, Ryan ALM) and Lynn Connolly (Principal, Harbor Peak, LLC), were well received on January 8, 2014. Part of a joint program that was sponsored by the Quantitative Work Alliance for Applied Finance, Education and Wisdom ("QWAFAFEW") and the Professional Risk Managers' International Association ("PRMIA"), our audience of investment professionals added to the lively debate about topics such as strategic versus tactical asset allocation, fees, role of the pension consultant and the likely capital market impact due to the implementation of strategies such as liability-driven investing ("LDI") and/or pension risk transfers ("PRT"). 

With the size of the U.S. retirement market at $20 trillion and counting, big money is at stake. Bad asset allocation decisions can lead to a cascade of economic woes. It is no surprise that fiduciary breach allegations in the form of ERISA lawsuits are increasingly focused on questions about the appropriateness of a given asset allocation mix and whether an investment consultant or financial advisor has helped or hindered the way that pension monies are allocated. Noteworthy is that scrutiny about the efficacy of the asset allocation process and resulting money mix can, and has been, applied to both defined benefit and defined contribution plans. Keep in mind that asset allocation decisions are likewise central to assessing popular financially engineered products such as target date funds. Accounting issues and how changing rules influence asset allocation decisions are yet another topic that we will tackle in coming months.

Click to access Susan Mangiero's asset allocation slides, distributed to members of the January 8 audience, and meant to peturb a discussion about this always essential topic. Interested readers can check out "Frequently Asked Questions About Target Date or Lifecycle Funds" (Investment Company Institute) and "Annual Survey of Large Pension Funds and Public Pension Reserve Funds: Report on pension funds' long-term investments" (OECD, October 2013).

If you have a specific question about asset allocation and/or the procedural process associated with asset-liability management, send an email to me.

Global Pension Assets: Another Tough Year

Hot off the press, the OECD's September 2012 issue of "Pension Markets In Focus" includes some notable statistics about pension schemes around the world. While aggregate assets increased to over $20 trillion (as of December 2011), post-fee real rates of return were miniscule at best. With an average annual rate of return of -1.7%, few winners bested the market at large. The award for the highest performing pension system went to Denmark with an annual return of 12.1% in 2011, followed by the Netherlands (8.2%), Australia (4.1%) and Iceland and New Zealand, each turning in a modest 2.3%. Turkey, Italy, Spain, Japan, the United Kingdom and the United States realized negative returns.

The news is not all grim.

According to André Laboul, OECD Head of the Financial Affairs Division Directorate for Financial and Enterprise Affairs, assessments of performance that consider many years show that the traditional 60% equity and 40% long-term sovereign bond mix have generated positive returns that range from 2.8% in Japan to 5.8% in the United Kingdom. Of course, many factors are at play, not the least of which is how much latitude an investment committee or policy-making body has to allocate monies locally versus internationally, the rate at which assets grow (and can be put to work) and the fees that are paid to various service providers.

Regarding asset class exposure, OECD researchers note that pension funds' allocation to "public equities declined significantly compared to past years." This trend is likewise noted in the "Global Pension Assets Study 2012." Published by Towers Watson in January, this compilation of interesting data points shows that the Netherlands and Japan have a "higher than average" allocation to bonds. In contrast, "in 2011, Australia, the UK and the US retained above average equity allocations." Apportioning more monies to alternatives is an undeniable reality for retirement plans in multiple countries

Since more than a few people posit that asset allocation decisions dominate portfolio returns, it is critical to track who is investing in what. Pension de-risking activity will likely have an impact on defined benefit plan portfolio mix going forward if, as experts suggest, more companies decide to exit or modify their exposure to the "pension business" by freezing a plan, using derivatives, offering lump sum payouts, entering into group annuities and so on.

Pension restructuring and adding more alternatives are factors that are changing the governance landscape in numerous ways. For one thing, the need for investigative due diligence and independent valuation services arguably becomes more acute. Second, the regulatory focus on holdings disclosure and compensation paid to service providers could inhibit the use of private funds at the same time that yield-seekers are writing checks.

The "push-pull" dynamic is holding everyone's attention since so much money is at stake.

Public Pension Plans and Private Equity

 Reporter Michael Corkery paints a grim picture of what lies ahead for government workers. In “Pension Crisis Looms Despite Cuts by Nearly Every State” (Wall Street Journal, September 22-23, 2012), steps taken to reduce costs “have fallen well short of bridging a nearly $1 trillion funding gap.” Besides reduced benefits for new hires, increased contributions required of both new and existing workers, suspended cost-of-living adjustments and lower benefits for current workers, governments are starting to implement defined contribution plans such as 401(k) arrangements. No doubt the debate about constitutionality will rage on but the fact remains that the status quo is nearly impossible to maintain.

For some plans, a solution is to alter assets and invest more in alternatives such as private equity and hedge funds. According to the Private Equity Growth Capital Counsel, private equity and some pension funds have done well by each other. Its map of state-by-state performance shows positive returns for public pension funds such as the California State Teachers’ Retirement System. Whether the relationship between the two groups will continue is uncertain. As Kate D. Mitchell, Managing Director with Scale Venture Partners and a speaker at the 2012 Dow Jones Private Equity Analyst Conference observed, a shift from defined benefit plans to defined contribution plans for countless state and local employers will likely mean fewer dollars for the private equity industry. What happens then will depend on whether new monies will be available from other sources or instead cause a contraction in long-term deployment of assets by general partners ("GP").

In addition, political pressures are a reality, especially with respect to how capital gains are currently taxed. Should rates increase at the same time that fewer dollars are available from public pension plan coffers, the private equity industry could find itself under pressure in terms of growth potential and profitability. Other speakers at the Dow Jones Private Equity Analyst Conference were extremely upbeat about the outlook for uber growth in certain geographic sectors and industries. If they are right, investors in private equity will want to look carefully at the make-up of a GP's portfolio.

Pension Funding Relief Passed Into Law

Signed on June 25, 2010 by President Obama, the Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Act (H.R. 3692) allows plan sponsors to amortize funding gaps over a longer period of time than is currently allowed. In addition, this legislation enables funding relief for up to two years.

While the financial markets have not been kind to more than a few defined benefit plans, new rules are going to make it even more difficult for financial statement users to assess the true economic health of any given retirement arrangement. This is not a good thing. Beneficiaries and shareholders alike deserve user-friendly information, especially if a plan is in trouble. The new law will make things even more challenging in terms of deciphering reported numbers and that's saying something.

As I wrote in "The Plan That Didn't Bark" (CFA Magazine, March-April 2008), financial analysts and other interested parties must learn to think like detectives. The current state of pension accounting is far from perfect. Taking into account the likely impact of H.R. 3692, published funding information is going to be clear as mud.

Click here to access the full legislation. Clear to read "The Plan That Didn't Bark" by Dr. Susan Mangiero. (Editor's Note: Pension Governance, LLC is now part of Investment Governance, Inc.)

Old Age Can Be a Bonus With a Price Tag

Enjoy this interview about longevity and pension risk management with Dr. David Blake, Director of the Pensions Institute. Professor Blake explains why understanding life expectancy trends across age, gender and socioeconomic groupings is so critical. He comments on new valuation rules that relate to financial statement transparency and share prices of plan sponsors. He differentiates between pension buy outs from pension buy ins and offers reasons why longevity swaps can be beneficial.

Click here to read "Longevity and Pension Risk Management," an interview with Professor David Blake, May 2010.

For other articles about longevity and pension risk management, visit for a complimentary subscription to best practices website,

Asset Allocation Alchemy


Asset allocation seems to be on the minds of many these days. This is not surprising since empirical studies repeatedly suggest that how monies are apportioned across sectors and instruments is a primary driver of returns.

Some states such as North Carolina are legislating more choices for state retirement funds. According to "Pension fund to get new options" by The News & Observer reporter David Ranii, the Tar Heel State Treasurer will soon have the ability to allocate to junk bonds and Treasury Inflation Protected Securities ("TIPS").

In "Asset allocation survey 2009," Mercer LLC queried European pension funds and uncovered a "continuing focus on risk management and recognition that good governance can improve the investment performance of institutional investors." Notable is the result that mature defined benefit plans tend to reduce their exposure to equity markets in favor of fixed income.

In contrast, Dr. David Gulley, Managing Director at Navigant Consulting, suggests that an exit from equity could be ill-advised for investors seeking returns over many years. In "A Surprising Bear Market Lesson About Bullish Projections" (Law360, July 2009), Dr. Gulley writes that "a substantial and objective body of evidence shows that equity returns are reliable in the long term" and that a positive equity risk premium is "actually a requirement enforced by the market's ability to deny money." If true, the impact is potentially sweeping. For one thing, a migration to Liability-Driven Investing ("LDI") which tends to favor fixed income might prove costly later on. Pension plan decision-makers seeking to reallocate away from long only strategies might incur transaction costs now, only to add opportunity cost to the mix if and/or when the sun rises again in stock land. The net result could be a doubling up of bad news bears (or worse).

Absent a universal acceptance about the role of stocks versus everything else, the debate about optimal strategic and tactical asset allocation mix will no doubt continue for many years to come.


Pension Report Card - Process, Not Point in Time Numbers

In "Pension Plans Under Closer Watch" (November 18, 2008), MarketsmediaLive reporter Karla Yeh quotes me as emphasizing process. Rather than dwell on singular numbers that can change over time and according to the selected time period and/or reporting rules, I urge interested parties to focus on what happens next. In the event that a defined benefit plan suffers a loss, how will things have to change as a result?

Here is the article for your reading pleasure. The original version can be found at

<< Pension funds struggling with declining asset values could be hurt more by the consequences from losses than the losses themselves, said Susan Mangiero, president of Pension Governance Inc., on Tuesday.

“The real question is what actions are forced upon plan sponsors as a result of reported losses,” she added. “For some plan sponsors, the pension chain of events is significant.”

The Organization for Economic Co-operations and Development last week reported average pension fund returns plummeted by more than 20 percent between January and October, resulting in a $4 trillion loss in pension assets. In addition, consulting and actuarial firm Milliman on Monday said corporate pension funds could be $93 billion in debt by the end of the year after asset values dropped by $120 billion.

“A loss of $120 billion is hard to ignore, especially since many economists believe that market volatility is here to say, for a while at least,” Mangiero said.

To combat record losses, Mangiero said companies could be forced to contribute billions of dollars in cash or freeze their defined benefit plans if funding ratios drop below 60 percent, pursuant to the Pension Protection Act of 2006. They might also reduce benefits paid to retirees and face ratings downgrades or higher capital costs in an attempt to replenish the funds, she added.

As the New Year approaches, shareholders and plan participants will most likely watch their pension plan sponsors under a close lens to “better understand the nature of the reported losses,” said Mangiero.

In the meantime, plan sponsors will “try to figure out how they are going to recoup equity sector losses” and “may be tempted to allocate more monies to riskier investments,” Mangiero said. She added that asset allocation will be a top priority for pension plans that need to boost money management and risk management focuses. >>

Financial Domino Effect: Pensions and Alternatives

As this blogger has said for many months, pension risk management trumps a return-only focus. Few care about the risks associated with the upside. It's the extreme tail of a price distribution that gets people's attention. When low frequency (read DIRE) values occur, watch out. The dominoes crash into other, the structure crumbles and someone is left picking up the pieces. Is that happening now? You betcha! Any problems with investments, heretofore put into neat asset buckets, spill over into other parts of the portfolio, forcing major decisions about asset allocation, liquidity and cash requirements.

A November 16, 2008 New York Times article makes my point. (See "From the Valley Comes a Warning.") Writers Jeff Segal, Lauren Silva Laughlin and Rob Cox explain that the California Public Employees' Retirement System (Calpers) has to now decide whether and how to rethink its strategic asset allocation to alternative investments. Originally meant to be about 10 pecent of its overall portfolio, equity sector losses have apparently pushed the giant public plan's relative exposure to hedge funds, venture capital, private equity beyond its limit, to about 14 percent of its asset holdings. Worse yet (from a strategic asset allocation orientation) is that a market downturn may now accelerate calls for capital from the private equity and venture capital funds in which Calpers is invested, forcing an even higher allocation. (The idea is that some portfolio companies need more money now because their respective revenue projections cannot be met as corporate spending contracts. Private equity and venture capital fund managers - and their investors - can either lose everything they have invested in the portfolio companies or try to help them stay afloat, by giving them a cash lifeline sooner than anticipated. Hence, the need to accelerate capital calls.)

Calpers is not alone. We've heard from plenty of plan sponsors that the "stay the course" or bid adieu to alternatives (some or all) is at the top of their decision list. The problem is that exiting a particular private fund may be costly, so much so that the plan sponsor is made worse off in the short- and intermediate-term. Additionally, plan sponsors seldom have the legal right to turn down a request for additional capital from private equity fund X or venture capital fund Y. According to private investment fund attorney John Brunjes, a partner with Bracewell & Giuliani, "in a private equity or venture capital fund is a contractual relationship. Except for fraud or duress, pensions are on the hook to write a check when the alternative fund manager comes calling."

If true, that some plan sponsors are "stuck" for the foreseeable future (i.e. must meet their capital commitments to alternative fund managers) AND their losses continue in traditional equity land, participants may take it on the chin in the form of reduced benefits. Taxpayers and/or shareholders may be asked to make up the difference. From the mail and calls we get at Pension Governance, Inc., there are a lot of individuals who are beyond unhappy about what they see as their diminished future due to rescinded benefits, disappearing plans, sponsor insolvencies and so on. (While our company focus is on plan sponsors and their service providers, our web presence encourages communication from plan participants.)

With respect to investment fiduciary duty, will members of the investment committee be held liable for not having properly assessed correlation patterns over extreme data ranges? When things go south and investor flee to quality, "contagion" is not uncommon. This means that bad news impacts the performance of multiple asset sectors, even those thought to move inversely or independent of each other. The "one world - one market" phenomenon translates into lower diversification benefits.

Will investment fiduciaries be held accountable for not better measuring liquidity or assessing transferability restrictions or the legal implications of capital calls? What is the role of consultants and fund of funds managers in evaluating risk factors beyond the numbers themselves? Are there some private funds deemed to have done enough to vet the suitability of alternatives for their institutional investor clients.

I'll be writing much more about the changing relationship between institutional investors and private funds. What do you want to know more about in these areas? Drop me a line.

Editor's Notes:

  • On January 4, 2007, I wrote: "Contagion itself is dangerous but when you consider what some describe as an inevitable convergence towards one global market, with trading that occurs 24/7, the potential for serious harm is real. Continued technological advances, international deregulation and investors' willingness to go offshore promote lightening speed information flow. When bad news hits, it's the shot heard 'round the world. Having worked on three trading desks during volatile times, I know firsthand how quickly things can change." (See "Pension Contagion - Should We Worry?")
  • The Calpers website reports that, as of September 30, 2008, its current allocation to alternatives is 12.2% versus a target of 10 percent. For more information, click here.
  • Here is the link to the slide show that has Silicon Alley shivering in their boots. Essentially famed venture capital firm Sequoia Capital told entrepreneurs to watch their cash and acknowledge that the funding party may be over, at least for awhile. See for yourself. Read "The Sequoia: 'RIP: Good Times' presentation: Here it is" by Eric Eldon, Venture Beat, October 10, 2008.

Equity Bye Bye - Asset Allocations Are a Changin'

According to Financial Times reporter Deborah Brewster ("Investors pull out of mutual funds," April 27, 2008), nearly all U.S. mutual fund managers saw a drop in assets in Q1-2008. Sagging returns are a main driver on the retail side. Citing Strategic Insight, Brewster writes that individuals and institutions have pulled $100 billion from American, European and Japanese equity funds.

Money market funds, charging lower fees, seem to be picking up the slack. This suggests an inevitable decline in profitability for the asset management business. In "Has the Financial Industry's Heyday Come and Gone?" (April 28, 2008) Wall Street Journal reporter Justin Lahart writes that "the businesses of borrowing, lending, investing and all of the middlemen in between" are slowing and thereby creating ripples throughout the U.S. economy. With documented job cuts in the financial sector, new regulations and questions about "excess" risk, a discernible shift is underway. A shrinking financial sector and reduced availability of credit hits consumers and corporations hard.

In addition, defined benefit plans are moving assets away from equity to alternatives and fixed income. In "CalPERS to shift $44 billion" (December 24, 2007), Pensions & Investments reporter Raquel Pichardo describes the giant retirement plan's move into international equity, real estate, private equity and a "new inflation-linked asset class." On April 17, 2008, New York Times reporter Mary Williams Walsh offers insight into what some of American's biggest plan sponsors are doing to manage market volatility. Referring to a new study by Evaluation Associates in "Market Turmoil Has Taken a Toll on Big Pension Funds," Walsh writes that General Motors, Ford, Boeing and Deere are a few of the large plans to turn from equities.

The issue is important for many reasons, not the least of which is the impact on statutory funding requirements, cash flow and related share price. In March 2008, money manager Charles Gilbert spoke to a Society of Actuaries audience about the double whammy of falling interest rates (increases the defined benefit liabilty) and unhealthy stock returns (reduces portfolio value).

PBGC Allocates to Alternatives

According to its February 18, 2008 press release, the Pension Benefit Guaranty Corporation is changing its asset allocation mix to 45 percent invested in fixed income, 45 percent invested in equity and 10 percent left for alternative investments. A spokesman explains that ratcheting up on private equity funds and real estate is expected to generate higher returns but reduce risk because of greater diversification, giving "the Corporation a 57 percent likelihood of full funding within ten years compared to 19 percent under the previous policy." In the past, the PBGC mix favored bonds with 75 to 85 percent being invested in fixed income securities, including some monies earmarked for liability-driven investing ("LDI") strategies. Some PBGC critics recently cited high opportunity costs by concentrating on notes and bonds.

With an accumulated deficit of $14 billion at the end of fiscal year 2007 and the recognition of the long-term nature of its obligations, the decision was arrived at, after "an extensive review process that began in mid-2007." Interestingly, an "Investment Program Fact Sheet" seems to contradict the newfound logic, stating that "Because of the statutory restrictions on investment of the Revolving Funds and a change in PBGC's investment policy adopted in 2004, fixed-income securities dominate PBGC's asset mix." Additional text emphasizes a relatively low tolerance for uncertainty. "The current investment policy continues PBGC's investment focus of limiting financial risk exposure by investing the majority of PBGC's assets in long duration fixed-income securities in order to reduce balance sheet volatility."

It would be interesting to know more about exactly why the PBGC decided to move into real estate and private capital pools now. How did they net the expected lower risk (due to diversification) against incremental risks association with interests that seldom trade? Access to meeting minutes would make for good reading. Though it is not an official U.S. government agency ("financed by premiums paid by employers, assets from failed pension plans, recoveries from bankruptcies and returns on invested assets"), many people believe that American taxpayers are ultimately on the hook in the event of a PBGC bailout. With a recession on the way and relatively low interest rates that push liabilities upward, bad news for this insurance agency is not out of the realm of possibility. Additionally, though premiums have increased, few economists believe that risky plans are paying their "fair share" and that "good" plans are subsidizing poor financial management elsewhere. If true, PBGC's exposure to default is that much higher.

The PBGC says it reviews its investment policy every two years. How often does it assess its outside managers? Will due diligence for alternative fund managers differ from the check-up imposed on traditional managers? How will the PBGC address valuation issues related to private equity, venture capital and real estate? What performance metrics can we expect PBGC to share with interested parties if "hard to value" assets are held at cost versus "fair market value?" Is there or will there be a Chief Risk Officer for PBGC who addresses asset-liability management on an enterprise risk basis? How will banks be impacted if private plans decide to follow PBGC's example and shy away from LDI? Will corporate plans follow suit?

Sub-Prime Losses Keep Coming

At this rate, one could spend hours blogging about sub-prime woes, risk and whether adequate controls were in place. In a December 4, 2007 Washington Post article entitled "Losses Stack Up: Local Officials in Florida Try to Assess Damage To Investments Linked to Soured Subprime Loans " by Tomoeh Murakami Tse, I was interviewed about pension risk management implications. (Click here to access the article. You may be asked to register.) The State Board of Administration of Florida itself acknowledges the importance of risk controls, both in a November 2007 account of their sub-prime losses and in later interviews about fund withdrawals, subsequent freezes prohibiting further withdrawals and the hiring of Blackrock to develop a financial game plan.

In a recent study by the Towers Group, risk management was found to be lacking at some organizations, arguably one cause for large losses. Describing the adverse consequences of siloed risk management functions in financial institutions, authors of "Multifunctional Integration: The Positive Side of Risk," cite the need to work across divisions. They add that  "Beyond defending against threats to the organization, a more integrated approach to risk management can drive other business and client-centric benefits, including: improved quality and transparency of information; relationship pricing; process simplicity and efficiency; more effective decision making; and overall resilience."

No surprise to this risk manager and blogger who has spent over 20 years in the areas of risk management consulting, forensic analysis, board and trustee training and process assessment. In trying to convey the importance of acting before the fact, our Pension Governance team oft-repeats the importance of a holistic investment risk orientation, commencing with comprehensive training for everyone - front, middle and back office staff included. Importantly, buy-in from the top drives the acceptance of an organizational-wide risk culture and allows for resources to purchase analytical systems, hire professionals and make sure everyone has a good understanding of checks and balances. (In a recent workshop I led on risk management, I encouraged pension fund professionals to spend time with the chief risk officers employed by their banks, mutual fund and hedge fund managers.) 

Whether separate risk management activity reflects a "penny wise, pound foolish" behavior depends on a host of factors and will vary across organizations. However, delay in implementing an effective process can be costly as pointed out in a December 2007 assessment of sub-prime litigation risk by Guy Carpenter & Company, LLC. In "What’s the State of Your State? E&O Risk Uneven across the Country," authors list six factors that give rise to litigation risk for real estate professionals (though noteworthy for other related parties, given the flurry of lawsuits now being filed). See below for excerpted text:

  • Percentage of mortgages in foreclosure
  • Percentage of subprime mortgages that are delinquent
  • Number of litigation attorneys per mortgage industry professional
  • Frequency of Truth in Lending lawsuits (per million households) through Q32006
  • Frequency of banking-related lawsuits (per million households) through Q32006
  • Extent to which a state is plaintiff-friendly, i.e., is deemed a “Judicial Hellhole” by the
    American Tort Reform Association (ATRA).

Mortgage bankers and real estate brokers may be getting pink slips but litigators are busier than ever. For retirement plan fiduciaries, it bears repeating. Ask external money managers if they have sub-prime problems, query about how they are addressing risk gaps and demand to know what lessons they have learned from the credit crisis.

Pension Fund Grinch - Rate Cuts and Investment Complexity

Disappointing many, the Federal Reserve cut rates by a smaller amount than expected. Equity investors responded with a resounding hiss, sending the Dow Jones Industrial Average down nearly 300 points. Defined benefit plan managers can't be too happy either. After all, many of them have more money allocated to stocks than bonds. Then there is the matter of reported net unfunded liabilities rising as rates fall. What's an asset allocator to do?

This blog's author recently read survey results that suggest a significant migration to more complex securities. Not surprisingly, researchers describe a struggle on the part of investors and financial advisors who need higher returns but are not always comfortable that they understand the risks. (See "Financial Advisors to Embrace More Sophisticated Investment Products Over the Next Two Years, According to New Data from Cogent Research," Insurance Newscast, December 7, 2007.) 

I hate to say it folks but here goes. Why invest in something you don't understand? Isn't that part of the reason why the sub-prime debacle is starting to make the S&L crisis look like a walk in the park? Several incidents come to mind.

Following the 1987 market crash, equity put option writers sued their brokers, saying they did not understand the nearly unbounded downside, forcing some into bankruptcy. In the early 1980's, a handful of prominent institutional investors sued their bankers for putting them into complex, new fangled derivatives. One treasurer acknowledged the need to know more, exclaiming "Due to my inexperience, I placed a great deal of reliance on the advice of market professionals….. I wish I had more training in complex government securities."

Mark my words. The courts will be hearing a lot of cases that address who ultimately has responsibility for investment strategies gone awry. Pre-exemptively, pension funds must seek legal counsel to review their fiduciary duties. Nevertheless, as strategies become more complex, there will be sufficient numbers of investors who simply do not understand the risk and, absent good process, will lose money.

This gets back to a point made many times herein. Shouldn't pension decision makers (regardless of plan design) be required and/or encouraged to have a particular familiarity (experience, education) with investment and risk management?

The fact that no such certification requirement exists amazes and disturbs. 

Pension Fiduciaries - Time to Wake Up and Smell the Coffee, Part Two

In "A Conversation with a Fiduciary" (published by Morningstar), independent pension fiduciary Matthew D. Hutcheson provides a thought-provoking assessment of ERISA Section 404 and passive versus active investment choices for 401(k) plan participants. Click here to read the article and here to read Hutcheson's March 6,2007 testimony about 401(k) fees before the U.S. House of Representatives.

On the other side of the fence, Financial Times writer John Authers extolls the virtues of Dave Swenson's "uninstitutional portfolio" approach in his June 9, 2007 article about the Capital Asset Pricing Model and market efficiency. With more than two-thirds of the endowment fund for Yale University in alternative assets "which are not readily marketable," the contrast is telling. While the evidence seems to strongly support Swenson's approach for Yale, issues abound with respect to alternatives investments and command attention. "See "Yale puts academic theory of investment into practice.")

I co-led a workshop on the valuation of "hard to value" assets on June 12, 2007 and came away with a renewed appreciation of the fact that more than a few institutions may truly be in the dark with respect to risk factors. Worth mentioning again is that risk itself is not bad. However, risk that is ignored cannot be measured and, by extension, can certainly not be managed. For most investors, limited resources make it difficult to replicate the Connecticut Ivy's success. Addressing a recent gathering of alumni, Swenson said that "Yale is set up to make high-quality active management decisions" with a staff of twenty and a long time horizon.

The debate continues with respect to style because it is a crucial (nay impossible to ignore) element of investment management. Strategic asset allocation and tactical implementation are likewise integral determinants of fiduciary liability for a given organization. To the extent that Hutcheson reminds us to focus on the "F" word and move the conversation to process that supports duty, plan beneficiaries applaud.

Tell us what you think. Should fiduciaries do a better job of justifying when active strategies make sense? We will talk more about these issues because there is a lot to say.

Click here to email your comments. Please indicate if you would like the comments kept private.

Pension Risk Management Tipping Point

I am the author of a book entitled Risk Management for Pensions, Endowments and Foundations (John Wiley & Sons, 2005). A primer about risk management (no math by design), the feedback has been gratifying. I'm particularly proud of the comments citing ease of use. (The book is replete with examples, checklists and references).

However, it's no Da Vinci Code in terms of sales. While I'd like to write a sequel at some point, few are competing for the honor and no one is knocking down my door to buy the movie rights. (You can visit our online bookstore at - Products, Books for what we think constitutes a good readling list.) True, it's non-fiction and written for a limited audience. Yet one wonders why, in today's benefits climate, more people aren't fast and furiously laying pen to paper to describe how to tackle what is arguably one of the most important topics in pension land - risk management. If there is a single message I can impart to those who will listen, it is this.

ANYONE involved in pension investing is a de facto risk manager. Believe it. You are.

Whether focused on the asset or liability side (or both), risk is an integral part of financial management. Those who deny this truism expose themselves to possible trouble down the road. Personal and professional liability aside, plan sponsors who passively manage risk (whether defined benefit or defined contribution) through ignorance or benign neglect invite unwelcome scrutiny. Unless they are lucky, litigation, economic loss and/or damaging headlines are high probability events.

Besides, plan sponsors who give risk management short shrift lose a precious opportunity to improve things. An effective process forces a plan sponsor to identify, measure and control risk on an ongoing basis. Taking inventory (in terms of uncovering sources of risk) enables plan sponsors to make meaningful changes. Lower costs or enhanced diversification are two of many possible benefits associated with the activity of collecting and analyzing data as part of the identification of risk drivers.

So a natural question arises.

Why don't more plan sponsors pay attention to risk management, whether for themselves or as part of hiring, reviewing and perhaps firing money managers and consultants? Asked another way, what is the tipping point beyond which risk management becomes front and center at meetings of board members, trustees, investment committees and so on?

Here are a few thoughts.

1. Based on the preliminary results of the pension risk management survey now underway, and co-sponsored by Pension Governance, LLC and the Society of Actuaries, there seems to be a HUGE gap between belief and reality. Many respondents say they actively pay attention to risk management. At the same time, they cite limited or no use of risk metrics other than standard deviation and/or correlation. (We'll talk about limitations of basic risk metrics elsewhere.) How can you improve on something you think you are already doing well?

2. Many plan sponsors are tasked with benefits-related work as an add-on to their regular job. Often, there is little organizational incentive for them to excel. In a way, it's a lose-lose proposition. They assume significant fiduciary liability with little or no recognition in the form of additional money, better title or other types of perquisites. At the same time, if they do a bad job, there is no escape. It's all downside. Sadly, there is so much perceived ambiguity about what constitutes a "good" job that it's often difficult to hold someone accountable. (Note the term "perceived" versus "real.")

3. Not all attorneys (litigators and transactional) feel comfortable with finance concepts, let alone financial risk management. That knowledge void arguably makes it easier to let risk control gaps slide unless, or until, an egregious act occurs.

4. Establishing a financial risk management process is seldom fun (or at least sort of enjoyable) for most people. It is often a complex activity that requires copious amounts of money, time, concentration and energy, especially if a plan's investment mix (DB or DC) extends to multiple asset classes. Moreover, benchmarking the process, and making appropriate changes thereafter, likewise consumes large chunks of time and money. Is it any wonder then that its ranking on one's "to do" list plummets in the absence of a strong risk culture?

5. When market conditions are "good" and benefit costs decline as a result, people tend to get lulled into false security. Instead of focusing on structural issues, it's easier to breath a sigh of relief and say "problem solved." Alas, markets change all the time and putting off the inevitable is hardly a smart move.

So what's the tipping point that has everyone wearing "I'm a risk manager" button? Certainly lower interest rates and/or an anemic equity sector are factors, as is regulation. A few recent surveys cite mandates as a central force in encouraging, sometimes forcing, plan sponsors to radically revise their asset allocation strategies and focus on plan risk.

Most folks think we're moving closer to the pension risk management tipping point. I agree but counter that movement is relative. Until (and hopefully not "unless") plan sponsors recognize the URGENT need for financial risk management, investment stewards remain vulnerable on many counts and that is not a good thing for anyone!

Bye Bye Equities

The Star Ledger reports that New Jersey state officials "adopted a plan to shift billions of dollars in state pension money to private investment managers and set a course to reduce the funds' heavy reliance on the stock market." Journalist Dunstan McNichol describes a $16 billion reallocation from stock "in favor of larger holdings in toll roads, hedge funds and international stocks."

A harbinger of things to come?

Many experts agree that pending regulations and increased focus on pension obligations will move asset allocation to center stage, resulting in a variety of questions that demand good answers. (Asset allocation is oft-cited as the most important determinant of performance.)

1. How will an increased emphasis on alternative investments change the expected return-risk tradeoff of the pension portfolio (particularly as relates to estimating pairwise correlations of returns that vary over time)?

2. What are the liquidity implications of investing in public works projects, hedge funds, international stocks, commodities, private equities and so on?

3. How should pension plan decision-makers proceed in selecting alternative investment consultants (especially with respect to their ability to thoroughly analyze the impact of performance fees on net returns)?

4. How do alternative fund managers value their holdings, if at all?

5. How will overseers evaluate performance in the event of diminished transparency of returns and risk drivers that influence returns?

6. Will fiduciary liability change for funds that invest outside the traditional mix of equities and debt?

7. Do fiduciaries need additional training to feel comfortable asking the right questions about alternatives (and interpreting the answers with confidence)?

8. How should the Investment Policy Statement change to accommodate the use of alternatives?

Get ready pension fiduciaries! There is a lot of work to be done in moving the money around.

Asset Allocation Anyone?

Taking time for some weekend reading, I was struck by several headlines that focus on a topic I predict we'll hear more about (much more) in coming months, namely how to best allocate assets to meet liability objectives. Here are a few examples.

"Big pension fund too equity-heavy, says consultant"

"Pension Fund to Expand Stock Buying"

"DB plan sponsors hedging their bets on hedge funds: Pension plans expected to invest $300 billion"

While a discussion of optimal asset allocation and portfolio re-balancing is left for another time and venue, a few questions and comments come to mind.

1. As new accounting rules encourage a focus on liability-driven investing, how will plan fiduciaries decide on a portfolio split between matching liabilities and generating excess return?

2. How can and should derivatives be used to transform assets and liabilities?

3. What role should alternatives play?

4. What will cause a shift away from the traditional equity-fixed income mix for defined benefit plans?

5. How should the equity risk premium be evaluated with respect to managing goals, knowing that greater reliance on fixed income is likely to widen a plan's pension deficit if equities outperform?

6. How should fiduciaries be evaluated and compensated if they focus on risk control in lieu of exceeding return targets?

7. Are decision-makers sufficiently trained to deal with surplus volatility, fat tailed distributions, side pockets and other financial delights?

8. What is the likely impact on capital markets as long-term pension investors begin to favor a radically different asset allocation mix?

As accounting rules, regulatory mandates, changing demographics and economic reality join hands, it's clear that a paradigm shift in asset allocation strategies and tactics is on its way. Are we ready?

Eggs in a Basket

Diversify, diversify, diversify! No smart investor should do otherwise, right? Well suppose individuals are not even saving enough, let alone investing wisely. What then?

Sad to say, financial illiteracy is reaching crisis proportion. In a recent release, the Bureau of Economic Analysis (part of the U.S. Department of Commerce), reported a continued negative savings rate. This means that individuals are spending more than they earn. Not surprisingly, personal bankruptcies are climbing higher. According to the Administrative Office of the U.S. Courts, "bankruptcies filed in the twelve-month period ending December 31, 2005, totaled 2,078,415, up from the 1,597,462 petitions filed in the 12-month period ending December 31, 2004", reflecting a whopping 30 percent increase. Similarly significant, they report that "this was the largest number of bankruptcy petitions ever filed in any 12-month period in the history of the federal courts".

A faint glimmer of hope comes in the form of a new study from the Jump$tart Coalition for Personal Financial Literacy. High school students showed a tiny improvement in their understanding of topics such as budgeting and credit cards. Survey designer Dr. Lew Mandell acknowledges the gain but stresses the need for much more work in the area of pecuniary preparedness.

Couple these alarm bells with pension safety nets that are in serious disrepair around the world and the fact that many employers are rescinding or reducing benefits, if offered at all, and we are about ready to enter a maelstrom of unprecedented proportion.

What do you think? Crisis or not? Take this five-question survey and see what others think.