There’s an old joke, most famously told by Ronald Reagan, featuring two men who are surprised by a grizzly bear in the woods. As the bear snarls and prepares to charge, the first man calmly pulls a pair of running shoes from his backpack and begins lacing them up. The second man scoffs, “What in the world are you doing?? You’re never going to outrun a grizzly bear!!” To which the first man responds, “I don’t need to outrun the bear. I just need to outrun you!”
Unfortunately, applying this apocryphal story to 2014 defined benefit (DB) plans has proven somewhat unsuccessful. Although many DB plan investments performed admirably, possibly even beating their benchmarks and finishing solidly in the upper quartile of their comparison groups, the majority failed to keep pace with briskly charging liability growth during the year. So while investments may have succeeded in outrunning their peers, the liability bear caught them all anyway – suppressing their market value funding ratios and eating their shoes regardless of style.
How the bear caught up with DB plans
This isn’t to say it wasn’t a good year for investments. Most of us are probably feeling fairly smug about the gross return figures on our year-end 401(k) statements. U.S. equities returned over 13 percent for the year and core bonds delivered almost six percent according to data collected by the Principal Financial Group® for our Client Market Monitor, so a classic “60/40” allocation probably delivered over 10 percent return in 2014.
But even the blogging actuaries among us don’t compare our 401(k) balances to the present value of our desired retirement income measured at current corporate bond rates. To do so would not make sense since we don’t expect to draw on our savings for quite some time. Yet this is precisely what U.S. pension accounting rules require of DB plan sponsors, making for a much less attractive relative picture at year end (much like those glossy Christmas postcards currently taped to your fridge).
Contrary to certain opinions at the beginning of 2014, corporate bond rates dropped steeply throughout the year. By December 31, the high quality corporate bond rates used to report accounting results were about 90 basis points below January 1 levels, forcing liabilities for a typical plan up 9 to 13 percent. So the 10 percent gross returns from classic 60/40 allocation barely kept pace or lost ground to the liability bear on a relative basis.
Making the chase even more challenging was the Society of Actuaries’ (SOA) decision to release updated standard mortality tables and improvement scales in October. Despite significant concerns from the actuarial community regarding some of the SOA’s methods and conclusions, many auditors are still requiring immediate updates to mortality assumptions. I’ll resist my morbid actuarial instincts to expound on mortality and merely point out that assuming people live longer tends to increase accounting liabilities by roughly five percent (give or take depending on plan demographics and current mortality assumptions).
Taken together, the impact of lower discount rates, longer mortality assumptions and the normal growth of interest can account for a liability increase of up to 20 percent! Suddenly a 10 percent investment return doesn’t inspire the satisfaction it once did, although it is greatly preferable to negative returns accompanied by sliding interest rates as happened in the pension crisis of 2008.
Emphasis on increasing gross returns, rather than relative returns against liabilities, has also led to increased interest in alternative investments such as commodities and hedge funds. Last year, many of these experienced lackluster performance, losing more ground to the bear. Ironically, the only strategy that seems to have kept pace with liability growth in 2014 was a commitment to a liability driven investment (LDI) strategy featuring long duration bonds, an idea many were loath to consider in January when the experts predicted rising rates for the year.
Winning the race in 2015
DB investment allocation decisions will be challenging for 2015. Economists are generally optimistic about the U.S. economy, but equity markets are at historic highs which introduces concerns of a significant correction. Conversely, corporate bond rates are back down to historic lows and predicted (again) by many to begin increasing within the year. Should this occur, the pension liability bear would turn tail back towards the woods, taking long duration bond values with it. Regardless of whether sponsors pursue a gross return or LDI strategy, there is risk of negative gross returns if events don’t unfold as forecast. As sponsors lace up their shoes in this environment, it is important to realize that they are not racing against one another. They are racing against the liability bear, the true benchmark against which their investment returns should be measured.
Mike Clark is a fellow of the Society of Actuaries (SOA) and a member of the American Academy of Actuaries (AAA), which qualifies him to make statements of opinion regarding the behavior of metaphoric liability bears.
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Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline.
Equity investment options involve greater risk, including heightened volatility, than fixed-income investment options.
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