Happy 401(k) investors across the U.S. know that the stock market bull had quite a run in 2017. Sure, investment professionals can argue subtle points around the relative strength of growth vs. value, small vs. large cap, or emerging market potential, but it honestly didn’t take a lot of skill to generate returns in the equity markets last year. If you fell out of the boat you were probably going to hit water.
Actuaries (Ugh, those people!) have been banging the drum of liability driven investing (LDI) as a way to reduce defined benefit (DB) risk for a long time, but 2017 was a pretty sweet year to take risk!
The S&P 500 Index was up 19 percent1, its best performance since 2013, and other indices posted similar gains. A typical traditional defined benefit (DB) allocation of 60 percent equities / 40 percent core bonds returned around 15 percent2.
Return of the Liability Bear
But when it comes to defined benefit (DB) plan investing, looking at large gross returns only tells half the story. Because when you are focused on the spread between plan assets and liabilities (present value of anticipated benefits measured at current corporate bond rates), it is the net return of investments against those of liabilities that matters.
I’ve compared DB liabilities to a grizzly bear in the past. (Outrunning the Liability Bear) And thanks to dropping bond rates throughout the year, that bear set a mean pace in 2017! The return on liabilities for a typical pension plan was over 12 percent2!
The following chart plots asset returns (vertical) against liability returns (horizontal) for a typical, traditionally invested DB plan over each year from 2015-2017. Times seem to be pretty good. Gross returns have been positive all three years; the cumulative gross return for the period is over 23 percent. (If this was your 401(k), you could stop reading here and gloat to your coworkers.)
Net return, however, is not measured as the vertical distance of each plot point to zero. It is the distance of the plot point to the light blue line where asset return equals liability return. (The objective of a theoretically perfect LDI strategy.)
On this basis, the returns over the past three years have been much less exciting. Instead of basking in the glow of a 15 percent gross return for 2017, sponsors are likely frustrated that they may have only gained 3 percent net. Funding ratios probably haven’t improved as much as hoped.
So the bull won last year…but only by a nose. Cumulative net return over the period is just under 5 percent2. The liability bear has kept up a pace worthy of a Pamplona runner.
The Next Leg of the Race
Investment decisions in 2018 may be difficult for sponsors and their advisors. With the lack of dramatic improvement in funding ratios, there is still a need for positive net returns for underfunded plans.
But the bull has been running hard for over nine years now, and history tells us it will eventually fatigue at some point. Lower gross returns from any slowdown aren’t necessarily a problem, but the liability bear would need to cooperate. This cooperation requires a meaningful increase in the high quality bond rates on which liabilities are calculated.
Hopefully when the bull does slow down it won’t resemble the two previous blowouts this century, which included simultaneous “flights to quality”. Loss of confidence in equity markets drove investors into safe haven corporate and treasury bonds, further suppressing those rates and increasing liability returns. (A slow bull plus a quick bear = bad news for DB investors!)
This is NOT Investment Advice!
As the runners take their marks in 2018, it appears investment managers will need to work much harder than last year. And if things go poorly, this could be the year those falling out of boats don’t hit the water, but rather get snatched mid-air by a hungry liability bear.
Of course, things may not go poorly. If the bull continues and rates moderate, traditional DB investors may beat the bear again in 2018. But I’m not an economist (or a veterinarian for that matter)…just an actuary who is legally prohibited from giving investment advice. So I will leave you with just one actuarial observation:
During uncertain times, a well executed LDI strategy can significantly reduce the risk of negative net returns regardless of what equity markets or interest rates decide to do.
Ugh, those actuaries!
Mike Clark is a fellow of the Society of Actuaries (SOA) and member of the American Academy of Actuaries (AAA), Ugh!
1 S&P index values at Jan. 1, 2017 and 2018 per Yahoo Finance
2 Wilshire Compass
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.
Instances of high double-digit returns were achieved primarily during favorable market conditions and may not be sustainable over time.
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.
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