public plan sponsors have recognized this and have done the best
they can, within the scope of their budgets, to increase their contributions to their plans. But now they’re facing new demographic
challenges, too. Their ratio of active employees to retirees has been
declining steadily for years, to the extent that many plans now face
ratios approaching or below 1, meaning there are more retirees in
their plans than there are active employees. The consequence, from
an investing perspective, is a shortening investment time horizon. We
all tend to think of pension plans as these perpetual entities, as the
ultimate long-term investors. The reality is they aren’t in many cases,
because with more and more people retiring and drawing benefits,
the size of their annual benefit payments is steadily increasing—and
will continue to do so for the next 20 to 25 years.
CIO: How is this shrinking active-to-retiree ratio impacting
investment strategy at public plans?
Wilson: It’s limiting their ability to take on risk. I use this simple
CIO: So how can public plans adjust their investment
example to illustrate the problem. If you’re sending your child to
college next year, and you have the cash on hand but want to invest
it, are you going to buy stocks or a one-year bond? Chances are
you’re going to buy the bond, because your investment time horizon
is too short to risk losing that tuition payment. It’s no different for
the pension plan that has benefit payments that are coming up this
year, next year and every year thereafter and are increasing along the
way. If we have a correction in the equity markets, or even worse,
a recession, and the plan has a large return-seeking portfolio—at
the same time it has increasing benefit payments and a shortening
investment time horizon—it could be facing a real crisis.
strategy—knowing they’ve still got a big unfunded liability
that could desperately benefit from return-seeking assets?
Wilson: One approach we’ve developed is called demographic-based investing, in which we seek to align the risk of the investment portfolio with the obligation. We do that by first breaking out
the plan’s liability into segments—active employees, retirees, terminated vested employees—and thinking about the characteristics of
each. For active employees, the benefits have not been calculated
yet because employees are still accruing them. They may retire next
year, they may retire in 50 years. Generally speaking, the tenor of
that liability is long, and the ultimate size of the liability might be
tied to inflation or wage growth. If you wanted to precisely match
assets to it, you couldn’t; it’s too long, and there are too many
uncertainties. But the characteristics of that liability align very well
with growth-related assets, such as equities and certain alternatives, so we recommend allocating to those strategies against this
segment of the liability.
If you look at the retiree segment, by contrast, the benefits have
already been calculated and have a shorter tenor. The only real variability is how long people live. This segment of the liability can be
addressed from a matching perspective, but we don’t try to dura-tion-match it, we cash-flow match it—because, as I mentioned
earlier, there is no duration risk associated with a public plan liability.
U.S Corporate Pension Funded Ratios Have Remained Low Since 2008 Credit Crisis
Nuveen Asset Management’s Funded Ratio Tracker shows the mont-to-month funded ratio changes of a typical
U.S. corporate defined benefit pension plan. Nuveen tracks two separate funded ratios—an “Actual” ratio,
which accounts for non-market items such as contributions, service costs and benefit payments, and a “Market”
ratio, which focuses on the funded ratio changes due only to interest rates, spreads and asset returns. As shown
in the graphic below, both ratios have remained well below 100% since the 2008 credit crisis, despite a strong
performance by the equity markets over the past nine years.
Dec’07 Jun’08 Dec’08 Jun’ 10 Dec’ 10 Jun’ 11 Dec’ 11 Jun’ 12 Dec’ 12 Jun’ 13 Dec’ 13 Jun’ 14 Dec’ 14 Jun’ 15 Dec’15Dec’07 Jun’ 16 Dec’ 16 Jun’ 17