CIO: Is this a one-size-fits-all solution?
Wilson: No. This approach needs to be customized for each individual plan. It starts with an understanding of the plan’s specific
obligation and then seeks to reposition the fixed-income allocation
of the plan’s assets from a traditional total-return approach to a
cash-match approach. It’s also responsive to changes in the plan. As
benefit payments increase, you can match more of your liability. As
your funded ratio increases, you can match more of your liability. You
can customize the match to get to your desired duration. You also
can customize your investment portfolio to your desired credit risk.
The net result is that this approach reduces investment risk because
you’re no longer concerned about duration risk, your objective is to
match cash flows. And by the way, in some cases you can enhance
the yield of the fixed-income portfolio along the way, too.
CIO: In effect, you’re eliminating, or at least minimizing, the
threat pension plans face of having to sell return-seeking
assets simply to make benefit payments, right?
Wilson: Exactly. If your plan is underfunded and you’re making
benefit payments, every time you sell an asset to meet a benefit
payment your funded ratio ticks down. A simple example is if you have
$80 of assets and $100 of liabilities, and you make a $10 payment,
your assets are now $70 and your liability is $90. Just by making that
payment, you went from an 80% funded ratio to a 77% funded
ratio. If you had that situation combined with a market downturn,
you could have a dramatic acceleration of that downward spiral in
your funded ratio—something we refer to as the Black Hole scenario.
What demographic-based investing does is mitigate the need to sell
CIO: So you’re not expecting interest rates to go up? You
return-seeking assets to meet plan payments. Instead, your bond
investments are maturing alongside your benefit payments. Another
key benefit is that this approach extends the time horizon of your
return-seeking assets so they have more opportunity to play out over
multiple markets cycles.
alluded to this earlier.
Wilson: It’s worth noting that we’ve all been wrong about the
impending rate rise for the past eight or so years. Now we’re in a
later stage of a very long economic recovery and expansion, and
there’s no certainty that rates will rise and save corporate defined
benefit plans, particularly if economic growth begins to slow. Also,
it is important to point out that long-term interest rates are what
really matter to corporate plans because their liabilities are long-term.
For example, if the Fed increases its federal funds rate target, that
doesn’t necessarily impact the level of longer-term rates and thus
may not matter to the plan.
CIO: We’ve covered a lot of ground. What’s the most
important thing you want plan sponsors to take away from
Wilson: I’ve been encouraging all of my clients, and all of the prospects I meet, to focus on managing their asset/liability risk—the volatility of their funded ratio—rather than continue to wait for interest
rates to go up and solve all their problems.
Sample Demographic-Based Investing Asset Allocation
The chart below shows the allocation to fixed income and diversified growth assets for each annual pension
payment for a hypothetical defined benefit plan, using Nuveen’s demographic-based approach to investing.
In this example, 26% of the pension payment obligation is matched with fixed income cash flows.
2016 2020 2024 2028 2032 2040 2044 2048 2052 2056 2060 2064
n fixed income n diversified growth unfunded liability