The answer to underfunding is a closer working relationship between actuaries and investment professionals in forecasting investment returns and setting lower discount rates, according to Karen Harris, vice-president in the capital markets research group at Callan Associates, who believes funds cannot rely on investment strategies alone to get them “out of this hole”.
Overcoming a disconnect between the actuary advising a pension fund and the professionals who price capital-return assumptions is a puzzle piece that could help solve the underfunding problems that face many funds.
“It may be some laziness on the part of the actuary but there is disconnection between actuaries and professionals who price capital-return assumptions. The best information the actuary has is the historical returns, but actuaries and investment professionals need to work together to forecast investment returns – not look back,” says Harris.
“Our worry and why it makes sense to lower the discount rate, is there’s no investment strategy that will get you out of the hole you’re in.”
While Harris believes the solution to the underfunding issue, at least in the US public plan arena, is to encompass actuarial assumptions, payout rates and investment returns, she says there are some investment strategies that are better than others.
She says there is a changing view in the public arena, with funds moving away from allocating assets according to return-drivers and focusing on the underlying risk factors.
“A lot of times, return – and the volatility of those returns – drove asset allocation, mean variance optimisation was always a return driving strategy. The new paradigm is to focus on risk buckets and protecting fund/assets from risk factors to damage portfolios. It’s not just what drives asset returns but the underlying risk factors.”
Hand in hand with this is a trend towards dynamic asset allocation, which Harris believes is really a revival of TAA as both are “saying valuations matter to me”, but with a longer time horizon.
“The question with DAA is do I always rebalance to a portfolio with 70 per cent equity beta or dynamically rebalance to some other beta. There are different ways to implement dynamic asset allocation. The challenge for many plans which lack the knowledge is they have to rely on someone else to do it,” she says.
“DAA in one form is to say, rather than predict future returns, I only need equity to get back to full funding and once we get there I will reduce the equity exposure, corporates are doing that.”
But corporates are in a different position to public plans, she says, because their liabilities grow at the corporate bond yield rate – financial economists are debating the benefits or otherwise of mark to market for public plans.
“There are two issues with this, one is of disclosure: should public plans disclose the difference between assets and liabilities on a true mark to market basis? Currently with different discount rates you can’t compare across funds. The second issue, should it be brought into the funding world? If I force them to mark to market and pay contributions only after they’ve earned the equity risk premium, it could be seen as the death of defined benefit plan that arguably provide a social service.”
Corporate plans in the US, that have to mark to market, have been looking at investment strategies that deal with liability driven investing. The public plans haven’t been made to do that, so while there is pressure to lower discount rates they are not required to mark to market.
But public plans are complicated by having more than one actuarial assumption, Harrris says, including underlying inflation, salary assumptions, long-term investment return, and real return above inflation.
“The critics of that say underlying inflation far too high, and real return assumptions are too high as well. Bond yields today drive future returns, and they’ve outperformed – so yields have come down dramatically. In the public world, asset allocations have about 20 to 40 per cent bonds, so long-term assumptions should be lower. Many view equities as having a risk premium, and that has widened over bonds so the overall return assumption has to come down too. People expect too much from equities.”
