Market observers can’t agree on whether inflation or deflation is the bigger threat right now. It seems that investing pension funds has never been so challenging, with the market uncertainty exacerbated by uncertainty about how much risk to assume in advance of accounting standards driving new reporting requirements for corporate plans and fiscal challenges for public sector plans.
The market evidence is indeed mixed:
- a Canadian equity rally of 57 % since the market lows of March 2009, leaving many people convinced that “the great recession” is now officially over;
- structural unemployment as high as 15% to 20 % in the U.S., when the data is adjusted to include those who are no longer actively seeking employment;
- debt to GDP ratios in almost all developed countries being at unsustainable levels, with Germany and Canada amongst the few OECD nations demonstrating positive fiscal trends;
- a sharp increase in the U.S. monetary basis from 2008 to 2009, giving rise to fears that the resulting inflationary pressures could be significant; and
- personal consumption, which represents two thirds of the U.S. economy, recording the lowest increase in over 50 years.
Pension funds that are still reeling from 2008 market conditions may be tempted to pull back from equities after the recent market rally as a “derisking” strategy. Unfortunately this strategy merely locks in today’s underfunded positions and most funds have limited room to consider further benefit reductions or contribution increases.
Pension funds still need to find appropriate ways to assume portfolio risk – with the most likely candidates being some combination of the following:
- Portfolio duration extension to take advantage of the steeper yield curve. While this exposes funds to the risks of rising rates, it will nevertheless improve funding positions regardless of whether interest rates rise or fall. It also positions portfolios defensively against any protracted periods of deflation, as an offset to their residual equity position.
- A carefully selected portfolio of blue chip corporate bonds and stocks from international companies that are expected to thrive regardless of market conditions, with an emphasis on the higher tiers of the capital structure.
- Exposure to emerging markets, or to those sectors which support emerging market growth, given that these are amongst the few areas forecasting strong economic conditions.
Most pension funds may wish to stay focused on traditional investments in light of what happened to leveraged, illiquid alternative investments in 2008 and 2009. While alternative investments outperformed equities in 2008, the inherent illiquidity prevented funds holding these instruments from participating in the market rebound which took place after March 2009. Some funds are still attempting to restore their portfolios after working through positions which were non-transparent and not well understood.
However if in fact we are entering into a protracted period of subdued economic activity and low market returns, the traditional portfolio strategies that worked in the last few decades of the twentieth century will not deliver sufficient returns to match the liability discount rates. Funds will still need to pursue additional, more aggressive investment strategies—such as taking advantage of the illiquidity premium and assuming some leverage. This suggests that pension fund managers and fiduciaries may nevertheless have to operate outside their traditional comfort zones, coupling market experience with an understanding of new complex products.