Wednesday, February 24, 2010

Overcoming Fiduciary Fear

There are two kinds of fears that 401(k) plan fiduciaries must overcome in order to effectively manage a prudent investment process .… the fear of doing something and the fear of doing nothing.

Specifically with regard to investment maintenance, fiduciaries often demonstrate a strong reluctance to swap out underperforming investments in an investment lineup. This behavior suggests they feel the risk implicit in changing a plan investment is far higher than maintaining an underperforming investment. Inertia makes maintaining the status quo seems like the risk-less option. Some fiduciaries are simply uncomfortable making decisions on behalf of others.

A countervailing fear, the fear of inaction, is characterized by a compulsion to act immediately when an investment falls below some established performance benchmarks. A mechanistic approach to policy adherence seems procedurally correct to plan fiduciaries, yet taking action too promptly can sometimes generate unnecessary portfolio turnover and detrimentally impact participant portfolios similar to a “buy high, sell low” strategy.

To manage the first fear, plan fiduciaries need to embrace the idea that a good investment portfolio is not static. Changes are inevitable and are required. Fiduciaries need to establish a pattern of investment turnover in order to fulfill their fiduciary responsibilities. The degree and extent of change will vary based on the level and sophistication of plan benchmarking as well as the bias employed in the investment selection process. The closer a plan gets to adopting timeless, consistently executed, and well diversified investment strategies with compatible benchmarks, the less frequently changes will be necessary. The more performance oriented the selection process, the more emphasis put on heroic investment alpha rather than the value of compound investment returns, the more frequently changes will be required. One of the most important skills that differentiate a good portfolio manager and a good fiduciary is the knowledge and ability to “pull the trigger” on meaningful and justified investment changes.

As we saw recently, an excessively mechanistic and pedantic approach to performance based investment changes can backfire on plan fiduciaries who execute their investment policies to the letter. Many good investments underperformed so substantially in 2008 that their longer term performance fell below peers and benchmarks. Strict adherence to standard 3 and 5 year oriented investment policy performance guidelines might have required these investment managers be cut loose…..only to see them outperform by a similarly wide margin in 2009 as the market rebounded. While following investment policy performance standards is a primary rule of prudence, even the best standards won’t always apply to every investment or situation. Prudent judgment is also required. Good investing requires patience, a bit of contrarian sentiment and an acknowledgement that specific facts and circumstances might invalidate general policy rules. Acting in the best interests of participants means making guality decisions not merely following guidelines.

Fiduciaries are required to make investment decisions in the face uncertainty. Avoiding decisions can harm participants and create liability. So can acting without the appropriate deference to current facts and circumstances. Fiduciaries should approach investment decision making with some reluctance…a reluctance borne of patience and careful judgment not one born of fear and lack of information.

Tuesday, February 09, 2010

Leverage Can Reduce Risk ???

That’s the conclusion of the State of Wisconsin Investment Board after it authorized a strategy to lever up its pension plan assets from 4% this year to as much as 20% over the next 3 years. This strategy, generally referred to as “risk parity”, has been used for several years by a number of well known hedge funds, including several which advised the Investment Board.

The essence of a risk parity strategy, which is showing up in public pension board room presentations across the country, is that an expected return rate similar to a traditional 60% equity portfolio could be supported with less volatility by using leverage to boost exposure to lower risk asset classes in a plans asset allocation. Leverage provides a way to ratchet up the returns of the lower risk assets while altering the portfolios risk profile by reducing the proportion of equity risk, the risk that has traditionally dominated most pension portfolios.

While it is not surprising that portfolio risk has taken on a more visible role in asset allocation strategies, it perplexes many that leverage, the proximate cause of the 2008 and other past financial crises, is now the centerpiece of a risk reduction strategy.

The theoretical case for using leverage in a risk parity framework to reduce risk for any given expected return level is sound. It follows the well accepted mean variance, efficient frontier framework that most pension plan sponsors have already accepted as a foundation for their asset allocation decisions. Risk parity simply factors in the ability to borrow at a rate less than or equal to the savings rate. When borrowing is considered, the efficient frontier (the set of portfolios that maximize risk adjusted returns) moves from the concave curve we are all familiar with to a tangent line to the curve originating at the risk free rate. Visually, the equivalent return portfolio on the borrowing frontier has less risk than on the concave frontier

While the risk of higher leverage is dependent on the predictability of the levered risk (in this case fixed income risk is regarded as a much lower risk than equity), the practical case for using leverage may not be as elegant as the theoretical case. Leverage tends to seduce investors because it amplifies investment results. While small amounts of leverage, like the 4% WIB starting position, can’t do irreparable harm, positive outcomes will inevitably lead to overconfidence and higher leverage. Higher leverage will eventually collide with unanticipated market conditions creating the potential for another species of leverage induced portfolio meltdowns.

Just like external leverage in the form of pension obligation bonds was once considered an attractive option for making up public pension under-funding, risk parity is the new way for plans to borrow their way to abundance. It may not turn out to be a bad strategy for all plans but is likely to damage a few as this theoretical free lunch is just too tasty to resist.

Sunday, January 03, 2010

The Value of TIPS in Pension and 401(k) Plans

There is a growing sense that the monetary and fiscal policies required to exit the great recession of 2008/2009 are laying the groundwork for future inflation. This sentiment alone can have an impact on asset returns and investor behavior, regardless of the future course of inflation. In light of that, we briefly examine the case for providing exposure to Treasury Inflation Protected Securities or “TIPS” in both pension plans and 401(k) plans.

TIPS provide investors protection against inflation while protecting against deflation. They are government issued bonds designed to provide a certain pre-tax real return when held to maturity. TIPS pay interest twice a year, at a fixed rate. The rate is applied to a principal value which is adjusted for accrued CPI inflation. Interest payments rise with inflation and fall with deflation. When a TIPS matures, investors are paid the greater of its adjusted principal or original principal, providing a hedge against both inflation and deflation.

The yield on a conventional Treasury bond that pays a fixed coupon must also include an expected inflation component to compensate the investor for future inflation. Its yield therefore includes a real rate of interest and an expected inflation component. With TIPS, the coupons and principal adjust relative to CPI so its yield is simply the real interest rate. The difference between the two yields reflects, among other things, expected inflation.

Pension Plans
While the primary role of fixed income in many non ALM pension investment programs is to serve as a volatility hedge for stocks, it can also be constructed to offer inflation protection. The value of TIPS in a fixed income allocation, specifically as an inflation hedge, will be dependent on the nature of the plan’s liabilities.

Since the typical defined benefit plan has a set of liabilities that acts like a mix of nominal (retirees, term vested or frozen actives) and inflation linked (benefit accruing actives or inflation indexed retiree benefits) bonds, inflation can have varying impacts. Inflation protection may be less critical for pension plans that are mature, are not duration matching their liabilities and don’t have benefits that are linked to cost of living. Mature plans with a lower proportion of active participants may not be as exposed to salary inflation and might even benefit from the impact that inflation can have on devaluing plan liabilities. If a plan’s liabilities are not indexed to inflation, it benefits by paying nominal liabilities in inflated assets. Deflation represents a more considerable risk for these plans, so inflation protection may not be a primary objective.

Pension plans with a "COLA" liability based on their benefit formula can be negatively impacted by inflation. They would be natural holders of TIPS, along with other investors who want to match assets and liabilities in real terms. Financial assets, like nominal bonds, typically do poorly badly during periods of inflation, so a mix of TIPS and other inflation hedging assets such as commodities might be a good fit for these plans.

TIPS can also be used in pension plan portfolios as a diversifier since they behave differently than traditional fixed income securities in various market environments. Recent changes in pension accounting rules and the funding calculations of the Pension Protection Act of 2006 add to the diversification value of TIPS as either a strategic or tactical asset class.

401(k) Plans
401(k) plan sponsors have traditionally emphasized long term growth investments such as equity funds for their retirement investors. Equity tends to grow faster than bonds and has outpaced inflation in the long run. Traditional retirement portfolio planning suggests that as plan participants approach retirement they should increase their allocation to bonds to avoid the volatility of equity and other inflation hedging assets such as real estate or commodities. However, as their bond exposure grows, inflation replaces volatility as a primary risk. At a modest 3% inflation rate, prices can double over the life expectancy of the average retiree.

Plan participants often have only a few bond fund alternatives. The majority of 401(k) plans offer either a stable value fund or a money market fund and maybe a market value intermediate bond fund or two. None of these alternatives may not fully hedge inflation. Nominal bonds can perform poorly in the immediate wake of an inflation spike as yields increase. As yields and prices stabilize, nominal bond returns can ultimately predominate price declines, but the timing of this catch-up depends on the nature of the bond fund. Money market returns are likely to increase after an inflation spike, but their response is based on monetary policy and may have limitations. Stable value funds can adjust to inflation, perhaps better than money market funds, though the extent of the lag and the degree of their participation depends on their portfolio structure, duration and cash flows.

TIPS fully hedge inflation as measured by CPI and therefore could be a valuable addition for some investors in a 401(k) plan. There are also certain tax advantages to holding TIPs in a tax deferred account. Investors receive full inflation protection if TIPS are held in a tax deferred 401(k). According to Hewitt research, specialty bond funds, including TIPS funds, increased by 10% in 2009. Vanguard’s 2009 retirement plan survey data indicated 19% of its defined contribution plans offer a TIPS funds.

While TIPS are well suited for a role as an inflation hedge or fixed income portfolio diversifier in a 401(k) plan, other aspects should be considered in determining their suitability for particular plan populations.

While TIPS are relatively risk-free in the long run, they can be quite volatile in the short run. Naïve investors might assume that the inflation adjustment is the primary source of total returns for TIPS. However, the change in real interest rates, positively correlated with investors’ inflation expectations, has historically had a more significant impact on TIPS returns. TIPS can generate losses, even with rising inflation expectations, should real rates be rising faster or should heavy demand for TIPS drive yields down.

If TIPS notes are not held to maturity, investors loose their fixed real rate of return. Fluctuations in the yield on newly issued TIPS result in changes in the prices of existing securities, exposing investors to capital gains or losses. This market price exposure means that holding TIPS for short periods of time negates their inflation hedging capabilities and exposes investors to almost a similar level of price risk as nominal Treasuries.

Most 401(k) plans that offer TIPS use a TIPS fund rather than individual TIPS. TIPS funds have some advantages but do not allow investors to hedge date certain future liabilities. TIPS funds can be thought of as a rolling ladder of individual TIPS which have a specific duration. This structure exposes investors to some level of realized gains and losses as they draw down their investment through retirement. The financial impact of these hedging mismatches will be determined by the dollar weighted inflation component of pre retirement accumulations vs. post retirement distributions. For long term regularly scheduled accumulations and distributions, these impacts would theoretically average out.

TIPS investments can provide a conservative way for 401(k) plan participants to diversify their fixed income portfolios and hedge a slower growth, inflationary environment. However, like many fixed income sectors, they are somewhat complex and less well understood by participants, raising the potential for inappropriate expectation and utilization. Plan sponsors should consider a number of factors when determining whether a TIPS investment would be a suitable alternative for their plans:
· Demographic distribution of plan participants
· Range and characteristics of existing total plan and fixed income alternatives
· Retention of retirement accounts by post retirees
· Associated defined benefit pension plan benefits
· Ability to educate/inform participants about TIPS
· Utilization of advice facilities

Friday, October 30, 2009

More International Equity?

A question posed by fiduciary investors today is whether they should increase their allocation to International Equity. The answer depends on whether their intention is to chase international performance or to adjust their long term strategic exposure to international equity?

A neutral global market capitalization weighted investment benchmark would allocate about 50% of equity to international. Academic studies and industry practice suggest there is diminishing value from international allocations beyond 40% of equity. A 20% international allocation of total equity is often considered a minimum prudent allocation. Many plan fiduciaries discount back from a strategic 40% exposure for the following reasons:

1) global market return correlations have been going higher thereby reducing the diversifying value of int’l equity,
2) pension plan liabilities are often denominated in US $’s making foreign denominated assets more volatile relative to liabilities,
3) foreign investments costs more than domestic investments, and
4) comparability with similar pension plan allocations.

Many investors are tactically overweighting international equity due to the weakening dollar and perceived lower valuations. Long term institutional strategies presume currency effects tend to cancel out over time and that valuations tend to mean revert. Using currency or valuation to support changes in international equity is tactical and implies performance chasing rather than strategic alteration.

Wednesday, October 28, 2009

Senate Committee Review of Target Date Funds

The Senate Special Committee on Aging held another fact finding session on Target Retirement Funds (TRF), concerned by their lack of transparency, high fees and and potential conflicts of interest. Testimony (available via webcast) provided by a range of regulators and private fund providers was similar to what has been presented in the past.

The Q&A portion was of particular interest in that it addressed arguments on both sides of proprietery fund management and whether conflicts of interest inherent in proprietary target date funds, but not addressed by ERISA due to an exemption, are adequately covered by securities regulations as intended by Congress when drafting ERISA. Other points of interest raised during the prepared comments:
  • SEC will be focusing on the use of dates in fund names, whether TRF sales material requirements provide sufficient information and balance and investor education.
  • EBSA is looking at QDIA regs to see if more specific guidelines are necessary to help plan fiduciaries better understand, select and monitor TRF's. In the Q&A it sounded like DOL will give additional consideration to the use of more conservative funds as QDIA.
  • Morningstar was concerned about the range of fee, the issue of proprietery fund management which would not be considered institutional investing best practice, and the low level of conviction managers have in these funds as indicated by their very low personal investments in them. 57% of TRF managers have no investment in them.
  • Fidelity made some important and often overlooked points about the intrinsic value of these products for uninvolved investors. They also indicated support for a number of recommended communication initiatives. A later point about investors desires to have a company and brand they are comfortable with manage the totality of their investments was well made. Having a good product is only half the battle, getting plan particpants to select the product is just as important and brand plays a big role in that decision. Plan fiduciaries must also consider that aspect when selecting a TRF for their plan.
  • A private TRF provider pointed out the inconsistency of DOL's rethink of the investment advice rules because of conflicts of interest while allowing proprietary funds to be used within a TRF product because they are not considered plan assets under ERISA. A point made here was that requirements & remedies are available under securities laws to address these issues.

  • The Committee members seemed to appreciate the difficulty in trying to legislate investment results in this area.

      Friday, April 10, 2009

      Mutual Fund Incubation

      Establishing a minimum required track record of at least 3 years along with setting a minimum asset requirement can help investment fiduciaries avoid the potentially misleading effects of mutual fund incubation.

      Tuesday, April 07, 2009

      Defined Benefit Plans - Modest Relief in 2009

      Market turmoil over the last year has severely impacted DB plan funding levels and future funding obligations. While plan sponsors can t directly control interest rates or capital market performance, they can influence funding requirements via plan actuarial assumptions. Recent legislation and regulatory guidance provides additional flexibility in this area.

      Liability Discount Rates: new IRS guidance allows plans to change their yield curve election in 2009 without IRS approval. Plan sponsors that choose to use the corporate bond yield curve in lieu of segment rates may use the same look-back period ( 4 months preceding January 2009 for a calendar year plan) that is allowed for plans selecting segment rates. This would allow plan sponsors to use discount rates that could be up to 1% higher than those allowed without the look back provision and in lieu of the segment rates. The IRS has not indicated whether another election will be allowed in 2010 so the use of a current yield method could introduce higher future volatility in plan funding requirements.

      Asset Smoothing : the IRS provided additional guidance (Notice 2009-22)on how asset smoothing, allowed under the Worker, Retiree, and Employer Recovery Act of 2008, could be implemented. This guidance is particularly valuable given large recent asset losses. The notice provides automatic approval for a change in asset valuation methods for plan years beginning in 2009.

      Adopting actuarial assumptions which reduce long term funding volatility while providing a beneficial current impact seem to be a win-win for plan sponsors. Adopting an asset smoothing methodology seems to be an easy decision while the benefits of adopting a corporate bond yield are not as straightforward. Each case should be determined in consultation with your plan actuary.

      Tuesday, March 10, 2009

      Fiduciary Liability Insurance

      Given market conditions and investors need to make up for losses, plan fiduciaries should get to know the details of their fiduciary liability insurance. Steve Saxon provides guidance in his comments at Plansponsor.

      Wednesday, February 11, 2009

      Mutual Funds Fees are Too High

      This study on mutual funds, Identification And Performance of Equity Mutual Funds with High Management Fees and Expense Ratios by Haslem, Baker and Smith, finds that economies of scale are not generally shared with fund holders because the market lacks the competitive pressures to drive fund expense downward. This is due to product a variety of product differentiation strategies that probably have little correlation to a funds future sucess.

      Active vs Passive

      Another perspective on the active vs passive debate. Typically, its a toss-up before fees and a loosers game after. Good managers do exist but they cant be uncovered simply by looking at past performance.

      Friday, February 06, 2009

      Active Manager Underperformance in 2008

      If your actively managed investment funds underperformed dramatically and collectively in 2008, Wurts & Associates developed a presentation which describes what happened. Their points may be useful in putting 2008 benchmark relative results in context for your investment committee.

      Thursday, February 05, 2009

      Target Date Retirement Funds - Best Practices

      According to testimony before the Advisory Council on Employee Welfare and Pension Benefit Plans, evaluating Target Date Funds(TDF) is challenging, difficult, complex and one-size-does not fit -all. Best practices noted in the testimony

      • the single most important decision is the design of the glide path of the TDF
      • active/passive management, value customization and participant impacts are other important factors in considering the utility of TDFs
      • TDF’s must be evaluated periodically (most often quarterly).
      • fiduciaries should compare TDFs to their peers and relevant benchmarks,
      • communications that effectively explain the TDF so participants clearly understand the underlying investments and how the glide path works is important also,
      • a plan sponsor should consider what levels of defined benefit, Social Security benefit or other pension benefit that participants are likely to have,
      • the design and structure should be compared to the plan’s unique demographics,
      • consider individual participant risks - participants need to understand the limitations of these funds,
      • customization will be big in the future,
      • annuity type options or managed payout type funds are going to become more and more prevalent,
      • benchmarking is a problem. Focus should be on trying to define a “process” for evaluating these things and not relying on one particular measure to monitor it,
      • one firm’s TDFs would be appropriate if the plan sponsor is comfortable with the overall philosophy and that should not change based on the target date of the fund,
      • looking at the underlying funds that may make a TDF could be illustrative since the underlying funds have likely been in existence long enough to build up a track record,
      • liquidity of certain investments in a TDF may be a challenge,
      • consider using different TDFs from different vendors,
      • carefully evaluate costs,
      • Plan sponsors should ask vendors for an investment policy statement,and
      • sponsors should strive to maximize the number of participants who reach a minimum level of income replacement in retirement.

      Mutual Fund Family Performance

      Many publications provide periodic data or rankings on composite mutual fund family performance. A question arises as to whether investment fiduciaries should derive comfort or concern from these lists.

      For instance, in a recent WSJ article, the performance of the 10 largest mutual fund families was profiled. The fund family rankings were based on asset weighted excess returns over their morningstar style box from the market peak in October 2007. The article acknowleges that "this overall scoring may have little correlation to your personal investment results" though they point out that "the results give some indication of how each complex has served its investors overall since the market peak".

      The provides its own ranking of fund families based on its rating system which they indicate should "provide a solid framework for making informed, timely investment decisions".

      There is often dissonance between lists. For instance, The Street's top performing fund family with more than 100 rated funds rates a 2.6 under the Morningstar ranking system where "the scores range from 1.0 to 5.0. A score below 2.5 is an indication that the firm has met with little success in that asset class. A score between 2.5 and 3.5 indicates the firm is about average".

      All performance rankings have limitations, especially those based on short time periods. Family fund rankings have even less value since they dont reflect the characteristics of any specific investment strategy. They are simply an artifact of a set of asset class, investing process, research and outlook biases that may be correlated across funds in a family.

      Investment fiduciaries whose investment programs, such as 401(k)'s, hold many investments from a single fund family may not be fully meeting their fiduciary responsibility to diversify plan assets. A study by Elton, Green and Gruber, "The Impact of Mutual Fund Family Membership on Investment Risk" finds:
      "evidence that mutual fund returns are more closely correlated within than between fund families. As a result, restricting investment to one fund family leads to a greater total portfolio risk than diversifying across fund families. The increased correlation is due primarily to common stock holdings, but is also more generally related to families having similar exposures to economic sectors or industries. Fund families also show a propensity to focus on high risk or low risk strategies, which leads to a greater dispersion of risk across restricted investors. An investor considering adding an additional fund either inside or outside the family would need to believe the inside fund offered an additional 50 to 70 basis points in return to achieve the same Sharpe ratio."
      Using fund family ranking information to assess the merits of an investment progam would be like selecting a job candidate by interviewing her family. Though some general traits may be "genetic", investment performance and therefore fiduciary attention should correlate to the unique characteristics of each investment fund.

      Monday, February 02, 2009

      401(k) Tweets

      A new 401(k) program ranking tool, Brightscope, is now available on line. According to the firms press release;
      "The new BrightScope Rating is a quantitative 401k plan rating developed by BrightScope, Inc. in partnership with some of the country's top independent fiduciaries, finance professors, and 401k experts. BrightScope Ratings take into account over 200 unique data inputs per plan and calculate a single numerical score to define 401k plan quality at the company level. The ratings algorithm runs thousands of simulations for each 401k plan in order to determine how quickly each plan will propel the average 401k participant to retirement. Using this rigorous approach, BrightScope ensures that every factor that affects retirement outcomes - such as company generosity, fees, investment menu quality, vesting schedules, and more - is accurately reflected in a company's rating. The site provides open access to 401k ratings, allowing anyone to compare any 401k plan with another."
      Proclaiming the value of true transparency and disciplined benchmarking, the firm indicates that;
      "Plan sponsors who use BrightScope can demonstrate to their employees, their board, their retirement committee, and to regulators that they are taking the necessary steps to improve the quality of their 401k plan."
      Unfortunately, transparency isnt very transparent when a proprietery and presumably undisclosed process generates rank results. Fiduciaries would not be wise to rely on a quantitative "black box", especially one designed by industry experts....because we have seen where that will lead. The quality and timeliness of plan data inputs have been a persistent problem in past plan comparability efforts. A database that relies on voluntary data of unknow quality or stale but offical public domain data shouldn't necessarily be relied upon for fiduciary decision making either.

      Perhaps, when a comprehensive suite of federally mandated investment and plan disclosures becomes available on a close-to-real-time basis and its ranking criteria and standards are revealed, a tool like this will have real value. Until then it will be an interesting curiosity.

      While their intentions may be good and the output is interesting, Brightscope seems to sacrifice meaningful detailed information and a transparent ranking process for mindless usability. That may be a wise tradeoff to capture the eyeballs of the twitter generation but probably won't support its goal of being a fundamental fiduciary support tool that plan sponsors could really use.

      Wednesday, January 28, 2009

      FAS FSP 132R-1

      Plan sponsors will be required to provide more transparency about the assets in their defined benefit pension plans based on FASB’s recently issued FSP FAS 132R-1, "Employers’ Disclosures about Postretirement Benefit Plan Assets."

      This new disclosure guidance addresses perceived inadequacies about the types of assets and associated risks in retirement plans. Plan sponsors generally provide info on only four asset categories: equity, debt, real estate, and other investments. The growing popularity of alternative assets and their lack of homogeneity and unique risks make the "other investment" category particularly challenging for financial statement users to evaluate.

      The new disclosures are designed to provide additional insight into:

      • The major categories of plan assets
      • The inputs and valuation techniques used to measure the fair value of plan assets
      • The effect of fair value measurements using significant unobservable inputs (Level 3 measurements in FASB Statement 157, Fair Value Measurements) on changes in plan assets for the period
      • Significant concentrations of risk within plan assets
      • How investment decisions are made, including factors necessary to understanding investment policies and strategies

      Required for financial statements with fiscal years ending after December 15, 2009.

      Sunday, January 18, 2009

      Pension Expected Return Assumptions - Hitting Back

      Current pension accounting allows pension plans to use an estimate of expected future returns instead of actual returns to compute periodic pension costs. The logic behind this accounting is that, in the long run, a combination of company resources and investment earnings must equal plan obligations. Pension plan liabilities are long lived and therefore some stable long run estimate of corresponding asset returns should be used to determine the periodic cost to the business of meeting plan obligations. Accounting further recognizes that annual differences between actual and expected returns are inevitable. These are accumulated and amortized into periodic cost over time.

      There is a natural asymmetry to how this accounting regime is viewed depending on market performance. In bull markets, most seem satisfied in the conservatism reflected by periodic pension costs being higher than current earnings might suggest. Yet in bear markets, critics become vocal about the potential manipulation and overstatement of income as a result of using positive expected returns when market returns are negative. The wider the gap the more vocal the critics and the more concerned the actuaries and auditors who have a professional tendency towards asymmetrical conservatism. A recent article reflects this view.

      “That 8 percent annual return on investment you and your pension fund manager were banking on is now looking almost as optimistic as Madoff’s magic 12 percent, as deleveraging and deflation bite. With extremely low or negative interest rates and everyone from consumers to banks trying to shed debt and assets at the same time, what seemed like reasonable projections for a mixed portfolio of stocks, bonds and other assets are now substantially too high.”
      It is a well accepted fiduciary notion that short term investment results are very noisy and carry little useful information to guide long term investment strategies. Yet, after market drops like 2008, misguided critics insist that plan sponsors should be lowering their expected return assumptions to accommodate what ever change in strategic assumption they would argue has been revealed by the market drop. In this case, presumably, overleveraging was explicitly factored into past return forecasts rather than being a source of an unexpected positive variance from past forecasts.

      In fact, long term expected return assumptions as defined by FASB, properly based on long horizon strategic factors, should not be subject to frequent marginal shifts given; the likely estimation error in any such forecast, the infrequency of major structural market changes and the provisions of accounting to amortize actual to forecast return differences overt time. Further, unless the market principle of mean reversion has been suspended, it is fallacious to assume that forward expected return forecasts should be lower after a market collapse. Historically, periods of heavy losses have been followed by periods with above average returns. Diamond Hill calculated that if the S&P 500 only returned to its April 2000 level in the year 2016, that appreciation, coupled with the dividend yield, would result in an annualized total return of over 12%.

      While we are not expressing a view as to whether the average pension plan’s expected returns accurately reflect future returns, it is illogical to presume that the passage of the last year has provided plan sponsors with significant additional insight on strategic factors that were embedded in their long term forecast assumptions. Though it is understandable from a risk aversion perspective, it is also illogical that pension actuaries and auditors should bias plan sponsors to lower long term expected returns after the market has seen its worst decline in 50 years. Given their biases, pension plan fiduciaries should not unduly allow their advisors to tactically influence their strategic pension accounting assumptions.