Tuesday, April 15, 2008

Commodities in Retirement Plans

In reviewing capital market activity over the last few years it has been impossible for plan fiduciaries to miss the parabolic increase in commodity returns. Global investment in the sector has surged about tenfold in five years, reaching $178 billion in 2007, according to Barclays Capital. Strategic investors must determine if the run up in commodities is sustainable based on long term fundamentals or primarily driven by cyclical factors and speculation. The fundamental argument is that commodities have and will continue to benefit from supply shocks due to an aging and constrained infrastructure and growing global demand from emerging markets, particularly China. Of course, investor’s proclivity to chase returns in the face of a weakening outlook for traditional investments and the rapid development of easy to use products like ETF’s to meet this demand must also account for some of the unprecedented growth in commodities.

The merits of commodities as a strategic asset class are not universally accepted. In an often cited study, Gorton and Rouwenhorst conclude, based on a 25 year review, that commodities offer equity like returns and volatility with a low to negative correlation to bonds and stocks and inflation. These investment characteristics are well aligned with institutional investor’s interest in alternative asset categories, especially as pension and accounting regulations increasingly penalize portfolio volatility. Pension funds have begun to develop meaningful allocations to commodities. Several large public pension plans have adopted commodities mandates. Calpers, the California Public Employees' Retirement System, the largest U.S. pension fund, invested $500 million in commodities last year and expects to increase its allocation substantially.

Yet, historical commodity prices have generally declined over the long term. Long term spot commodity prices have fallen by about 1.5% over the last 100 years according to a paper by Ronald Layard-Liesching. Historically the “roll yield” has been the predominant provider of commodities returns as futures prices were consistently lower than spot prices. In today's world however, spot prices tend to be lower than futures prices for many commodities. Erb & Harvey in a 2006 study "The Tactical and Strategic Value of Commodities" concluded that holding a basket of commodities provides investors with no real (after inflation) return, though they acknowledged their countercyclical diversification benefit.

While there is general consensus about the positive portfolio diversification properties of commodities, the extent and source of their strategic expected returns is unclear. Commodities contracts are conceptually a zero-sum game where the long position can only earn a risk premium at the expense of the short position. There are other factors which should be considered in evaluating commodity returns & characteristics for suitability in a pension plan
• actual commodity index return streams are relatively short. This should be considered in developing a confidence level and reliance on past history as it influences the allocation,
• the risk reduction benefits of commodities are period-sensitive according to some studies,
• high fund fees and high trading costs must be overcome before commodities provide excess returns,
• normal "backwardation", a process which created returns in the last 25 years to protect against inflation may be lost as a broader range of investors bid up prices for inflation protection,
• after several years of double-digit returns, commodities have suddenly become a core asset class,....it must be different this time
• the commodities product market has deepened and become more liquid potentially reducing risk premiums and introducing a more speculative and volatile facet

While commodities appreciation might continue based on both fundamentals and momentum, it has been a very volatile asset class and promises to be even more in the future. Fiduciary investors should develop specific rationale aside from returns for adding commodity exposure to their self managed portfolios. Be it a dollar hedge, an inflation hedge, a hedge on financial assets, a play on global growth or a portfolio diversifier. Though the fundamental premise for allocating to commodities seems sound there is a speculative element in the market that would suggest a strategic allocation should be very carefully considered, implemented over time and modest in relative proportion to real return producing assets such as stocks and bonds.

Given commodities controversial asset class merits, it's recognized volatility and the speculative flavor of today's markets, fiduciaries should use the utmost care and prudence in determining the suitability of commodity investments for participant directed investment offerings.

Friday, April 11, 2008

Other Public Plans Seek to Expand Retirement Coverage

The State of California is considering a proposal (Assembly Bill 2940) to allow employees at businesses without retirement plans to set up IRA type accounts that would be managed by the California Public Employees Retirement System (CALPERS). The retirement industry questions whether this and other similar proposals are effectively publicly funded subsidies which create an unfair competitive disadvantage for them. The unique details of each proposal may have to be further developed to ultimately decide that question.

What is absolutely clear is that many small business employees are competitively disadvantaged in their ability to save for retirement. They either don't have access to a retirement program or must contend with the debilitating effects of high fees and/or poor investment alternatives.

The small retirement plan market, which seems to be the primary focus for these proposals, is obviously not homogeneous. There are many reasons why employers don’t have plans. The diversity of needs and objectives in this market should accommodate many providers and solutions. The State plans could provide a very attractive solution for certain segments of this market and might simply increase overall retirment savings, not materially displace existing programs. These models could provide a very modest form of self-funded public intervention in very inefficient markets. This has the potential to provide substantially more benefit than downside.