by Thomas Aubrey.
Making the right asset allocation decision is critical if pension funds are to generate sufficient returns to meet their liabilities. A recent analysis by GlobalSWF indicates that US public pension funds are only 75% funded and face a $1.3 trillion shortfall. Other public pension plans, such as the Universities Superannuation Scheme (USS) in the UK, are also suffering shortfalls. Figures from the latter’s last annual report indicates it is only 84% funded. This shortfall has created a challenge for USS, which subsequently presented scenarios requiring an increase in employee/employer contributions from just over 30% to between 42% and 56%. This issue has triggered a series of strikes by academics across the UK.
The challenge for pension fund trustees is that the typical approach to asset allocation is unlikely to help them much. Grounded in the capital asset pricing model, the traditional method assumes an economy operates around its equilibrium level over time. Hence, the expected rate of return can be explained by the market’s historic performance, with differences in future returns understood as representing deviations from equilibrium. Attempting to manage the volatility of returns over the business cycle has resulted in most funds holding a mix of equities and bonds. The equity portion helps generate upside, while bonds, which are assumed to be uncorrelated, provide some positive return when equities are performing poorly.
Embracing balanced asset allocation strategies, however, requires accepting that around half of deployed assets will constantly be underperforming. This is not a great strategy if a fund’s liabilities significantly exceed the current value of its assets.
The Global SWF data shows that Public Pension Fund asset allocation is pretty static through time, with a mix of 41% equity and 44% bonds in 2016 moving to 42% equity and 39% bonds by 2021 (and with a range of other assets making up the difference). In general, equities performed well in these years but bonds did not, hence about 40% of the portfolio underperformed.
As argued previously here, the typical approach to asset allocation is flawed on two counts. First, an analysis of returns data indicates that equity performance is by far the most important driver of pension fund returns. Second, equity returns are affected by the credit cycle, which can be measured by the change in the Wicksellian Differential. Hence, the challenge for asset allocators should be to allocate capital to equities when the relative difference between the return on capital (natural rate of interest) and the money rate of interest is increasing, and to move out of equities when returns on capital decline relative to the money rate of interest. Such an approach enables investors to avoid periodic capital losses when equity values drop, while also enabling them to allocate capital to outperforming assets rather than underperforming ones.
The results of this approach, since the publication of quarterly notes from 2014 (based, in turn, on my 2006 model that formed the basis of Profiting from Monetary Policy), has been significant outperformance compared to buy and hold strategies for equities, bonds, balanced funds as well as 60:40 equity/bond portfolios. Crucially, this higher return comes with lower volatility, as measured by the coefficient of variation. The data excludes trading costs, although since 2014 there have only been 9 signals that have resulted in switching between different low-cost ETFs.
Exhibit 1: Comparison of returns and volatility by strategy since 2014
Last quarter, the signal indicated a move out of the broader US stock market into US energy equities, given the rising inflationary outlook and the expectation of losses from bond investments. The latest quarterly signal for the US market is negative for equities, with near-term profit expectations falling and the BBB cost of funding rising. Hence it can be expected that the Wicksellian Differential will begin to decline.
Exhibit 2: Outlook for US Wicksellian Differential
While this declining level of profitability is likely to have a negative impact on capital values, the overall economic outlook has a number of positive factors. First, US consumers are increasing their leverage, indicating that in spite of the decline in real earnings, demand is unlikely to stall dramatically. This leverage is supported by the fact that interest rates remain at relatively low levels. Indeed, bond yields (by credit category) appear to be stabilizing at the levels they reached at the end of 2018, which should be seen as a positive sign.
Exhibit 3: US bond yields by credit rating
Second, the latest credit transition matrices from Credit Benchmark for North American corporates do not indicate a deteriorating credit environment. On the contrary, sub-investment grade obligors are still seeing a higher ratio of upgrades to downgrades than was witnessed in the 2018-19 period. Furthermore, although investment grade obligors are seeing more downgrades than upgrades, these are at a lower levels than seen 2018 2019.
Exhibit 4: North American Corporates – Credit Transitions
One key question bond investors are trying to answer is whether long term bond yields have stabilized, based on the view that inflation will trend down towards 3%. One signal indicating a downward trend is that nominal wage growth appears to have slowed a little in April. However, if inflation remains sticky at around 5%, then the Federal Reserve is likely to continue raising rates. Such a scenario may well result in a flattening of the yield curve, rather than a scenario where long-term yields rise in conjunction with short term rates. Hence longer maturity bonds, along with certain elements of credit, are more likely to sustain capital values.
As the Wicksellian Differential declines, the risk increases that equity values will fall, impacting funds that have large exposures to equities. Conversely, as inflation begins to drift downwards, investors in long maturity bonds might experience relatively higher returns than to equities. This is why consistently maintaining around half of a pension portfolio’s assets invested in something that is underperforming is unlikely to solve the challenges posed by the underfunding of pension plans. Investors need to abandon the premise of general equilibrium and instead examine the fluctuations of the credit cycle. This can provide a clearer picture of the expected rise and fall of capital values. Until pension fund trustees do this, their ability to maintain pensioner wellbeing remains a major challenge.
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