Why I believe a fixed income strategy makes sense for our pension funds: A critical look at pension investment strategy

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1 Why I believe a fixed income strategy makes sense for our pension funds: A critical look at pension investment strategy By Rod Hiebert, Past President, Telecommunications Workers Union Pensions are a little like teeth. We think about them only once a year when it s time for our annual statement or checkup, unless they start to hurt. And right now they re hurting. -Fiona Anderson (Vancouver Sun, November 20, 2008) Can I afford to retire? Is my pension fund safe? Millions of Canadians are asking these questions in the wake of the latest world-wide stock market meltdown. Even at the best of times, planning for retirement is very challenging for Canadian workers. They want to know how much they should save, how much they will be able to spend each month and whether they will be able to live comfortably on a retiree s income. Most unionized workers are fortunate enough to have a pension fund to help them with the challenge of ensuring a reasonable retirement income. The job of delivering on this pension promise falls to pension fund trustees and the professionals they hire to help them. Understanding the plan s liabilities (the amount the plan is promising to pay its members when they retire) and its investment strategy (financial and mathematical principles, how the markets for stocks and bonds work, and numerous investment tools) are crucial to the task. My involvement in pensions began more than thirty years ago when my union went on strike for 4½ months. Led by the visionary Bill Clark, President of the Telecommunications Workers Union, we were fighting for joint-trusteeship of our pension plan and better pension benefits. In 1991, when I was elected President of the union, I was named a trustee on the Telecommunications Workers Pension Plan (TWPP) and served in that capacity for fourteen years. When I joined the board of trustees, the plan s contributions were insufficient to meet plan objectives. Members contributed 2% and the company (B.C. Telephone Company at that time) contributed 6½% of payroll. Through bargaining, we boosted the Company contributions to 10¾% and members raised their contributions to 5%. That meant contributions were moving in the right direction, but on the investment side, things didn t look so good. By the late 1990 s, our fund was invested in a balanced mix of stocks and bonds, an approach favoured by most money managers and consultants. But with interest rates falling, our plan s surplus was eroding. Liabilities were growing faster than assets. I worked hard to understand investment principles and the money management issues we faced. By the spring of 1998, I was convinced of three things. One was that long-term interest rates would continue to drop. The second was that signs were pointing to a serious stock market correction. The third was most controversial of all. I believed that as prudent trustees we needed to face up to the high level of risk in our plan and decide immediately to change our asset mix so that our liabilities the pensions we had promised to pay were matched by secure investments with guaranteed income streams that would pay those promises. This process is referred to Immunization because it immunizes the plan against the negative effects of falling interest rates and insecurity of the stock market. 1

2 After many lengthy discussions and help from professional advisors, our board of eight trustees four appointed by the company and four appointed by the union concluded that revising our investment mix so that it matched our liabilities was the right thing to do. The immunization of our plan took place in Many members who had been watching the bull market on Wall Street and the considerable stock gains of the preceding years felt that we were compromising future earnings of their pension plans. However, it was not long before the technology bubble burst, stock markets fell apart and long-term interest rates continued to decrease and the wisdom of our lower-risk approach became obvious. Some may have considered our change, specifically a move to government bonds and select corporate bonds, a stroke of smart market timing and expected that we would move back into stocks. But that was not what we set out to do. Rather, we were taking a fundamentally different approach to managing investment risk, one that continues to go against the grain and against the advice of most professional investment advisors and money managers today. Here is the story behind our decision. Pension funding and investment basics Pension plans were established with the objective that workers collectively could have a percentage of their wages set aside in a pension fund that would generate sufficient income over their working career to enable them to live a comfortable lifestyle for their senior years when they retire. Trustees are appointed or elected to exercise their fiduciary responsibilities by investing pension funds in the best interests of plan members. Pension trustees must look for stable, low risk investments to fund long-term liabilities reaching years into the future. For these reasons, future earnings and securities became a critical factor in building successful pension plans. There are two major categories of pension plans. The first is the defined contribution plan, or DC plan, in which only the rate of contribution to the plan is defined (or specified). The second type is the defined benefit plan (or DB plan), in which the benefits on retirement are defined. That is, the income you receive upon retirement is specified and guaranteed. Defined benefit plans are required to file detailed plan evaluations every three years with the Superintendent of Financial Institutions, to indicate whether they are fully funded or whether they have unfunded liabilities. After five years of posting unfunded liabilities, the shortfalls in funding must be addressed either by increasing contributions of cutting benefits. Rather, we were taking a fundamentally different approach to managing investment risk, one that continues to go against the grain and against the advice of most professional investment advisors and money managers today. To determine future earnings for a pension plan, actuaries must take into account many factors, such as inflation, current wages, future wage increases, mortality rates, number of members, growth plans, liabilities and future earnings of the plan. One of the most critical factors is the valuation rate, which is the rate of return that can be expected for the plan assets over the valuation term. The valuation rate chosen by the pension plan is required to be at or very close to the current long-term interest rate (some would argue that it should be slightly below). This valuation rate is used to determine how much return you will reasonably earn on your investments for the next years. In an environment of declining interest rates, every 1% drop in rates means a deduction of 1% for each year, totaling 15-20% of future earnings for the plan over the valuation period. Using 2005 as an example, long-term rates dropped from 5% to almost 4%, so the cost of a 30-year liability went up by 28%. That year the Toronto Stock Exchange (TSX) went up by 21%. The TSX did very well, but not well enough to meet its liability. When long-term rates are moving downward, pension trustees can match plan assets to long-term liabilities by purchasing secure long-term bonds or other secure 2

3 fixed income assets of the same duration. Structuring the pension fund in this manner would immunize or lock in profits and future earnings to meet long-term commitments regardless of the market shifts or longterm rate decreases. In other words, they lock in the valuation rate to reflect guaranteed higher returns and have no reason to adjust downward to reflect longterm interest rate decreases. In addition to securing future earnings, bonds increase in value when long-term interest and bond rates are declining. Bonds are valued like perpetuities. In other words, you place a today s value for the guaranteed income stream of the bond. The calculation for this value utilizes a long formula that basically boils down to: present value equals annual payment divided by the current long-term (bond and interest) rate. If you were paid one dollar per year continually and the long-term rates were 10%, then the present value would be $1 divided by 10%, or $10. If the rates are 5% then the value would be $1 divided by 5%, or $20. Using the above formula, you will find that a 1% drop in rates when rates are low has a more significant impact on the costs of liabilities than when rates are higher. As the long-term rates have slipped from 16% in 1982 to around 4% and counting, it can easily be seen that combined with the prospect of higher guaranteed future earnings, bonds are a powerful investment tool for pension funds over such a period of time. To put this all in perspective, one must consider interest rates over an extended time period. If we view long-term interest rates historically, there are two notable and important observations. One, long-term rates move in very slow cycles. Two, the average longterm rate over the extended period is approximately 5%. What is more important, however, for pension funds is the real long-term interest rate, which is used to compute future earnings on trust fund assets. The real interest rate is generally considered to be between 3-4%. The U.S. Department for the Treasury, for instance, has determined that the average real interest rate from 1870 to 2003 is near 3%. Balancing return and risk The decrease in rates, combined with stock market volatility, has caused much stress to pension funds that have significant exposure to equities. These funds will likely have difficulty meeting the solvency test (the solvency test is required to measure whether a plan has sufficient assets to pay each of its members the promised pension in the event of plan wind up). Pension plan members work for the greater part of their lives saving for their retirement, and when things go bad and their retirement income is threatened they understandably get angry. A Vancouver Sun article written by Fiona Anderson (November 20, 2008) suggests, among other things, that plan members should ask for The investment policy of a plan, to reveal whether it likes to gamble on the stock market or plays it safe by focusing on government bonds. This aptly describes another potent question that pension trustees must ask themselves when deciding on an appropriate investment strategy. (Canadian government bonds, provincial bonds, and municipal bonds are the most It appears that today, all of these plans are fully funded and most have a healthy surplus. secure investments available today. Corporate bonds in general are much more secure than the stock market and operate much like government bonds, but the probability of default is greater.) For these reasons, a number of major union and jointly-trusteed pension plans immunized against falling long-term interest and bond rates by exiting the stock market and reinvesting their entire pension funds in long-term government bonds, high-quality corporate bonds, and other fixed income vehicles. It appears that today, all of these plans are fully funded and most have a healthy surplus. This success is now strengthened greatly relative to other plans because they have not suffered equity losses due to the recent stock market meltdown. In fourteen years as a pension trustee, it was a rare occasion indeed to meet a money manager who advised clients to immunize a pension fund with long-term bonds. (A notable exception was the late Bruce Rollick, an actuary and advisor who promoted 3

4 and supported Immunization Strategy and played a key role in helping me understand the actuarial, financial and historical reasons for immunization.) Financial analysts in general repeatedly tell trustees that stocks will always outperform bonds. And usually trustees listen. However, according to Andrew Allentuck in Bonds for Canadians, Government bonds issued by major nations seldom default, while companies that issue stocks have a high rate of failure. The result is that the comparison is between old governments and new companies. Had the stocks of companies in deep trouble been carried forward after their bankruptcies, rather like the shares of airlines that are serial bankrupts, the averages look very different. The historical returns show that bonds are superior not because they pay higher returns (which remains unlikely), but because they fail far less often. That is why it is also important to understand that if at any time you do consider an immunization strategy; bonds will appear on the surface to yield a lower rate of return. The decision to immunize will nearly always be a risk management decision and it will take real leadership among pension trustees who set the investment strategy to ensure a positive decision. Bonds appear to be quite boring when compared to the hype and sentiment of the stock market, but they can achieve slow, predictable, good compounding returns with little or no management fees. While defined contribution (DC) pension plans do not have a defined benefit promise to meet, the trustees of a DC plan still have a fiduciary responsibility to attain good pension benefits for their members. In a market where long-term rates are falling, it is very prudent to incorporate a long bond, fixed return strategy. This investment strategy will work equally well for personal savings. Some pension plan advisors believe that a plan cannot adopt an immunization strategy if it has unfunded liabilities or if it could not meet solvency tests. It is important to point out that the immunization strategy is a risk management decision that works well when long-term bond and interest rates are falling. Government bonds are low-risk investments, and to increase over those rates of return you generally have to choose higher-risk investment. In fact, as the subprime crisis suggests, the investments offering the highest returns are usually the highestrisk investments, no matter what some credit rating agencies might suggest. This becomes especially crucial in a bear market. A bond portfolio would receive the guaranteed bond returns and would not lose 15-20% of future earning every time long-term rates dropped by 1%. Funds following a fixed income strategy also find themselves insulated from capital loss through stock market declines. This is why a number of pension plans that were in an unfunded liability situation greatly improved An immunization strategy that focuses on fixed income investments offers a balance of return and risk their position by adopting an immunization strategy while interest rates continued to slide. Is immunization a short-term strategy that would work only in the current circumstances? No. Long-term bond and interest rates have been falling for 30 years, and for pension funds during that period long-term bonds have significantly outperformed the stock market. But all large pension funds cannot immunize with bonds, can they? According to W.H. Cunningham in his book In your Best Interest The Ultimate Guide to the Canadian Bond Market, Bond trading volume are enormous, averaging approximately five times the daily amount of equity trading (approximately $26.3 billion). Why is this? First of all, the amount of bonds outstanding is huge, exceeding $1.1 trillion in Canada. Andrew Allentuck, in his book Bonds for Canadians, point out: The international bond market has grown into what is arguably the largest capital market in the world. The total value of bonds outstanding has been estimated at US$30 trillion. Governments and corporations issue new bonds continuously for many different reasons. As well, there are other fixed income investments that are available for investors. 4

5 Looking ahead It is true that the scenario changes significantly when long-term rates start to edge upward and in a meaningful direction. Using the same formula we used for falling rates, you will find that the value of a bond decreases when interest rates are rising. In other words, trustees would not look favourably at 30-year 2% bonds if current long-term rates moved upward to 4% or 5%. If your plan or portfolio is immunized and accrued liabilities are covered by matched bonds, it is unnecessary to sell any bonds to seek higher returns. The good news when rates are rising is that the cost of future liabilities will shrink by a corresponding amount for the same benefit promise, making it dramatically easier to fund future contributions and bond coupon rates at higher rates of return. What this means is that the plan s past liabilities would already be covered by bonds already held by the plan, and future contributions and plan income (coupon returns) will generate higher than assumed returns (based on valuation rate assumptions) with correspondingly lower liabilities for the same benefit level. This may allow the plan to increase future benefits to retirees without drastically changing the plan investment strategy. A first reaction to the historic low long-term rates and where they are headed could be, They have to go up now so let s get back into the market while stocks are priced low. Such thinking could lead to devastating results. We have not yet seen the complete fallout from the stock market and economic crash. There are many layoffs, corporate failures, foreclosures and financial disruptions which may follow. After years of avoiding the R word, experts are now talking not only about recession, but also there are fears of deflation and depression. If we look farther back in history, interest rates remained at historical lows from 1880 to 1960 (other than a short spike about 1920 when rates rose to 5%). On January 2, 2008, economic guru Steven Roach gave this quote of the day: Rates can go to unusually low levels for a lot longer than people think. It is quite probable that interest rates and the stock market could bounce up and down along the bottom for some time before initiating a meaningful upward direction. At the end of the day, the stakes are high. Workers depend on their pensions to live comfortably on a retiree s income. First and foremost it is critical to ensure that pensions are safe and secure. An immunization strategy that focuses on fixed income investments offers a balance of return and risk, and helps to deliver on the pension promise. Rod Hiebert served as President of the Telecommunications Workers Union (TWU) from During his tenure, he was a trustee on the $3.2 billion Telecommunications Workers Pension Plan (TWPP). Rod is a member of the SHARE Board of Directors. 5