Paul Brodsky, proprietor of macro-allocation.com, invited me to write about a liability approach to asset management. His brief: Macro Allocation Inc (MAI) is an investment consultant that provides analysis and practical applications to professional investors and advisors, investment boards, foundations, endowments, family offices and other fiduciaries.
The gist of my piece: The Interest Rate Falling Generation made big money by managing the expansion of investible assets. The Interest Rate Rising Generation will need to understand liabilities and balance sheets, or will be dinosaurs. This may be especially true for the large fund management companies.
The Interest rate Rising Generation (I emphasize – the generation of interest rates, not the age of the person participating in the rise: a 60-year-old in 1979 who was investing for two years ahead had a very good decade in store), and the financial institutions that do well, will have a different focus than the Interest Rate Falling Generation. This will include investors understanding the balance sheet, the peculiarities of how the liability is structured and how to restructure it, banks that disintermediate and securitize assets of fiduciaries into cash flows for their pension plans. These are great opportunities.
I think a bank could build a business by handling the needs of either selling the assets of, or creating Public Private Partnerships for, cities, colleges, endowments. The bank could then structure the assets in a securitization. The securitization would be structured and offered to institutions that need yield, but can’t get it without large risks. Pensions, insurance companies.
A model: Ontario Employees (and others) bought a Chicago toll-road operator on November 12. According to BL, the plans have been buying “alternative assets, such as toll roads, ports, and other infrastructure assets with long term, stable cash flows…”
There is often a match between pension plans and assets that can be securitized. Cities with parking garages and “other infrastructure assets” can sell the assets to a bank that can turn the assets into securities, structured to pay the needed level of income.
In “Liability Solutions” (attached below), I discuss pensions and municipalities. I could have chosen other beleaguered groups. This is valuable information for the parties I discuss: The adviser must understand that parties place different values on liabilities: portfolio managers, security analysts, credit analysts, private equity firms, law firms, investment bankers (M&A), banks that lend to the entity, municipal lenders and bondholders, and distressed debt investors. Each has a particular interest. There is very little analysis addressed to these parties.
I doubt there are many investment managers who know the missing link – assets v. liabilities, across a cornucopia of institutions, offers valuable information.
This also offers investment managers a competitive advantage. They’re knocking heads now. At Hancock, I advised pension plans on asset allocation by starting on the liability side and moving to assets.
An investment management firm could offer “free” advice on the liability side and receive its fees by managing a portion of the assets from a very grateful client. That was how we operated the business at Hancock. There are some huge chunks of money today – pensions, endowments – with no idea what they are doing. I was told by the wife of the mayor of a large city exactly that; “We need help. Nobody on the pension board knows what to do.”
More exogenous market disruption? As liability specialist Fred Sheehan notes, asset prices may be greatly influenced in the coming years by pension fund mismatches.
Cities are broke. Pension plan promises are in the courtroom. Insurance companies are flying blind, unable to earn a yield. Liabilities have entered a boom market; inevitable, now that the interest rate cycle has turned. The liabilities (contractual promises) of cities, pension plans, insurance companies, and many other entities will be discounted, rediscounted, and discounted again.
This is a moment of great opportunity. Investment management has prospered through the expansion of financial assets over the past generation. Total debt in 1970 was $800 billion. Total world debt today is incalculable.
Investment management is consumed with earnings per share. Corporate finance concentrates on the income statement. Balance sheet analysis has atrophied. Yet, balance sheet commitments need to be managed, particularly when liabilities and leverage are growing in proportion to assets.
Similarly, financial firms are not organized for 2015. A quick historical detour explains why: Interest rates rose from 1946 to 1981. The final decade of this period was notable for its anomalies, only one of which was the evaporation of Wall Street. There were also precursors, little noted at the time, such as Drexel Burnham Lambert building the junk bond market in the late 1970s. Noteworthy is DBL’s “outsider” status. In the 1980s, establishment Wall Street firms played catch up to the much smaller DBL.
Today, investment firms are built for growth. That’s been the story, in the post-1981 period, when long-term U.S Treasury yields fell from above 15.78% to 1.40%. The most significant fact accompanying this period is financial and balance sheet expansion: with very few interruptions. Leverage grew, appetite for junk bonds blossomed, financial analysis loosened (EBIT was expanded to EBITDA), and risk management was homogenized (VaR, which evaporates when correlations converge, has now been imposed by federal regulators on banks). Access to funding has suffered only occasional depletion. Every such instance of famine has ended after central banks slashed interest rates. The rate that central banks control is now zero percent.
It is astounding, in 2015, after a generation of wind-to-their-backs, that so many of the institutions entrusted to meet long-term financial commitments are grasping for means to meet their obligations. Even if interest rates remain in the zero-range (improbable), liabilities have already swamped the parties’ assets. Pension plans, public finance, insurance companies (both life and P&C), universities, professional sports, and finance itself (a huge employer) are all in trouble. Most of us know this. The cashiers at Home Depot know it. But those in charge timidly look ahead, some in fear, some because their knowledge – including the advice they receive – is compartmental.
Comprehensive management demands the integration of assets and liabilities. One cannot get the right answers when the wrong questions are addressed. This is why a “bottom up” understanding of liabilities is needed. We will look at the management of defined benefit (DB) pension plans and municipal finance.
Defined Benefit Pension Plans
There are three types of DB pension plans: corporate, public and Taft-Hartley (unions). There are differences. Only corporate plans will be addressed here so as to reduce the moving parts.
Long-term strategic planning is handicapped since pension asset values and liability levels are unpredictable. The difference between the two is calculated each year. Changes from the previous year alter earnings per share and the required plan contributions. Underfunded plans make additional contributions.
The coordination of pension plan management to corporate strategic planning should start with the most basic question: “What does the plan promise?” Yet, analysis is usually top-down.
Here is an example of how surprises may lurk without bottom-up analysis: A plan sponsor wanted to terminate its pension plan. An insurance company was willing to annuitize the benefits for $5 million. Before offering the quote, it hired a firm to analyze the plan in depth. This plan offered a “rule of 85” option: A plan participant with a combination of age (e.g., 60 years old) and service (e.g., 25 years on the job) that equaled 85 was fully vested. The worker could immediately start collecting full benefits. The insurance company changed its cost of annuitization to $10 million.
Pension plans (corporate, municipal/state, and union) receive advice on how to structure assets, particularly their fixed-income assets, to achieve specified objectives. But consultants usually do not integrate asset management advice to the specific design of the liability. Plan liabilities can be restructured (reduce lump sum options, change the benefit formula from final-salary to average-salary, split into dual plans, and many other possibilities to the particular promise and plan population). This is an iterative process. Restructuring liabilities then opens windows to supplemental asset strategies.
See full PDF below.