Category Archives: Investment

Defined benefit plan investments: Planning for the future now

Marzinsky-JeffDuring December 2014, U.S. equity markets peaked at all-time highs—over 18,000 for the Dow Jones Industrial Average and 2,090 for the S&P 500 Index. Then, in January, equity markets became more volatile and both indexes pulled back dramatically, as international economic uncertainty rose and oil prices fell. Some thought interest rates couldn’t go any lower during 2014 with the U.S. Federal Open Market Committee (FOMC) hinting at an upward adjustment. But interest rates on the longer end of the maturity spectrum dropped during 2014, which most likely had a detrimental effect on defined benefit (DB) pension plan liabilities.

Now, more than ever, plan sponsors should be reviewing their DB plan investments as we react to these market movements, which are critical in the asset allocation process. For more perspective on the shifting landscape, see my paper “Developing pension plan investment strategy: A variety of considerations,” published last year to help DB plan sponsors understand the range of considerations and how they interact in the development of a pension plan investment strategy.

Developing pension plan investment strategy: A variety of considerations

Investment committees face a variety of considerations when managing pension plans. In the past, these committees focused mainly on strategies for investments, but now they need to consider multiple dimensions. Taken together, the multiple aspects affect the value of plan assets and liabilities when effectively managing a pension plan. They also affect the development of an investment strategy for the plan assets. As a pension plan sponsor, it is important to fully understand the various areas that will affect the volatility of assets, liabilities, and contributions on the pension plan and to develop a strategy that will lessen this impact. This paper authored by Jeff Marzinsky offers some perspective.

Google+ Hangout: What is InvestMap™?

Milliman’s retirement glide path technology, InvestMap™, enables plan sponsors to deploy an age- and risk-based asset allocation strategy for the core funds held within a defined contribution (DC) plan. By creating a custom target date glide path overlay, plan sponsors and participants are able to personalize their investment approaches while taking advantage of automated account management features.

In this Google+ Hangout, Jinnie Olson discusses InvestMap with Brittney Hagenbart.

To learn more about InvestMap read Jinnie’s blog “What is InvestMap?

Hedge funds and investment alternatives

Albano-MatthewOver the last week, a few large defined benefit (DB) programs announced they are migrating away from using hedge funds in their investment strategies, stating that fees, complexity, and changing investment approaches played a part in their decision. In the current environment, when investment managers are increasingly packaging hedge fund types of investment instruments into mutual funds, some of the largest DB programs are moving away from them.

According to Morningstar, their alternative mutual fund categories saw 17 new funds in the first quarter of 2014, following a record year for 2013 for both new funds and asset inflows from investors (70 new funds and $40.3 billion in net inflows). These include the Morningstar categories Market Neutral, Long-Short Equity, and Multialternative. Historically, managers of these types of strategies have locked up or limited investors’ access to their money in order to employ the complex investment tactics. This made the investment “illiquid” as the investor needed to give the manager some amount of lead time, three months or sometimes more, in order to withdraw the money from the fund. However, with these new mutual funds the investor has daily liquidity and can buy and sell the mutual fund just as they would an S&P 500 index fund—making them “liquid alternatives” or “liquid alts.”

One of the essential benefits these alternative strategies bring to a portfolio is additional diversification (lower correlation), which is not available from simply using stocks and bonds. As the portfolio’s core asset classes move up and down, the alternative strategies are intended to dampen those moves. Ideally this helps to preserve capital when the other asset classes are negatively performing, at the cost of lowering portfolio returns when the core assets are performing positively. Because of the introduction of daily liquidity, there is increased discussion over including these types of funds within the investment menu of defined contribution (DC) plans such as the 401(k) and giving those participants access to the additional diversification benefit.

Typical of any decision, plan fiduciaries need to weigh this additional diversification benefit against some of the adverse aspects, including participant mishandling as well as fees associated with these funds. As with the other investments in a plan’s line-up, these alternative strategies are intended to be used as a piece of the whole portfolio and not as a stand-alone investment. Additionally, because of the complexity of the investment strategies these alternative mutual funds can carry expense ratios of over 1.5% to well over 2%. In comparison, an S&P 500 index fund typically carries an expense ratio of around 0.1%.

Master limited partnerships: An option for investment diversification

Diversification is an important part of a sound investment strategy. Yet achieving true diversification requires investment vehicles that have low correlation to one another—in other words, they don’t react in a similar manner to market developments. During periods of significant economic growth, typical investments tend to demonstrate significant correlation, even across dissimilar industries. Investments that are minimally correlated with the market as a whole are challenging to find. This, plus a history of strong returns, may explain a growing interest in investments known as master limited partnerships (MLPs).

In this paper, Milliman’s Jeff Chalk provides an overview of what MLPs are, their potential benefits, risks, and tax treatment, and the vehicles available for investing in them.

Update on the Federal Reserve’s tapering and rate increases

Young-DorianOn March 18 and 19, 2014, the Federal Reserve’s interest-rate-setting committee, the Federal Open Market Committee (FOMC), held its first meeting led by Janet Yellen, the new Federal Reserve chair. The outcome of this meeting in terms of the Federal Reserve’s plans for tapering and future increases in the federal funds rate provided more data points toward a base case that continues to increase in clarity.

This is an opportune moment to update you on this base case given the level of clarity, a level higher than we’ve seen since the global financial crisis.

FOMC schedule
The FOMC has eight scheduled meetings per year—two each quarter—one at the end of the first month of the quarter, and one in the middle of the third month of the quarter. During these two-day meetings, the FOMC has been providing increasingly longer-worded guidance on its thinking regarding any changes to the federal funds rate and its thinking regarding any changes to tapering its monthly purchases of bonds (Quantitative Easing 3, or QE3).

The FOMC began tapering after its final meeting in 2013 by reducing its bond purchases from $85 billion per month to $75 billion per month, a reduction of $10 billion per month. In its first meeting of 2014 (January 28-29), the FOMC continued its tapering, down to $65 billion per month. In its second meeting of 2014 (March 18-19), the FOMC again continued its tapering, announcing it would decrease bond purchase to $55 billion per month commencing April 1, 2014.

If the FOMC continues to decrease its purchases over the remaining six meetings in 2014, as is widely anticipated, then in the eighth meeting of 2014 (in mid-December), the FOMC will reduce its purchases from $5 billion per month to $0 (i.e., tapering will come to an end) and QE3 will be complete.

The risks to this base case are that the FOMC could either accelerate or decelerate this rate of change. Should these risks be realized, there may be noticeable reactions in the market, albeit temporary, lasting no more than three to six months and similar in nature to the May-June 2013 and September 2013 market responses.

Federal funds rate
The FOMC continues to communicate that it plans to keep short-term interest rates “low” for a long time. These short-term interest rates are driven by the federal funds rate, which is traditionally increased or decreased in increments of 0.25%.

The federal funds rate base case is that the FOMC will keep the rate unchanged until mid- to late-2015, at which point the FOMC will begin to increase the rate slowly. From a calendar perspective, mid-2015 could be as early as the late-April meeting, while late-2015 could be as late as the mid-December meeting. In terms of the FOMC increasing the rate slowly, slowly may mean a 0.25% increase every other FOMC meeting. A back-of-the envelope analysis could show the first rate increase happening in mid-June 2015 and subsequent rate increases every three months, which would put the federal funds rate at 1.00% in mid-December 2015, going to 2.00% in mid-December 2016, and continuing until ultimately leveling out somewhere around 4.00% sometime in late 2018 or early 2019.

The risks to this base case are that the FOMC could either accelerate or decelerate either the commencement of rate increases and/or the speed of the rate increase. At this point, we have little clarity on exact timing, while we do have reasonable clarity on the range of start dates.

Heading into this second FOMC meeting of 2014, one of the key news items in the financial media was how Ms. Yellen was going to improve the FOMC policy statement’s communication. When communication is the key question heading into a FOMC meeting (instead of federal funds rate changes or the execution of tapering), then there is more clarity in the market.

In 2013, the FOMC had first communicated that, when the unemployment rate reached 6.5%, it would begin to increase the federal funds rate (or at least this was how it was widely interpreted). Then this 6.5% unemployment rate was subsequently reported as the point at which the FOMC would begin to “think about” increasing the federal funds rate. Now the communication is that there is no longer a direct connection between the unemployment rate and when the FOMC will commence the rate increases—which we interpret as a standard investment mosaic process where everything the FOMC feels is relevant is pieced together to form its overall picture.

Discussions about the timing of when the FOMC will begin to increase the federal funds rate have been going on for years, but we now believe there is meaningful clarity. As we move through 2014, we expect QE3 to be tapered to $0 near year-end. If this occurs, we expect the FOMC would make its first rate increase sometime around mid-2015 to late 2015. And at this point, we expect subsequent rate increases to be slow.

Should you like to discuss these topics further, please contact us at Milliman Investment Consulting.

The risk tolerance paradox

The risk tolerance level many investors expect to achieve over the long term rarely equals the same tolerance investors actually experience over shorter periods. This paper by Ken Mungan and Matt Kaufman describes this paradox, explores the main reason it might exist, and introduces a risk management strategy that seeks to solve the problem.

As more “low volatility” and portfolio risk management strategies hit the marketplace, it will be imperative that advisors and investors explore each strategy to uncover how risk is actually being addressed. Identifying those techniques that address both diversifiable and systematic risk is likely to provide better overall results for investors.

Federal Reserve issues statement of monetary policy change

Cottle-StevenOn December 18, the Federal Reserve announced that its bond purchasing campaign, widely known as “quantitative easing,” will begin to lessen as the U.S. economy has shown signs of improvement. The Federal Reserve first mentioned its intentions of reducing bond purchases back in the spring of 2013. Following that initial announcement, markets reacted swiftly and negatively, bringing fixed income yields up and equity prices down. Since then, the United States has steadily shown encouraging signs of improving economic activity. The latest Federal Reserve move is a gradual change, and an explicit acknowledgement that the U.S. economy is heading in the right direction and financial markets are well-prepared for a reduction in monetary stimulus.

As a response to the economic downturn in 2008 and 2009, the Federal Reserve began purchasing U.S. Treasury and mortgage-backed securities in an unprecedented effort to create liquidity, keep interest rates low, and ultimately support the economic system. The policy was designed to be accommodative, purchasing $85 billion in fixed income securities per month, in order to revive economic growth, lower unemployment, and induce a healthy, moderate amount of inflation. Since the policy began, the Federal Reserve’s balance sheet has expanded from well below the $1.0 trillion mark to nearly $4.0 trillion today. Beginning in January 2014, bond purchases by the Federal Reserve will be scaled back modestly from $85 billion a month to $75 billion. A continued reduction of future bond purchases will be dependent upon a lower unemployment rate and encouraging signs of economic expansion.

Reaction to the Federal Reserve announcement was positive, as measured by the S&P 500, which rose nearly 1.7% on the day of the news. The domestic bond market, as measured by the Barclays Aggregate, was modestly negative by 14 basis points. The reduction in Federal Reserve bond purchases could be interpreted as a vote of confidence in the U.S. economy and financial markets. Ultimately, the Federal Reserve may be initiating this exit from the financial markets as a necessary and appropriate conclusion to its unprecedented efforts to stimulate the economy. With that said, the Federal Reserve was explicit about its intention to maintain low levels of interest rates until it is comfortable with a healthy level of inflation and unemployment is at or below 6.5%.

Retirement savings: Don’t confuse past performance and future expectations

Regli-JinnieThe Wall Street Journal recently published an article (subscription required) that indicated individual investors are returning to investing in stocks, but that this could have negative implications for Ma and Pa’s retirement savings accounts.

Optimistic figures about the stock market, such as a 29.32% increase (as of November 26, 2013) of broad market indexes and potential for the Dow Jones to hit 20,000 this year, have been tossed around like rice at a wedding. While these numbers have encouraged the average investor to return to stock investment it’s important for retirement plan participants to keep a few things in mind.


Source: Carl Richards, The Behavior Gap.

While the short-term returns on stocks may have looked incredible on your third-quarter statements, you absolutely cannot invest based solely on short-term returns. Investors in 2008 likely saw the same incredibly high returns right before the market took a downward turn. All too often I overhear people saying, “Wow, did you see returns are up to 20% on Fund XXX, I need to sell out of Fund YYY and buy in.” Because the prices are being driven up, your hard-earned money actually buys fewer shares than if the prices were lower.

I’m not saying that our economy is building up for a fall but it’s important to keep in mind that, even while the market is doing well, you need to protect the nest egg that you’ve worked so hard to build.

Regardless of the market, the key to investing your retirement assets is diversification. Financial advisors tell us that, by spreading the investments in a retirement account across different asset categories, investment risk can be greatly reduced. By investing in a mix of stocks and bonds you are creating your own small “cushion” of protection against losses in case of market fluctuation. It’s important to remember that you’re investing for the long term, and more than likely those incredible returns will only last for a short period of time.

Lifecycle funds, version 2.0

Smart defaults, lifecycle investing, and target date funds have been widely discussed since the global financial crisis highlighted the flaws in the traditional asset allocation approaches adopted for superannuation fund members. Superannuation is a type of long-term investment arrangement designed to help individuals accumulate savings for their retirement. It is a government-mandated program in Australia, akin to North America’s 401(k) system.

A recent article authored by Wade Matterson entitled “Sci-fi super” discusses a new generation of lifecycle approaches that use cutting-edge technologies to strengthen investment strategies exposed by the global financial crisis.

Here is an excerpt:

…The next generation of life cycle funds has learned from the mistakes of the past and addressed them via the use of three key features or enhancements to the existing vehicle. They can best be described as:

• Proximity sensors – broader mandates or strategic asset allocation ranges that can take into account views with respect to asset valuations and seek to navigate through them.

• A traffic GPS system – this has been implemented through the adoption of glide paths that target levels of volatility, rather than equity/bond allocations.

• Air bags – installing explicit risk management through the use of approaches such as hedging or tail-risk strategies that are capable of dealing with unforeseen events when the risk is the greatest.

Milliman’s Financial Risk Management (FRM) practice has helped in the implementation of these concepts in lifecycle funds in the United States and is currently exploring other options to bring these ideas to defined contribution (DC) participants.