Why Pensions Should Invest Like Pensions: It’s All About Liabilities, And Some Policy Thoughts

By: Todd Groome
Todd Groome has over 30 years of experience in international financial markets, working in both the private and public sectors.

What is a pension? Put simply, a pension is a vehicle to provide deferred compensation to employees (and usually their partners) in retirement. Properly managed, a pension must cover its liabilities as these become payable.

Nevertheless, many pension plans today invest their assets independently of the promises or liabilities created. There is evidence that US pensions still invest close to 60% of their assets in equities, almost 25% in bonds (down from prior periods), and the rest in cash/other. This can create an asset-liability mismatch, meaning that retiree benefits may not be payable if the stock market takes a tumble and stays down for years or during periods that liabilities/promises fall due.

There may be lessons to be learned from endowments and sovereign wealth funds (SWFs). Most critically, the “better-managed” among these institutions tend to incorporate both a liability and a funding analysis in their investment program. That is, similar to pensions, endowment and SWF obligations can be outlined in terms of near/medium/long term funding needs: for instance, a sovereign or organization may save and invest for the population’s aging-related costs, such as medical or long term care, or to finance a new university library.

Similarly, we can think about ourselves as needing to understand our future liabilities or needs, identifying both the “hard” and the “soft” liabilities. Hard liabilities could involve a mortgage or a child’s education costs, while soft liabilities may include travel or expensive hobbies, or uncertain health issues and broader family obligations, such as care for parents.

To the extent that some of your retirement needs are longer term, this can allow you (and your pension fund) greater investment flexibility. For instance SWFs, endowments and life insurers often provide or “sell” liquidity via investment capital seeking a 4-6% illiquidity premium; this means they lock-up capital for longer periods, rather than having more immediate access.

Yet regulators and policymakers largely focus on the asset side of institutional balance sheets, rather than liquidity, funding and liability structures. Indeed, this was a contributing factor to regulatory shortcomings before the financial crisis of 2008. Today, we seem to be doing the same again…for example, efforts to regulate non-banks – including pensions – the same as banks, leads to short-termism, and we are implementing non-risk based rules on banks (e.g., leverage ratios), which lead banks to provide less market liquidity. Such regulatory policies influence market behavior, making it more difficult for retirement investors to exercise the flexibility inherent in their balance sheet structures. What we need is for the less-liquidity-constrained investors to provide longer-term capital, given their longer-term liabilities, and not encouraging pro-cyclical or short-term investment behavior.

Our financial system would be more stable if financial policies encouraged – or even tolerated – diversity among market participants, based in part on differing liability and funding structures. The world’s financial policymakers are poised to meet at Jackson Hole and the IMF/World Bank, and they will no doubt discuss market liquidity concerns. Nevertheless, I am skeptical they will analyze the financial stability benefits of market participants differing liability structures and related liquidity preferences.


This piece was originally posted on August 14, 2015 on the Pension Research Council’s curated Forbes blog. To view the original posting, click here.
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