Investment Portfolios and Death Spirals
Nobel Laureate William Sharpe was recently quoted as saying the decumulation phase of the investment life-cycle is “the nastiest, hardest problem in finance.” The decumulation phase, or the spend-down stage, is when net contributions into a benefit fund or plan are negative – more money is leaving the account than coming in. Without that cushion of increased contributions coming into the plan, it can face severe challenges that can be difficult to overcome.
Maturity with Poor Funded Status Can Lead to Death Spirals
Maturity is not a problem by itself for a fund. However, when maturity is combined with a poor funded status, it can lead to unintended consequences. For many plans, contributions and benefit payments are relatively fixed. For example, Taft-Hartley plans’ contributions are determined by their collective bargaining agreements, with a variable of the amount of hours worked during a period by covered participants. Public retirement systems may have long amortization policies that gradually adjust contributions. Endowments and foundations may have spending targets that are also very sticky.
In all these cases, the benefits and payments are difficult to adjust. Thus, these poorer funded, more mature plans find themselves in a position where it is virtually impossible to invest their way out of an underfunded position. This is what is known as a ‘death spiral.’
For Some Plans, Avoiding the Death Spiral Means Earning More than 7.5%
The table below is instructive in showing the math on how this happens. It demonstrates the rate of return needed to maintain a fund’s funded ratio during the year given an actuarial assumption rate of 7.5%.
You may be tempted to think a fund needs to earn 7.5% to hit a 7.5% actuarial rate. That is only correct when either the plan is fully funded or the fund has a net contribution of $0. In cases where the fund is both underfunded and in the decumulation phase, the return needed is higher, and is sometimes much higher.
Contributions equal benefit accruals. All cashflows assumed to be end of year.
For example, a plan with a funded ratio of 60% and net benefit payments of 10% of assets needs a rate of return of 11.5% just to maintain its funded ratio at the end of the year, even though the plan’s actuarial assumption rate is 7.5%.
A death spiral can occur when a fund is matching the actuarial assumption rate, yet each year the plan’s net benefit payment/market value of assets ratio increases and the funded ratio declines. The trend quickly accelerates, leading to insolvency for the Fund, and the rates of return needed to climb out of the spiral quickly grow out of reach.
Preventing Death Spirals Means Managing Risks Carefully
As with many things in life, prevention is the best cure for ‘death spirals’. Today, more than ever, funds need to evaluate the risk profile of their strategic asset allocations. Funds should only take compensated risks, and should only take enough risk needed to reach their key objective: meeting current and future benefit payments. While we all agree that funds should not be swayed by short-term market noise, for many the motto that ‘in the long run, everything will be okay’ doesn’t hold, as survival to the ‘long-term’ is not guaranteed.
For funds that have low funded ratios and high net benefit payment ratios, and therefore the potential for a death spiral, all three levers of the plan operation will likely be needed:
- Investment strategy
- Benefit design
- Contribution policy
With respect to the investment strategy, an obvious first step for fiduciaries is to evaluate the strategic asset allocation (if it hasn’t been reviewed recently). Reviewing illiquid exposures is paramount as part of this evaluation. Trustees can also evaluate the fund’s capacity for a higher return and risk portfolio that can be implemented in a dynamic fashion, with an eye toward reducing risk as escape velocity from a possible death spiral is reached.