In a new paper, “Pension Investing: An Alternative Strategy for Public and Church Defined Benefit Plans,” River and Mercantile Managing Director Tom Cassara lays out the case for a new way for these types of pension plans to invest, similar to an approach that the consultancy suggests for corporate pension plans.
Cassara says he has served church pension plans for many years, but since joining River and Mercantile a year ago, he has become more conversant in the use of equity derivatives. Generally, church and public pension plans and the consultants who serve these plans are not familiar with the use of these types of instruments.
This inspired Cassara to develop a new investing approach for these types of plans consisting of an underlying fixed income investment strategy comprised of high-grade, longer-term securities that deliver higher yields, paired with equity derivatives that provide contractual exposure to the equity markets, but in a way where risk can be managed. The primary goal of this approach is to provide insurance protection against market downturns in exchange for giving up some of the upside when market returns are good.
Non-Employee Retirement Income Security Act (ERISA) church pension plans and public pension plans are managed differently than corporate pension plans that fall under ERISA, Cassara tells PLANADVISER. “Non-ERISA church plans are backed by the church organization, and the public plans are backed by the entity they serve, so they have a little more financial freedom,” he says. “ERISA mandates a certain funding ratio, whereas these plans have more freedom on their minimum funding to support future benefit payments. The rules regarding them tend to be a little more forgiving on minimum funding status, so they tend to be a little less funded than their corporate counterparts.”
How church and public pension plans typically invest is in a well-diversified portfolio with the objective of maximizing returns and minimizing risk through a myriad of investment styles, Cassara says. Their emphasis is more on returns than on liabilities, he explains, and they do invest in the private markets, including equity, debt and hedge funds.
“We tend to be more comfortable with an investment strategy where we hit more single than doubles [in terms of returns on the upside], in trying to avoid falling backwards into what I call a ‘death spiral,’” Cassara says. “The portfolio we have put forth is one where we have invested in high-quality fixed income vehicles, typically bonds issued by investment-grade corporations, public entities and governments, that are longer-dated and produce higher yields. That would provide a good amount of cash flow and a reasonable rate of return.
“On top of that, we would reach out to the futures market to gain equity exposure–not to ride the market’s fluctuations but to create a collar,” Cassara continues. “Each collar would be unique for each organization and designed differently.” One could provide insurance protection against a 10% decline in the equity markets, for instance, he says.
To pay for that premium, River and Mercantile proposes selling off some of the securities delivering upside.
The goals is to help church and public pension plans “be more confident about where their returns will be and to try to advance the funded status of their plans in a more measured way, with limits put in place to protect the plans from any of the downs the economy could bring,” Cassara says.
River and Mercantile has just completed its back testing on this approach and is only just now starting to discuss it with these types of pension plans, he says.
As he writes in his paper, “A vast number of pension plans rely on diversified portfolios dominated by global equity allocations and a significant percentage of alternative investments (hedge funds, private equity, private debt)—yet funding ratios have remained stagnant even in the face of the longest equity bull market in history. We believe that an investment strategy which encompasses more predictable returns and increases protection against shocks to its funded ratio via a recession or economic downturn is most prudent for plans to consider on behalf of their participants.”