Recently Ortec Finance conducted a proof of concept with one of our clients to evaluate the added value of incorporating your liabilities in the performance evaluation. The results clearly showed a different view and also different conclusions on how well investments performed if you take the reason they exist into account: paying out pension benefits.
Institutional investors are moving more and more towards a liability driven investment policy. By taking their core goal into account, investors build a more robust strategic investment policy to achieve this goal. For example for a pension fund to be able to pay pension benefits in the future. Their policy has to at least match, but preferably outperform the growth of the liabilities. We believe that if you determine your investment strategy like this, you should also evaluate the actual performance of the strategy in the same framework. This brings up the comparison of investment return to liability returns and the concept of funding ratio attribution.
During the proof of concept we extended the more traditional performance attribution where the total investment return is explained via an attribution to different asset classes/managers into two directions.
First of all, we compared investment returns at different levels of the fund hierarchy to liability returns (where applicable). For example, we compared the total performance of the fund to the return of the liabilities. It is really good to get a return of 6%, however if your liabilities grow with 9%, you are still moving into the wrong direction. Another example, we compared the specific liability hedge of the client to the liability return. The liability hedge is specifically designed to hedge away interest rate and inflation risk on the liability side. This comparison was quite remarkable as the hedge had a complete different (and negative) return compared to the liabilities. Whereas you would expect the hedge to a big extent to follow the liabilities movement: its original objective.
Second, we introduced the concept of funding ratio attribution. Instead of looking at investment return, we looked at funding ratio return. In other words, incorporating the return of your liabilities into the analysis. Funding ratio being defined as asset over liabilities. If you think about a return in this ratio, a positive return means you are outperforming your liabilities. Now funding ratio attribution means you are trying to explain the return of your funding ratio to different asset classes/managers/decisions. It completely shifts the focus from asset only or comparing investment returns to a market index to a goal based attribution. This really helps to evaluate your strategy towards your core goal: paying out pension benefits. In this concept you also include the impact of contributions and payments, cost of living adjustments and actuarial results into the analysis. Therefore it will give you a complete picture of how the situation of the fund has changed and what the main causes are.
From the proof of concept we learned that this concept is still quite new in the industry. Performance teams, but also pension boards, are not used to this type of analysis. However once the concept is explained and understood, it does provide very insightful conclusions and can really help to align your performance evaluation with your strategic policies. This should all together lead to better risk management and more stability for pension funds, which in the end leads to paying out pension benefits. Wasn’t that the reason pension funds exist?