Why Advisors Need to Pay Closer Attention to Pensions

Pension income may seem predictable but assuming this can be shortsighted, says this expert.

By Michael Markov

Retirement-focused advisors have tremendous visibility and tools to assess the health and safety of defined contribution plan and IRA options. Yet, a significant portion of some clients’ retirement income comes from defined benefit plans like pensions.

Pension performance is one of those things most advisors ignore. After all, there is nothing necessarily to “manage.” Income is supposed to be predictable.

But is it?

For advisors creating a holistic retirement plan, the answer is elusive because, with pensions, there is a distinct lack of transparency. Unlike public investments that are marked to market frequently, and even private investments that are sometimes valued quarterly, many pensions report results just once a year. For funds that are so important to the financial well-being for millions of retirees, that seems to us to be insufficient and irresponsible.

Earlier this year, we used our proprietary software, which financial institutions and advisors use to perform quantitative analysis of potential investments for defined-contribution plans, to unlock additional information about more opaque investments like college endowments and pensions. We compile and publish the data free so that stakeholders can get a better sense of where these funds are investing and project performance, even though many only report annually.

Risky business

On the pension front, we have uncovered one area that should be a red flag to any retiree who receives or plans to receive income from pensions, and for the advisors who counsel them: Most pensions underestimate their overall market risk, meaning their investment approaches may not be as safe as they appear.

This is true of pensions as a whole — even those that do more frequent performance reporting than their peers.

As an example, take a look at the $92 billion Oregon Public Employees Retirement Fund (OPERF), which is actually among the most transparent funds in the nation. It provides a wealth of information on its website for anyone to review, which includes detailed quarterly and monthly reports, including detailed holdings and returns. Quarterly factsheets show asset allocation, performance and risk.

Yet, while performance numbers are mostly objective, portfolio-risk calculation relies on many assumptions that are often provided by third-party consultants and yield unexpected results. OPERF, which invests about 50% in equities (public and private), has annual standard deviation (the preferred metric for assessing market risk) of approximately 5.5% over the past 10-year period. That seems unusual, since it is akin to a safe, 100% fixed income allocation with two- to three- times the fixed income returns. As a result, it tops pretty much all large public pensions, as well as any major asset class, in both return and efficiency.

Trouble is, our own calculations show that Oregon’s state pension has a 10-year standard deviation of 10.9% — twice the one shown in the report from the state website.

What gives?

To arrive at our risk numbers, we analyzed public annual returns of a pension portfolio and then, using public proxies for asset exposures, compute “marked-to market” risk and return. How is it possible that OPERF arrived at such a different number in its public report? What is special about this pension’s portfolio allocations?

The answer lies in OPERF’s significant allocation to private equity — 27%, which tops most of the large-state pensions’ PE allocations. It’s well documented that stale asset valuations for private equity, venture capital and private real estate lead to smooth and autocorrelated returns and cause significant underestimation of market risk when risk statistics are computed directly from fund returns.

Understating risk when using composite fund returns is not unique to OPERF. In fact, when corrected for staleness, standard deviation of all large pensions in our sample are higher than the one computed straight from annual returns. In short, they all bear significantly more market risk than what has been publicly reported.

A call to action

We have argued that it’s time for pension boards to look critically at the risk information provided by consultants and question calculation methodologies and the underlying assumptions. Tools and methodologies to diagnose and remedy these issues are available and should not be ignored.

But don’t wait for pensions to get around to better risk assessment. Since so many people rely on pension income, advisors who are stewards of retirement planning should begin to use more tools to assess where defined benefit plans fit into retirees’ risk profiles. At a minimum, they should use available data to get a better sense of risk and safety of the underlying pensions.

Michael Markov is CEO and founder of MPI, a leading provider of solutions for investment research, analysis and reporting to the global wealth and investment management industry.


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