Public Pensions: New Discount Rate, New Strategy?
By: Colyar Pridgen, Capital Group
A new Actuarial Standards Board requirement for reporting public pension liabilities may prompt plan sponsors to consider allocations to actively managed long duration fixed income.
This is an excerpt from NCPERS Fall 2023 issue of PERSist, originally published October 24, 2023.
A recent change in actuarial reporting standards may make this an opportune moment for public pension plan sponsors to take a fresh look at their fixed income allocations. The Actuarial Standards Board now requires that actuarial reports for public pensions reflect plan liabilities using a discount rate based on the yields of high-quality bonds, as corporate pension plans do. This does not replace public plans' long-standing approach to the discount rate, which is based on long-term expected returns.
The actuarial reporting change is unlikely to drastically alter public plans' use of their traditional discount rate or their overarching investment philosophy. However, it creates a secondary implied funded status that could experience greater volatility and create “bad optics.” Mitigating some of that volatility could be worthwhile to plans, especially if achievable within the confines of the existing investment philosophy.
Consequently, public pension plan sponsors may want to consider whether allocations to actively managed long duration credit would better align with long-term return goals compared to existing fixed income.
Here are three other points for public pensions to consider:
1. Long bonds may be the fixed income style of choice for many long-term total return investors
Many public plans shun longer dated bonds, which can cause them to miss out on potential risk-mitigating benefits when return correlations between equities and bonds are low. These benefits, along with long-dated fixed income return expectations, have only become more attractive with the run-up in bond yields that began last year.
2. Public plans' discount rates tend to follow the direction of long-term bond yields
For corporate pensions, discount rates are tied directly to market yields on long duration bonds, so they have tended to be more responsive to shifts in fixed income markets. However, even under their traditional expected returns-based discount rate, public pension plans' liabilities are sensitive to bond yields in the long run, which is what typically matters for long-term investors.
3. Long bonds can offer a measure of protection during rare (black swan) events
The Governmental Accounting Standards Board (GASB) requires public pension plans with insufficient funding levels to use high-quality 20-year tax-exempt general obligation municipal bond rates as a portion of the primary discount rate. Whether or not a plan is sufficiently funded to avoid this GASB 67 requirement, the high-quality bond-yield-based discount rate represents a “shadow liability” that can emerge in black swan situations. Investing in long bonds can help mitigate the potential double whammy of an extreme market drawdown and imposition of a muni bond component to the discount rate.
Public pensions have historically not utilized much long duration fixed income. While there are sensible reasons why use of these instruments may differ in manner or scale as compared to corporate plans, it may be time for public pensions to take a fresh look at long duration. The new actuarial reporting requirements are the latest and highest profile reason, but a close inspection through a variety of other lenses may confirm the strategic suitability of the asset class. Incorporating long bonds into strategic allocations — particularly long credit — should not require a wholesale adoption of LDI across the board but should dovetail well with some existing investment philosophies.
About the Author: Colyar Pridgen is a lead pension solutions strategist at Capital Group. He has 16 years of industry experience and has been with Capital Group for five years. Prior to joining Capital, Colyar worked as a senior LDI strategist at Standish Mellon Asset Management. Before that, he was a consultant and actuary at Towers Watson. He holds a bachelor's degree in economics from Cornell University. He also holds both the Chartered Financial Analyst® and Chartered Alternative Investment Analyst® designations, and is a Fellow of the Society of Actuaries and an Enrolled Actuary under ERISA. Colyar is based in Los Angeles.
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