At Markets Group’s 7th Annual Tri-State Institutional Forum, which took place on March 27th, Antonio Rodriguez, director of investment strategy at the New York City Board of Education Retirement System, moderated a panel entitled: Conversation with the Region’s Leading Chief Investment Officers. Rodriguez led the discussion with a trio of panelists that included: Anthony O’Toole, executive vice president and chief financial and investment officer at the Truth Initiative Foundation, Scott Stone, senior vice president & chief investment officer, Pentegra and Donald Walker, deputy chief investment officer of The Board of Pensions of the Presbyterian Church. (O’Toole declined to be quoted for this article.)
The investment officers delved into topics that included how their investment teams approach issues of governance with the boards, the difficulties of managing asset allocation, and how they prepare for an economic recession, which some expect will occur in the next year or so.
Rodriguez: The theme of this panel is around markets and governance. I’m a big believer that structure and governance dictates actions, and it dictates reactions, particularly when it comes to markets. Let’s start, first, by having everyone introduce themselves.
Stone: We [Pentegra] are still the pension retirement management company that was formed for Federal Home Loan Bank systems to manage their pensions. Our goal is to fund the liabilities as consistently and as with as little cost as possible to the pension plans. Later, our mission expanded to help people plan their 401k plans and retirement and to help them to select proper investments that are appropriate for them. We live for good retirement outcomes.
Walker: The Board of Pensions manages approximately $10 billion, almost 90% of which is defined benefit pensions; the remainder is [composed] of other medical plans and assistance programs, which support the clergy and lay staff of the Presbyterian Church USA and affiliated entities. We have an assumed 6% investment return; the defined benefit pension was 126% funded as of December 31, 2018 using a 3.75% discount rate on liabilities.
Rodriguez: Who is on your board, and what is the current structure and how much discretion do they give you to implement your plans?
Stone: They give me just enough rope to hang myself, but not so much that I am tempted to do it. (audience laughs) We have a rather complicated structure. Our main legacy pension plan, for the home loan banks—the Office of the Comptroller of the Currency is in there as well–along with 250 other institutions around the country who are members of the home loan bank system provides our senior level of governance.
So, four times a year, quarterly, we have the defined benefit plan meetings, another four times the defined contribution plan, six times a year we meet with our operating company, plus several other subsidiary operations. We have a lot of governance.
Walker: The board of directors meets three times a year, and we bring recommendations to the investment committee of the board for investment manager hiring and firing decisions. Our asset allocation ranges are determined by the investment committee and approved at the full board level. Management has enough operational latitude to monitor and change manager allocations within those ranges. If we need committee approval on an investment issue between meetings, we can schedule a conference call.
Rodriguez: Matching up your asset allocation and governance is a journey. How did you get your board to accept the asset allocations? Because we always talk about asset allocation, in the current snapshot, but it takes time to get to an asset allocation, it takes time to get your board comfortable with an asset allocation. So, can you talk about the mix between the sophistication of your board, the governance structure, and how it matches with your asset allocation, and what the journey has been like over time?
Stone: So, for the 12 banks—11 now since two of them merged in 2015–the people leading these institutions have investment banking backgrounds or merchant banking backgrounds, and are knowledgeable about capital markets, finance, risk management, Washington regulatory issues – you name it. For the Home Loan Bank system, starting in the late 1990s through the global financial crisis, their collective balance sheet was bigger than the Federal Reserve’s. Quantitative easing changed that, among other things, but it is still collectively more than a trillion-dollar balance sheet. We probably have one of the most, if not the most, sophisticated pension boards in the U.S.
They understand capital markets, they understand politics. We meet twice a year in Washington, because they are in front of the Federal Housing Finance Authority (FHFA), which is their regulator. So, we must meet on their schedule. They are appearing in front of Congress and with regulators.
We are blessed that we have people who ask smart questions and understand the way markets work, so I don’t have to explain what a bond is. I can’t stress enough, in terms of governance, [how important it is] having people that understand, or have a basic understanding of the way markets work when you come into the room, so that you are not wasting a lot of time answering questions that are not really pertinent to the situation or risks at hand.
One of the things they understand best is risk; they understand capital market risk, they understand interest-rate risk, and equity premiums in risk, so the risk discussions are the most interesting. They tend to be the best, and they tend to be pertinent. In terms of our structure, we pretty much are the consultant in this case.
We were created 76 years ago as an OCIO. We have an actuarial consultant for the actuarial side of the business. We have a risk management consultant that does a lot of the verification of our risk calculations for us, and we have various other vendors we use, but essentially the organization got its expertise over the years and became an asset allocator. Markets Group has an Institutional Allocator magazine now; this is kind of our thing: choosing between U.S. and international stocks; large cap versus small cap, versus mid cap; active versus passive. Of all the various allocation choices and the reasoning behind each of them, that is what they expect us to focus on. Having a board that understands what those things are is probably one of the keys to our success.
Walker: Our governance structure is different from Scott or Anthony’s. The board consists of professionals and clergy—all members of the Presbyterian Church U.S.A.—who are elected by the General Assembly of the Presbyterian Church U.S.A.
Like my fellow panelists, we also focus on risk, but we define it a bit differently. Our 6% investment return assumption is the pension plan’s objective, but we manage the portfolio for total return over a very long time horizon. We need to be fully funded, and we need to be able to increase the benefits we pay to our pension plan members on a regular, hopefully annual, basis, due to the unique nature of our plan. Our plan relies on these increases for benefit adequacy. Unlike many plans in which members accrue benefits based on a career average salary or highest five-year salary, anyone paid below the median salary in our plan earns credits based on the median salary. The community nature of our plan means that we have some lower paid pastors who receive more in annual pension benefits than they did in cash salaries. So, when we talk about risk, we are talking about being able to pay an increasing benefit over time.
Rodriguez: What is your asset allocation currently? And how do you approach it?
Stone: We are a liability-driven shop. We start with liabilities.We know we are going to have some U.S. dollar fixed income, as a starting point, so we create our own internally managed bond portfolio, with principal maturities, pre-payments and coupons that is designed so that the cash-flow off of the bond portfolio pays a number of years of benefits in cash, so that we are not having to rely on selling assets. And then you give them a point in time to fund those liabilities as they come due. When I first got there, eight years ago, the number they had in mind was 30 years. With the low interest-rate environment, we talked them into 20 and then 12, although we will probably advise that we go back to a higher number with the inverted yield curve.
We are probably going to take it back to 15 or 20 again, and the reason is that we want a minimum of a full cycle of cash flows that we can count on from a high-quality source and not have to sell anything. One third of the assets will be devoted to doing that.
That last two thirds of the assets must be dedicated to funding the growth and the service and the benefit costs we have. By using this methodology, it is essentially, if interest rates go up or down or sideways it doesn’t matter for that portion of the plan, because that 15 or 20 years of the plan will remain funded.
It’s important to take care of the cash and liquidity needs first. That is one of the rules we have. The single biggest risk that most investors take is the one they didn’t know they were taking. And for pension plans it was cash risk tied to interest rates that dictated how much they had to set aside. Many didn’t realize when interest rates fell that the cost went up so much.
We have a 50-50 equity and fixed-income split. We have only 25% to 30% in public equites, 20% in real estate and private equity, and of the rest, a third is in fixed income and the rest is opportunistic, high-yield distressed debt, or direct lending. We have any number of equity-like debt instruments out there. For the most part, our target is 50/50, and we can vary it from 40 to 55. Right now, with markets where they are, we reduced in the fall, and now again, as the market rallied, and are increasing our hedge ratio. For a pension plan to hedge the interest-rate risk and the funding risk you must own more intermediate and long bonds, and that’s where we have moved to in the last couple months.
Walker: Due to our unique plan design and long-term focus, we are very careful about how we manage liquidity. We have 55% in public equities, about 30% in fixed income, limited partnerships at 10% and market diversifying strategies at about 5%. Unlike many of our peers, the fixed-income component is a total-return portfolio. Only 45% comprises traditional core fixed income, but it also includes almost 6% in cash currently. We maintain cash and short-duration fixed income at a level which represents approximately 125% of the previous year’s benefit payments. The board engages in an asset-liability study every few years with its actuarial consultant. In the event of another period like 2008, the plan can readily pay benefits without reducing return-seeking assets. We remain flexible to manage through more difficult periods.