Asset Management
Should Wealthy Families Act As Pension Funds Change Investment Strategy?

If this is indeed an historic shift, what are wealth holders of significant wealth “smart” to do? Should they follow suit?
The Wall Street Journal and other observers have recently pointed
out that pension funds (“smart money”) are moving out of stocks
and into bonds and alternative investments in a significant
way. If this is indeed an historic shift, what are wealth
holders of significant wealth “smart” to do? Should they
follow suit?
To answer those questions, it is critical for families to
understand the factors at work and then determine the best course
of action by executing an investment strategy that is, first and
foremost, appropriate for the family’s specific circumstances and
consistent with what their wealth is intended to achieve.
In fact, while institutions may be undertaking a fundamental
reallocation of assets, that doesn’t necessarily mean families
should do the same.
Volatility Averse
Why the seismic change in the pension fund industry? As a result
of the financial crisis, corporate plans have been going through
a soul searching. The asset allocation strategies that were
supposed to insulate plans from a 20 per cent to 30 per cent
catastrophe clearly failed.
Facing the same obligations – and with smaller asset bases to
meet obligations – many plans are now seeking to minimize the
volatility of their surplus (deficit) due to legislated or
regulated requirements. Owning bonds, particularly long bonds,
generally provides a better match between asset and liability
movement. In making this change, corporate plans may be
sacrificing return for less balance sheet volatility.
Accounting realities are driving ERISA plans more than ever
before.
At the same time, the move to bonds is being accompanied by an
increased allocation to alternative investments. The expectation
is that higher returns in alternatives will offset some of the
lower returns from moving from stocks to bonds. In essence,
however, this is not fleeing stocks for the perceived safety of
bonds. More precisely, it is the adoption of “minimization of
surplus volatility” over the short term as a more important
objective than total return over the long term. In other
words, these corporate plans are reacting to a redefinition of
risk – not a market-based event.
Structurally, the minimization of risk becomes important in terms
of the plan’s goals and objectives and in meeting obligations
over time. The construct between funds to meet obligations
and “surplus” reflects the substance of how a pension fund should
be analyzing its own needs; the fund has fixed obligations and
those are fixed in dollar terms. Buying dollar denominated
bonds helps the fund reserve for obligations in ways that do not
look volatile. Many of these funds must also strongly
consider the need for current income and liquidity due to defined
cash flow needs resulting from mature plans with large retiree
populations.
The Impact On Private Wealth Holders
What lessons should the private wealth holder draw then from the
movement by US corporate plans into US denominated bonds?
A key lesson is that any examination of investment performance
must consider appropriateness as well as percentage return.
Whether that appropriateness is determined by reference to after
tax consequences, risk, and similar matters or by reference to
political and social views, the evaluation will always be
different from appropriateness for a corporate pension fund.
That a pension fund with obligations payable exclusively in US
dollars is moving to dollar denominated bonds should lead to no
conclusion for a family with members in Hong Kong, Paris and
London as well as New York. Of course, similar concerns can
possibly result in similar movement by private wealth holders. A
wealth holder or trust with long-term fixed dollar obligations,
such as a guaranteed annuity, charitable or otherwise, or a
substantial dollar-based mortgage, should reserve for dollar
obligations with dollars.
But for many families there will be no necessity to reduce dollar
volatility. And for smart families today, currencies are
seen as volatile themselves with exchange rates fluctuating
dramatically. How many families would say that
fundamentally the most appropriate investment for a long-term
investor is the US dollar?
A family whose wealth was built over one hundred years in
equities illustrates the central issue. About five years ago,
this family had shifted investments toward alternatives and
absolute return funds at the urging of advisors. After two
years of anxiety due to the funds’ lack of transparency, the
family’s inability to understand the strategies, and the delays
in filing tax returns, all members of the family decided to move
out of the alternatives and back to portfolios of stocks and
bonds. They made a move back to traditional portfolios
because they realized that they did not mind volatility; funds
were available for their cash needs. So long as the wealth
was available as needed, volatility was fine with this
family.
The specific issues raised by a modification of an investment
strategy are actually part of a broader discussion of what is
appropriate to ensure that the wealth is doing what it is
intended to do. “What is the wealth for?” must be addressed
person by person and entity by entity. If it is clear what
the wealth is intended to do, then the investment strategy
becomes self-evident. Without clarity, it’s easy to make
mistakes. Unfortunately, many families go generations without
asking what the wealth is intended to do.
The flight to bonds in the corporate pension industry is
interesting and may prove wise for the pension plans. But
private wealth holders should not see that flight as one they
must mimic. Wisdom and process must set the investment
strategy and must start with understanding appropriateness wealth
holder by wealth holder.
Charles Lowenhaupt is chairman, chief executive officer and
president of
Lowenhaupt Global Advisors. Tim Barron is president and chief
executive officer of
Rogerscasey.