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Tuesday, December 2, 2008

Pension Plans, the Equity Market, and Irrational Behavior

Are pension plans indirectly adding volatility to markets? Back in October an email circulated around trading floors about what to expect during the last week of that month (as reported by the FT):

Gut wrenching declines in US and global equity markets during October coupled with bond market outperformance will undoubtedly require MASSIVE monthly asset rebalancing by US pension funds –- rotating OUT of bonds and INTO stocks. This may have a profound “short-term” impact on performance of risk assets since the required rebalancing appears to eclipse even the large rotation after the 1987 stock market crash.
In other words, this rebalancing was expected to cause a significant end-of-month rally and this is exactly what occurred.

This scenario played out exactly the same way in November:
  • Equity Sell-off
  • Bond Rally
  • Rebalancing, which reversed those two trends (though Treasuries rallied at the end of the month)

So pension plans are propping up the equity market... what's the problem with that? Well, rebalancing works in a "normal" market environment, with the goal of maintaining a portfolio's risk profile. As Vanguard notes:
If a portfolio is never rebalanced, it will gradually drift from its target asset allocation to higher-return, higher-risk assets. Compared with the target allocation, the portfolio’s expected return increases, as does its vulnerability to deviations from the return of the target asset allocation.
Again, true in a "normal market", when asset returns fluctuate around a long-term mean. However, this market is far from normal. In the current environment this has the potential to cause significant damage to pension plans, not the diversification and reduced risk they are hoping for.

Lets look at an exaggerated example, a portfolio made up of only two assets:
  • Equities which return -25% per period = down 95% after 10 periods, not far from the 89% drop of the Dow in the Great Depression
  • Bonds which return 2% each period

Rebalancing monthly to equities (i.e. catching the falling knife), results in a portfolio that is down 70%.

Maintaining positioning in this example (i.e. not rebalancing), results in a portfolio stung (down 40%), but around to live another day.

What's my point? Well, in this period of uncertainty I can envision equities going one of three ways; down, flat, or up (yeah, not much help, but that's the point).

On the other hand, I see a world in which a balanced bond portfolio has likely (hey, you never know) seen the worst of it (i.e. defaults will happen, but most of that is priced in). The crazy thing is, most plan managers AGREE. The problem is that many plans (if not most) have policies in place which REQUIRE them to rebalance. If they don't and markets go up, their career is at risk.

So, while these pension plans can function and make payments (and actually increase their funded status) by maintaining exposures to the "safe" bond asset class, they are forced to rebalance to equities. If the equity market continues to sell-off, expect end-of-month rallies to be the norm as plans continue to buy on the way down; and if this becomes "Great-Depression-like" (i.e. down ~90%), expect the next bailout to be of the PBGC.