Managing Pension Assets: Investment Policy
By Jim Meynard
Executive Director
Pension funds are typically pools of assets held in trust to pay for future benefits. The pools begin life as cash receipts of some sort and are invested in “assets” for growth and income to meet long term obligations of the benefits promised. In this manner, as discussed in a previous article, a pool of assets will take on an extended life to support a long-term benefit payment stream such as a pension benefit. Just how that life is extended is dependent on the care and prudence of the investment program. For indeed, while cash stuffed in a strongbox over 20 years will be safe, it will lose purchasing power to inflation, (significantly these days). Conversely, money put in highly speculative arrangements would risk being lost in its entirety. So while capital must be put at some risk, that is, it must be invested for growth and income, that risk must be measured and controlled, fully understood and accepted. Containing the risk inherent in the investment program is the function of the Investment Policy, which identifies actuarial requirements and investment objectives. In addition, it dictates asset diversification, asset selection and retention standards, and performance requirements.
The Georgia Firefighters' Pension Fund (GFPF) is not of such size to warrant a full time investment staff. The Board of Trustees was assisted by an Investment Consultant, who, with the Executive Director, developed a new Investment Policy to guide the investment decisions over the long horizon, thus enabling, or as it were, encouraging the Board to look through capital market fluctuations, good and bad, to a stable decision process and to avoid knee-jerk reactions to sudden swings in market values. While the overarching investment direction is dictated by Georgia Statutes 47-20-83 and 84, the Investment Policy provides for the strategic allocation to lower asset classes and for policies to guide the implementation of those investment policies. The Investment Policy is memorialized in the Investment Policy Statement, a formal document developed and recommended by the Executive Director and the Consultant, reviewed and adopted by the Board of Trustees, and included as a condition of engagement by each Investment Manager employed by the GFPF
The Investment Policy Statement or IPS provides a clear understanding between the Board of Trustees, the Consultant, and the Investment Managers concerning the policies and objectives of the GFPF. The IPS establishes and relates for the GFPF:
| Investment Philosophy |
| Investment Objectives |
| Investment Time Horizons |
| Portfolio Risk Tolerance |
| Asset Allocation and Diversification |
| Implementation, Rebalancing and Performance Criteria |
| Selection and Retention of Managers |
| Responsibilities of Managers and Consultants |
Perhaps the most important aspects of the IPS are the asset allocation determination, or policy mix, of allowable assets and the implementation/rebalancing criteria. We all know Ben Franklin’s old adage, “Don’t put all your eggs in one basket.” The real art is putting the eggs in enough baskets to protect the clutch, but not so many that you cannot keep them warm and let them hatch. Without getting into the details of the science underlying the art of asset allocation, (e.g. Modern Portfolio Theory, efficient frontiers, et al,) suffice it to say we attempt to distribute the assets across as many diverse components of the markets as possible, minimizing any overlap in security selection. The components of diversification that we consider are:
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Asset Class:
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Stocks vs. Bonds, this is all that is allowable under the state code. |
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Domicile:
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Domestic vs. International, the state code allows up to 10% international. |
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Capitalization:
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Large vs. Medium vs. Small Cap Companies, their stocks behave differently. |
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Quality:
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We use only “investment grade” securities, but that is a wide range and high quality companies behave differently from the lower quality companies, even within the credit quality grades. |
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Style:
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Stocks are generally classified as “growth” or “value” based on their fundamental pricing characteristics, and they behave differently. |
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Strategy:
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We use a combination of passive (indexing), quantitative enhanced, and active hi-alpha generator strategies. |
The initial mix of assets and strategies is set by efficient frontier modeling and a little “Kentucky windage.” Once all of the managers have been selected and the assets deployed, a correlation analysis of the actual mangers’ historical returns will be prepared and an optimal mix determined. The portfolio will be re-balanced to that mix and the IPS will be updated to reflect the result of the analysis. This optimal mix then constitutes the new “target mix” or “policy mix” of the portfolio. This policy mix must be within the allowable ranges set by the IPS risk tolerance guidelines and the state code.
Re-balancing is the process of keeping the portfolio in tune with the stated objectives of the IPS. The process forces a discipline of buy low, sell high on the total portfolio as well as requiring the reaffirmation of retaining managers that are trailing their markets. Thus, the re-balancing/retention process is as important as the asset allocation determination in the overall management of the fund.
The IPS and the Consultant’s Agreement provide for ongoing performance monitoring of investment managers, with appropriate action to be taken when conditions dictate. Each manager is measured against a performance benchmark that is unique to his/her asset class, capitalization, style and strategy. That is their part of the market, or “fishing pond,” and they are expected to exceed the performance of this benchmark with regularity. On a routine basis, the Consultant will report each quarter on the performance of the entire fund and examine the allocation of assets relative to the policy mix and the max-min range limits of the IPS. The Consultant will then recommend any required adjustments in the asset levels of manager assignments due to capital market performance, if required. Each year, the Consultant will perform an analysis of the current allocation, including manager correlation and performance, and recommend changes in the policy mix, if warranted. If assignment adjustments or policy mix changes are proposed, Board discussion follows and votes to approve and adopt those changes are required for implementation to proceed.
Clearly, a documented investment policy is an important component of pension fund governance, and is very much a requirement in the world of corporate pension funds. At a recent conference that I attended, during a session on investment policy, the speaker asked for a show of hands for those who had a policy in place and recently updated. Less than 50% of the audience could claim to have a current policy in place. GFPF has had an investment policy, formally documented, since 1989. Since it was first issued, it has been updated several times to reflect changes in the governing statutes as well as the Board’s philosophy towards the management of the assets. Over the last several years, we have been through some historic capital market changes, and so we have revisited our approach toward the management of the portfolio. The new, updated and revised Investment Policy Statement represents a more aggressive approach to investing on the one hand in that we are utilizing a much broader array of assets. On the other hand, it is a much more diversified approach to investing, and therefore inherently less risky and more prudent, as it should be.
Jim Meynard