Understanding how your plan’s assets are valued is the most important step in pension plan analysis. Plan advisors may present investment options as either “equities” or “fixed income.” But this distinction is too simplistic and ignores the characteristics and risks of assets that might be buried in each general category.

The key thing to look for is which assets are valued at level 1, and which assets are valued at Level 2 or Level 3, or are valued outside the fair value hierarchy.

LEVEL 1 ASSETS

Level 1 assets are highly liquid holdings, marked to market at least daily, on an active public trading market with ample trading depth, such as NYSE or NASDAQ. These are typically mutual funds and most ETFs.

You can readily identify the fair market value of your Level 1 assets on a daily basis; and can make informed re-balancing decisions that may be required, based on a clear understanding of the asset’s fair market value.

This is a principal goal of ERISA: that you are given sufficient information to understand the composition of your plan to make informed allocation decisions.

So, to the extent your pension plan holds Level 1 assets, you pretty much know where your plan stands, and what market risks you may expect. One caution, however, is duration risk and withdrawal limitations or penalties that can practically affect liquidity. And even though mutual funds and ETFs typically use “net asset value” (NAV) as a value reporting metric, the publicly-reported fair market value is almost always very close in value to the NAV.

OTC ASSETS VALUED OUTSIDE THE FAIR VALUE HIERARCHY

On the opposite end of the valuation spectrum are assets traded over-the-counter (OTC) that are privately valued by the two trading partners outside the Fair Value Hierarchy, and reported at an arbitrary net asset value (NAV), such as asset cost or a nominal unit price of $1.00.  OTC NAV valuations say nothing about fair value of the asset. OTC asset trades are nearly always alternative assets held in a collective investment trust. These include holdings in hedge funds, private equity funds, real estate, asset backed securities, structured notes and other complex products. OTC-traded assets are not regularly marked to market, are typically valued at an arbitrary value, and therefore lack a clearly defined fair market value. 

TYPICAL ASSET DISTRIBUTION

Nowadays, many 401k plan options are distributed about  half-and-half: with about half of a plan’s offered investment options built around liquid, valued at Level 1; and the remaining half of a plan’s offered investment options built around assets held only at an arbitrary NAV, without reference to fair value, in a collective investment trust.

A plan option that includes alternative investments in a collective trust may be nominally described as “fixed income”–but if the assets in this option are not marked to market daily, they are high risk assets susceptible to evaporating liquidity in a down or volatile market.

Again, these include holdings in hedge funds, private equity funds, real estate, asset backed securities, structured notes and other complex products. Compare, for example, standard bonds, with a fixed duration and coupon, that are traded on a public market: these are liquid fixed income assets, which are much safer investments than the illiquid variety of fixed income assets. Again note, however, the duration risk that may be present in a long-duration bond (see below).

Historically, interest rates in the range of 5% – 6% have been considered normal. This interest rate range provided for stability of the global financial system for a very long time.

But following the Global Financial Crisis of 2008, the Federal Reserve (and other central banks) lowered interest rates charged to banks and non-bank financial entities (such as hedge funds) to 0%. This caused a 10+year asset-buying spree by hedge funds and private equity funds. Additionally, corporations used low interest rates to borrow money used to fuel stock buyback plans that pushed stock prices higher and higher.

Most often, hedge and PE funds borrowed money in the short term markets (money markets and the repo market), while investing in long-term projects. And this investing strategy, assuming low interest rates would last in perpetuity, created a built-in financial crisis for that day if, and when, hedge and PE funds would need to start borrowing at higher rates to make interest payments on long term payment obligations using short-term borrowed funds; and corporations could no longer justify borrowing money for stock buybacks.

The day of higher interest rates has arrived.

Since 2022, the Federal Reserve has raised interest rates to the current level of 4% to 5%. These rates make the borrow-short / invest-long hedge fund and PE fund strategies unsustainable, since fund business plans assume a much lower interest rate for borrowing money to make interest payments on long-term obligations.

As long as interest rates are low, duration is of minimal risk to pension plans, for the reasons explained immediately above: In a low interest environment, hedge and PE funds can borrow money in the short term markets (money markets and the repo market), while investing in long-duration projects.

And as long as interest rates remained low, duration of the investments hardly mattered. Bonds matching retirement dates became popular–and made sense. It was logical to purchase long bonds to match expected retirement dates–until it wasn’t. The first crack in this strategy became obvious in the UK pension crisis of September 2022. The pension funds held long-duration investments at a low rate, while market interest rates, and bond yields, turned higher. This immediately lowered fair market value of UK gilts (bonds), creating an enormous pension shortfall.

But today, market interest rates have gone from near-zero to the 5% range. In turn, bond yields have risen, which has caused the prevent value of existing bonds to fall.  So, even though treasuries and corporate bonds were highly liquid in a low-rate environment, those same bonds became dangerously under water because of high interest rates.

So, even though traditional government and corporate bonds are theoretically “liquid” in a high-rate environment, bond values on older long-duration bonds can drop so considerably that they are, for all intents and purposes, “illiquid.”

An important consideration in understanding a plan’s risk factors is leverage. Leverage accelerates growth in a bull market, but also accelerates a value decline in a volatile or falling market. Leverage clearly helped grow asset values in the past ten years, where financial markets experienced substantial upswing. But leverage in this current market is a destructive force. As losses occur, leverage punctuates the decline in value.

So, leverage cannot be applied indiscriminately–it is a tool that must fit the circumstances of the existing financial markets. Unfortunately, many plan assets are committed to investing strategies that deploy high leverage.  For example, many hedge funds lever trades to an incredibly high ratio of 50:1. On the other end of the spectrum, mutual funds are restricted by law to apply leverage only 1/3 of the value of the asset fund.

When diversifying in order to avoid the risk of large losses, minimizing leverage is a great place to start.

An important consideration in understanding a plan’s risk factors is withdrawal restrictions and penalties — that are now commonplace. It is common for a plan to be invested in long-term bonds that cannot be transferred to another asset type except at designated withdrawal dates, or with significant withdrawal penalties. Withdrawal limits can be though of as a different version of duration risk. Even if assets have Level 1 liquidity characteristics, if withdrawal limits minimize any withdrawals, you are forced into a longer duration hold than you may expect.

Needless to say, committing to a long-term investing portfolio in a volatile market carries its own risk. But it is important to understand that any long-term investment with withdrawal limitations poses a liquidity risk to your pension plan.

Why do so many pension plans have heavy investments in illiquid assets in collective investment trust structures?

It’s easy to see who benefits: the plan managers and investment advisors who have far greater income potential by maximizing illiquid plan investments. This is because illiquid assets are exceedingly complex, allowing for many obfuscations that, in turn, maximize an investment manager’s opportunity for high fees and carried interest accruals.

ACTIVE INVESTMENT ADVISORS

Active investing is absolutely the best approach to plan management–but only if the investing strategy is designed to throw out underperforming assets and minimize the risk of large losses.

As a plan participant, it is your right to understand the motives of your plan advisors and fiduciaries, and act accordingly, based on your own best judgment, possessing all the salient facts as to why certain investments were chosen.

Pension risk is a structural set of risk factors that can set your plan up for success in the long term. If pension risk is properly accounted for, the daily impulse of market risk will be survivable.

Pension risk is not just a function of one thing; rather, it depends on a multi-factor risk profile that plays out with different variations in any given market situation.

Liquidity risk must all be systematically evaluated–and acted upon–to achieve and sustain long-term gains.

Collective Investment Trust