Return, Risk, Time-Horizon, And Pension Plan Design: Another Look

"This article challenges a mindset that is common among trustees of perpetual endowments and long-lived trusts. Those investors, like virtually all investors today, focus much of their attention on market values. However, for overseers of very-long-term funds, a focus instead on cashflows would be more productive."

JIM GARLANDFROM "A CASHFLOW FOR ENDOWMENTS AND TRUSTS"CFA INSTITUTE RESEARCH FOUNDATION

Worth Another Look

We offer no apology for returning to the ‘return, risk, time-horizon, and pension plan design’ theme so soon after devoting the recent August and September Letters to the topic. The reasons are two-fold: 1. It takes time and steady persuasive messaging to shift still-prevalent investment paradigms based on (despite claims to the contrary) short investment horizons to ones based on long horizons, and 2. The recent publication of Jim Garland’s CFA Institute paper which clearly explains the rationale for, and implications of such a shift, and documents the benefits (i.e., superior long-term return/risk opportunities) in an endowment context. This Letter shows the same to be true in a pensions context.

The opening line of the Garland paper (quoted above) says it all: the focus of long horizon investors should be to acquire and nurture sustainable cashflows. For investors who do not face the risk of having to sell assets to meet payment obligations, such a focus is much more productive than focusing solely on how financial markets price those cashflows on a daily, weekly, monthly, or even annual basis. Why? Because trustees of endowment funds must establish payout (i.e., spending) policies that are fair to successive  generations of fund beneficiaries, and to base actual payout decisions on those policies. Ideally, the payout is based on the fund’s actual future net real return, but that is an unknown number. So how should       trustees decide on a payout policy?