CIO Corner with Jason Malinowski
Liability aware investing: A framework that could help public pensions improve asset allocation and performance assessment
Jason Malinowski, Chief Investment Officer of Seattle City Employees’ Retirement System, discusses why public pension liabilities deserve to play a more central role in portfolio construction, and how liability awareness can help provide a more holistic measurement of performance and total plan risk. He builds on a paper about liability aware investing (LAI) that he co-authored last year. 1
Q: So what is liability aware investing, for a public pension plan?
Malinowski: Liability aware investing for our public pension is managing the portfolio, setting the strategic asset allocation, in a way that's aware of the characteristics of the liabilities and aligned with the purpose of the portfolio—which is to meet these liabilities.
Q: And how does liability aware investing (LAI) compare to liability driven investing (LDI), which is popular with corporate plans?
Malinowski: Corporate plans apply LDI based on their relatively focused accounting rules, insofar as their liabilities are valued according to high quality bond yields. For public pensions, liabilities are valued based on expected return of assets (EROA).
The LAI investment framework reflects this difference in treatment by looking at the interaction between the performance of the asset portfolio and changes in the EROA. It borrows from some of the same foundational principles that apply to corporate plans’ use of LDI, but it's a more generalized application of that framework.
Q: Do you think, generally speaking, that public plans currently consider liabilities in setting their strategic asset allocation?
Malinowski: I don't believe so. Nor are they fully incorporated into asset liability studies, from what I've seen. The consideration of liabilities in these studies only focuses on the liquidity, or the net cash outflows, expected over the next several years, to make sure that the portfolio will have sufficient access to liquidity to meet those cash flows.
And while cash flow requirements are important, they’re only one piece of what liabilities are. Plans differ in their liabilities on many dimensions: How long-lived are they—what is their tenor? What are the liabilities’ inflation sensitivities—are they real or nominal? My sense is that the differences, across public pensions in these two dimensions, are significant, so I believe there is a more expansive way that liabilities could be considered in strategic asset allocation.
Q: What catalyzed your interest in liability aware investing?
Malinowski: SCERS has the benefit of a terrific investment advisory committee and they suggested several years ago that we could improve our portfolio’s asset allocation and overall decision-making by considering liabilities more explicitly.
Here’s why. Really strong asset returns often coincide with a declining expected return, and that means your liabilities are increasing. So, while great asset performance is good when looking just at the assets, if you think of it in conjunction with the increase in liabilities, it isn't as good. And the same is true in reverse. When assets decline, it tends to coincide with an increase in expected returns and a decrease in liabilities, which offsets some of the negative impact.
Q: Why is liability aware investing important to SCERS now?
Malinowski: One reason is that it has let us better reflect on the progress of the whole plan—rather than being reactive to short-term asset performance. This framing has helped the board take prudent steps such as when they meaningfully reduced the investment return assumption following a period of strong asset performance.
Q: Do you think other public pension plans and consultants are integrating liability aware investing into their current investment frameworks?
Malinowski: Not that I'm aware of. My objective is to suggest a framework that sets out how to integrate liabilities in an EROA world—and by doing so, to encourage a broader dialogue. Much like a framework has existed for LDI to measure the duration of the corporate pension plan’s asset portfolio, there is an opportunity to develop a LAI framework to help public pension plans measure the characteristics of their liabilities, and consider them in asset allocation decisions.
Q: Plan trustees often wear two different hats when they review liabilities and asset returns. It sounds like you are suggesting they review both using a holistic approach.
Malinowski: Yes. When you do an annual review of the asset portfolio, trustees, at least from my perspective, should consider how the liabilities have changed, too. Even if you're not doing a full-on experience study, even if you're not reassessing your contribution rate, it's important to think about those two together. I find that it helps trustees to more fully consider and understand a plan’s risk and success.
Q: Can you give us an example of how integrating liability aware investing has changed how you think about asset allocation?
Malinowski: We went through an asset liability study in 2019 when LAI was still a conceptual framework. We were setting our strategic asset allocation and reassessing the role of diversifying strategies in our portfolio, primarily hedge fund strategies. The main goal of this allocation was to reduce asset volatility and asset risk. And we asked ourselves, “Does this allocation actually advance our plan goals? Do these diversifying strategies reduce funded status volatility?” And we came to the conclusion that the allocation did not.
Diversifying strategies, as we then defined them at SCERS, were not long-lived assets consistent with the long-lived nature of our liabilities. They didn't have this relationship between asset returns and changes in expected return. We communicated this to the board and recommended eliminating the allocation.
Q: Have the last few years’ attractive returns made your plan much healthier?
Malinowski: The last three years, through the end of 2021, has been a period of dramatically positive performance, 15% or so annualized, far exceeding our assumed return. On an asset mark-to-market basis, our funded status increased by about 20% over this period, a dramatically healthier picture than three years ago.
But the other side is that return expectations declined over the period, by 100 or 125 basis points. And that has had a real impact, increasing our liabilities materially. If we mark-to-market the liabilities, funded status only improved by 10%. So it is healthier but I wouldn't say much healthier. It speaks again to the importance of a holistic perspective.
Q: How do you recommend other public pension plan CIOs might get started with liability aware investing?
Malinowski: I would first try to understand, likely by working with actuaries, the characteristics of your liabilities—their tenor, their sensitivity to changes in EROA, their makeup with respect to being real or nominal. And then think about the asset classes in your portfolio and the degree to which they are aligned with those liabilities’ characteristics.
Our white paper (Buchenholz and Malinowski, 2021) points out that for a generic public pension with long-lived liabilities, asset classes like equities, real estate and long bonds look more attractive under a liability aware framework than under an asset-only framework. And assets like cash, commodities and hedge funds look less attractive.
So keep some of those broad takeaways in mind, see which are emphasized in your portfolio, and scrutinize the asset classes and strategies whose main goal is to dampen asset volatility.
1 Michael Buchenholz and Jason Malinowski, “Liability Aware Investing for Public Pension Plans: Formulating the role of liabilities in asset allocation and performance measurement,” J.P. Morgan Asset Management, August 2021. In practice, adoption and implementation across public plans will vary over time based on unique plan characteristics, governance, beliefs, etc.