Angelo A. Calvello

To help realize your organization's financial goals, it's important to employ an investment evaluation process based on sound, well-proven economic practices.

Issues and Actions 

Today's troubling economic times call for financial managers to take a back-to-basics approach to investment management.  

  • Goals and investment practices should be reexamined to determine if they continue to meet the organization's needs. 
  • The policy asset allocation and portfolio should reflect the appropriate weight and mix to serve the organization's present and long-term goals. 
  • Consultants, investment managers, and custodians should be evaluated carefully to support cost-efficient, effective service.   

There's no denying times are tough. The average defined-benefit plan went from being 100 percent funded in January 2002 to 77 percent funded in September 2002. And of the 360 companies in the S&P 500 that have defined-benefit plans, 90 are underfunded.

Endowment funds are faring no better. Few are able to generate enough revenue to support the programs and projects to which they are dedicated. The typical endowment lost 6 percent last year, with many smaller endowments posting their third straight losing year. Worse still, early indicators for the year suggest the trend will continue for quite some time.

As a healthcare financial manager, you're probably beginning to realize that despite this tough economic climate, you're going to have to contribute to defined-benefit plans. Simply put, it's no longer feasible to wait for better times.

The good news? By following a back-to-basics approach, you can take steps to help guide your board to the most desired position and improve the likelihood of future investment success.

Step 1: Define Your Goals

The first step is to review the organization's investment goals. Goals should be broad yet clearly defined for each pool of assets. For example, investment goals of the defined-benefit plan might be to ensure that the present and future liabilities of the pension plan are met, to fulfill the fiduciary responsibilities and obligations as stewards of the plan, and to be cost-effective while attempting to outperform comparable funds. Other typical investment goals are to maximize shareholder wealth by serving as a competitive tool that cost-effectively attracts and retains qualified employees, and to structure competitive employee benefits and ensure the security of these benefits for pension-plan participants today and in the future. For an endowment, investment goals might be to have adequate and consistent independent sources of investment income to fund the philanthropic work for which the endowment was established. For funded depreciation, the investment goal might be to have adequate funds to meet planned capital expenditures.

Once goals are defined, it's important to tie them to specific investment objectives. For example, the defined-benefit plan might seek a return of 8 percent to meet its projected liabilities and achieve the desired funding status. The investment objective for the endowment might be to earn a 7 percent real return to accomplish its philanthropic mission.

Step 2: Find the Right Fit

Next, you will need to determine whether these investment targets remain appropriate. For example, will a target return of 8 percent on the defined-benefit portfolio allow your organization to meet its pension liabilities?

To answer such questions, you should commission an actuarial study. Actuarial studies provide an estimate of benefit costs expected at a particular point in the future. The studies also project pension obligations and identify the return the defined-benefit plan must earn to meet these obligations. These estimates are based on certain assumptions about the compensation plan and the demographics of participants. Future obligations are discounted to a present value.

To fully understand the conclusions and implications of the study, you will need to discuss with the actuary the plan's assumptions. Even a slight change in these assumptions can have a profound impact on the plan and the sponsoring organization. The higher the expected return, the lower the pension obligation will be and the better the organization's earnings will hold up. The lower the discount rate, the higher the obligations will be and the greater the gap will be between current assets and future liabilities.

Actuarial studies also provide information that can help you forecast needs that might influence the financial health of your organization. For example, consider a defined-benefit plan with assets equal to $100 million and a pension-benefit obligation of $115 million. Let us say that over the past five years, the pension-benefit obligation grew by about 10 percent and assets grew by 8 percent. If these assumptions were to remain the same and the organization wanted to simply maintain its current 13 percent underfunded status for the next five years, the organization would have to contribute about $2.5 million a year.

Obviously, this liability would affect the organization's earnings and business development in general. Therefore, it is important to perform and analyze the actuarial study routinely, especially in times of market disjunction/disruption or when the organization's benefit structure or workforce has changed significantly, so senior management will have enough time to take steps to improve the financial situation.

Step 3: Examine Asset Allocation

Assume that the actuarial study discloses that the defined-benefit plan is in reasonably good shape and that an 8 percent target return is appropriate and sufficient. The next step is to review methods used to achieve these return targets. The first step in this review would be an evaluation of policy asset allocation because asset allocation ultimately drives portfolio returns. As David F. Swensen, chief investment officer, The Yale Endowment, says, "In many ways, establishing policy asset allocation targets represents the heart of the investment process. No other aspect of the portfolio management plays as great a role in determining a fund's ultimate performance, and no other statement says as much about the character of a fund."a 

Prudence requires a thorough review of each pool's policy asset allocation when capital market expectations or the organization's risk profile has changed. This review should examine the asset classes available for investment and the weightings of the asset classes within the policy portfolio.

The review should be founded on a theoretical exercise that generates an expected return and level of risk for the portfolio by inputting the long-term capital-market assumptions for returns, risk, and correlations for each of the included asset classes. The abstract exercise should be based on the best available information and should apply widely accepted financial principles. (Data required for the exercise should be available from the actuary, investment consultant, and current fund managers.)

Should the exercise indicate that current policy allocation makes the achievement of the target return unlikely or unlikely without bearing an unacceptable amount of risk, then it's important to examine whether the target return is unattainable because of certain restrictions placed on the pool of assets. For example, the opportunity set might be too narrow or the weightings of the asset classes might be too limiting.

Step 4: Add Uncorrelated Classes

Next, consider adding uncorrelated, higher returning asset classes to the policy asset allocation (e.g., high-yield bonds, emerging market equities, real estate, hedge funds, or private equity). Adding uncorrelated classes typically improves the risk/return characteristics of the policy allocation.

Care should be taken when including these options or changing asset class weightings. It's best to avoid the academic exercise of mixing asset classes to achieve just the right balance. Unconstrained, such exercises can produce unrealistic results. For example, although the risk/return characteristics might seem attractive for a portfolio of 70 percent U.S. small-cap equities, 10 percent real estate investment trusts, and 20 percent high-yield bonds, this outcome is more likely the result of an odd combination of historical returns and correlations than prudent economic theory.

Also, keep in mind that reevaluating the policy asset allocation is a forward-looking exercise and should not be overly influenced by recent investment results. This examination is done to improve the likelihood of success, not to chase returns or time markets.

Step 5: Review the Rebalancing Plan

Investigation of the policy allocation also should include a review of the rebalancing plan. The plan should be explicit in terms of how and when the actual portfolio will be rebalanced to its policy weightings. It makes little sense to expend effort designing the optimal policy asset allocation only to have the actual weightings be dictated by the market. A well-reasoned rebalancing plan will improve the returns without adding more risk.

Step 6: Discuss the Allocation with Your Board

If investigation of the policy allocation suggests a need to change the policy allocation or weightings, you should be able to explain to your board how these changes will contribute to realizing the organization's objectives and why these changes should be made at the particular time. This explanation should make clear that the changes conform to the organization's fundamental principles and beliefs, employ best practices, and are not an attempt to chase returns. It's also important to discuss the risk/return associated with these changes and possible implications for the portfolio. Senior staff and the governing committees should accept these changes in writing and ensure they are reflected in a revised investment policy statement.

Step 7: Examine Implementing the Allocation

Regardless of whether the current policy asset allocation will be changed, focus should then shift to the best way to implement the investment policy statement and policy asset allocation. For example, consider a policy asset allocation with 60 percent equities and 40 percent fixed income. The 60 percent equities might comprise 70 percent U.S. stocks and 30 percent international stocks. The allocation of the U.S. stocks might be 60 percent large-cap equities, 20 percent mid-cap equities, and 20 percent small-cap equities. The allocation of the international stocks might be 90 percent developing markets and 10 percent emerging markets. When looking at the U.S. equity portion of the portfolio, you should consider whether you want to achieve desired equity exposure passively, actively, or through a mix of passive and active mandates. Another consideration is whether to include enhanced investment approaches, apply a mix of enhanced and active approaches (e.g., combining enhanced core with active mid-cap and small-cap equities), or split each exposure into core, value, and growth components.

Step 8: Research Vendor Costs

When considering the appropriate portfolio construction, you also should include a review of the funds' current vendors (see "Know Your Vendors," above). You will need to examine the explicit fees and costs associated with managing and protecting the pools of assets. Also, you should review and analyze the cost structure of overseeing the assets and renegotiate where necessary.

In addition to itemizing all relevant costs by vendor type, you should look for hidden costs. For example, the assets might currently be invested in separately managed accounts rather than placed in commingled funds structured for institutional investors-an approach that typically costs five to 10 times more to oversee and often is employed without sound economic reason.

Vendor turnover presents another area for examining cost. Any change in vendors, even expensive, substandard vendors, results in certain costs. For example, when investment managers are replaced, the terminated manager often sells the portfolio and gives the cash to the new manager to buy new holdings. This approach incurs unnecessary commission, market impact, and opportunity costs, which can result in a serious drag on performance. A less costly approach is to use a transition manager to handle changeovers. Following the vendor review, you should be able to confirm the efficacy of the current situation or recognize a need for improvement. Any changes in vendors should be made cautiously and with the full approval of the organization's supervising committees and board.

No Quick Relief

There is no quick relief from the current economic maelstrom. Finding the next great large-cap value manager will not extract us from these troubling economic times. Instead, it's time to return to basics and rethink the current situation.

When employing the fundamental investment evaluation process discussed, take care to document and explain actions to the appropriate committees and boards. Written approval from supervising committees should be secured at each step in this process. Undertake changes judiciously and only after considering all possible consequences in terms of factors such as risks, direct and indirect costs, and operational and procedural changes. Keep your organization's utmost objective at heart: The search should not be for short-term returns, but to refine a prudent process that increases the likelihood of realizing investment goals.


a. Swensen, David, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, New York: The Free Press, 2000, p. 329.

Publication Date: Sunday, June 01, 2003

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