Portfolio managers do a balancing act to 'immunize' against inflation
Managing pension portfolios used to be fairly simple: You bought some bonds, some Treasury bills, some stocks, and other securities and let them earn interest. Nobody worried that 4 or 5 percent interest might not be enough.
But like many other Americans looking for ways to protect their assets against inflation, pension managers are looking for ways to protect their clients' portfolios against the rapid rate changes in the bond and securities markets -- changes that are themselves responses to inflation.
One technique some pension managers are using is called "immunization," a term that comes from the medical practice of attempting to protect a patient against a disease before he is affected by it. In retirement fund managing, it means taking a percentage of the portfolio and investing it in the bond markets in such a way that a nearly guaranteed rate of return -- the current rate is about 13 percent -- can be offered over a medium-term period of five to eight years.
The word was first applied to financial management in the 1930s in Britain, where the practice began. But it was not until recently that it was available in the United States. Manufacturers Hanover Trust in New York, for instance, has only been offering it for a year, even though the firm has the most money in immunized portfolios, at over $500 million, says vice-president William C. Petty III.
The fund managers "had to find something to avoid getting beat up all the time," Mr. Petty noted. When interest rates shoot up, as they did last spring, bond prices drop, and so do the values of the bond portfolios the pension managers are supposed to be managing. And when interest rates drop, as they did this summer, the cash from maturing securities is forced into buying bonds at lower rates.
Immunization is basically a set of mathematical techniques designed to ensure that a portion of the portfolio will be protected against these fluctuations. Writing in a recent issue of Pension & Investments, a trade journal for pension managers, James A. Tilley, an actuary at the John Hancock Mutual Life Insurance Company, gives a simplified example of how immunization works:
The portfolio consists of two US Treasury securities, a 6- month bill and a 30-year bond. In six months, the bill will mature and the bond will be a 29 1/2 -year bond. If interest rates have risen, the bond will have lost some value, but the proceeds from the 6-month bill can be reinvested at the higher interest rates. If the money in the portfolio is split properly between bonds and bills, the depreciation of the long-term bond and the reinvestment of interest from the bill at higher rates can neutralize each other.
On the other hand, if interest rates fall, the proceeds of the bill will have to be reinvested at lower rates, but the 30-year bond will have increased in value. Again, the two can be made to nearly cancel each other out.
How much of the total pension portfolio is immunized is up to the client and the fund manager to work out, Mr. Tilley says. A client might choose to have anywhere from 25 to 50 percent of the funds placed under this protection, which could last anywere from five to eight years. It is too hard to anticipate the fluctuations of the bond market beyond that, Mr. Tilley adds.
But within the five- to eight-year period, "there's no way this [immunization ] isn't going to work, unless the federal government can't pay off its obligations."
Before immunization, the only way a pension manager could offer a sure rate of return was with a "guaranteed investment contract," or GIC, an insurance company product that assures the client of a specif ic rate of return. But at 5 to 8 percent, GIC rates have been well below the inflation rate in recent years, or "a guaranteed loss," Manufacturers Hanover's Mr. Petty notes.
Unlike John Hancock and some other firms offering immunized portfolios, the Manufacturers Hanover program annually adjusts, or "rebalances," the po rtfolio to maintain at least the immunized level and, if possible, improve it. If interest rates seem to be falling, for instance, more long-term bonds will be added. Or, if rates are going up, more short- term bonds will be added.
"If we can make changes that enhance the value of the portfolio, why not do it?" Mr. Petty asks.
But Mr. Tilley of John Hancock contends that if the portfolio is adjusted every year, it ceases to be immunized and reverts to a more common, un-immunized condition, with a greater risk that the actual rate of return will come in under projections.
Immunization has not been practiced in the US long enough to know if it actually does maintain the promised rate over several years, but it did pass one important test this year. When bond prices were tumbling in the spring, the immunized portfolios held their yields, Mr. Petty said. "A lot of our own people who were skeptical about it said, 'Maybe you've got something here.'"