LACERS BOARD UPDATE
By Michael R. Wilkinson, LACERS Commissioner
LACERS uses the principle of diversification in its investments to get a reasonable return without taking too much risk. In previous articles we have discussed using strategic asset allocation to get a complementary division of investments using a combination that includes assets such as traditional stocks and bonds along with other strategies such as real estate and private equity.
One of the concerns in investing money for a pension plan is handling the effects of inflation. As we all know as consumers, if the cost of living goes up, we fall behind if we do not get an increase. Our yearly LACERS COLA pegged to the local Cost of Living Index helps to keep us from losing money to inflation.
LACERS invests in high-quality bonds such as ultra-safe US Treasury securities as part of our diversified investments. These bonds are favored because they are backed with the full faith and credit of the US government. Bonds are also popular because of the need to make regular pension roll payments. However, bonds lose value when interest rates go up.
Let us look at an example. If you bought a bond paying 3 percent interest and then the interest rate on new bonds went up to 4 percent, the older 3 percent bonds would lose value. Why is that? No one wants to buy an existing bond paying 3 percent when the current rate is 4 percent. The holder of the lower-paying 3 percent bond must drop the price and take a loss if the holder wants to sell the bond.
What if there were a product that had the interest-paying ability of a regular bond, but with inflation protection? That is exactly what the US government created in 1997 when it began issuing Treasury-Inflation Protected Securities (TIPS).
TIPS make interest payments that start lower than a regular bond, but they come with an inflation adjustment that causes both the value of the bond and the total interest payment to go up in times of inflation and down in deflationary times. Why wouldn’t you want all your bonds to be TIPS? It sounds too good to be true. The answer is cost. You must pay for the inflation protection with lower returns if inflation is low. However, if inflation is high then the investment pays off handsomely and provides the protection that no regular investment grade bond can provide.
LACERS’ current asset allocation target sets a 3.6 percent commitment of the entire fund to TIPS. In the most recent quarterly report (through Sept. 30, 2020), TIPS returned 11.0 percent for 1 year, 6.10 percent for 3 years and 4.80 percent for 5 years. While it is very satisfying to look at those returns, they are unlikely to repeat at that high level. However, TIPS will continue to be a part of the LACERS investment plan for the unique protection it offers to offset the destructive effects of inflation.
