Many institutions, including pension funds, have a two-phase life cycle. During the first phase, the fund grows and compounds. Sooner or later, however, the fund converts from the compounding phase into the second, payout phase.
The dollars accumulated in the compounding phase depend on the rate at which income can be reinvested. Once a fund has passed the conversion horizon, however, it is not so much the dollars accumulated in the compounding phase that counts, but their power to generate income. The latter depends critically on the level of interest rates prevailing beyond the horizon. When reinvestment rates during the compounding phase and beyond the conversion horizon are linked, the level of payout the fund can sustain (the so-called “horizon annuity”) becomes very sensitive to the joint rate.
The author develops a simplified model of a two-phase investment fund that permits him to examine the implications of this sensitivity. The model shows that the best passive defense against a secular downtrend in reinvestment rates is a truly long-term portfolio protected against excessive exposure to call. Unfortunately, the best long-term portfolio will often have an extremely volatile short-term performance. The growing popularity of short-term performance measurement has made it difficult for many managers to gear their portfolio structure entirely to long-term objectives.