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Jared B. Gross
This article originally appeared in Pensions & Investments online on 30 July 2014.
Been down one timeBeen down two timesI’m never going back again— Fleetwood Mac
Pension funds are bracing for a big hit from the adoption of new actuarial tables, which will extend the life expectancy of plan participants (a good thing!) and increase the value of pension liabilities. Without a corresponding increase in asset values, plan funding will suffer. Many sponsors are preparing for a potential drop in funded status of 5 to 10 percentage points, which would erase much of the gain from 2013 and leave them farther away from their target funding levels.
Under the circumstances, we believe it is natural that pension investors would consider reversing the course of de-risking embedded in their glide paths and increasing their allocation to return-seeking assets. After all, if the guiding principle of glide path strategies is that a higher level of funding (more assets versus a given level of liabilities) justifies taking less risk, should it not follow that a decline in funded status would justify taking on a bit more risk?
Maybe. But keep in mind that simply reversing course and pushing capital back into equities is only one possible approach among many. Consider the following points:
First, recognize that historical asset allocations that were heavily skewed toward equity are not typically the “natural” position for pension portfolios. Prior to the financial crisis, it was very common for plans to hold 70% or more of their assets in some form of return-seeking asset, usually equities – regardless of funded status.
Even if a plan has now de-risked and moved a meaningful portion of its equity allocation into long-duration bonds, it is still likely to have sufficient return potential to outperform liabilities. Don’t assume that a change is necessary.
Second, accept that stocks may not be the best choice. As a source of potential outperformance versus liabilities, traditional equity strategies have some clear positives: long-term return potential, liquidity and the availability of low-cost investment options. However, there also are clear downsides: potential for high volatility, tail risk and historically low correlation to liabilities. Further, the broad U.S. equity market has had a strong run over the past two years and we believe equities are fairly valued. Therefore, be cautious when looking for risk.
Third, recognize that other asset classes may be able to deliver returns of a magnitude similar to equities, but potentially with less absolute volatility and improved diversification characteristics. Consider the full universe of return-focused investments, including some of our favorites:
Fourth (and very important!), don’t ignore the possibility of interest rates being the key driver of potential outperformance (as opposed to asset returns). Many plans are hedging only a portion of their liability risk and may stand to benefit a great deal from rising rates. Standing pat remains a viable option for many.
Nonetheless, it is possible to reduce the interest rate sensitivity of the portfolio in an attempt to benefit more fully from the impact of rising rates on long-term liabilities, either by shifting fixed income into shorter-duration strategies or, through the use of derivatives, to tactically reduce the interest rate exposure of long-duration portfolios. Given the very low level of current bond yields, this approach may have limited downside and potentially strong outperformance versus liabilities, if rates do rise.
Finally, stay liquid. We have observed in recent years that interest rates have the capacity to rise sharply (witness the “taper tantrum” last year) but also that long-term investors (pensions and insurance companies) are waiting in the wings to buy long-term bonds at higher yields. We believe pension investors who will ultimately want to acquire long-term bonds should ensure that they maintain adequate liquidity in their return-seeking portfolios to take advantage of higher yields when (and if) they arrive.
Act, but don’t overreactFunding losses from the extension of longevity may be inevitable, though that makes them no less unwelcome and frustrating when they arrive. Take a deep breath. In re-evaluating asset allocation decisions, it may be helpful to take a “clean-sheet-of-paper” approach – and not simply default to a prior strategy that is no longer advisable.
Positioning a plan in an attempt to outperform liabilities can involve more than just rolling back into equities. We urge investors to consider carefully the target level of return and risk they want to maintain, and evaluate all possible strategies to make that a reality.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. PIMCO’s liquid alternative strategies are without the principal lock-ups of traditional private equity funds and hedge funds and include separate accounts whose holdings can be liquidated at a client’s request subject to current market conditions, mutual funds that can be liquidated at NAV on a daily basis and ETFs that can be liquidated on the secondary market under normal market conditions. There is no guarantee that a security will be able to be liquidated in a timely fashion or when it would be most advantageous to do so. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss.
Glide Path is the asset allocation within a Target Date Strategy (also known as a Lifecycle or Target Maturity strategy) that adjusts over time as the participant’s age increases and their time horizon to retirement shortens. The basis of the Glide Path is to reduce the portfolio risk as the participant’s time horizon decreases. Typically, younger participants with a longer time horizon to retirement have sufficient time to recover from market losses, their investment risk level is higher, and they are able to make larger contributions (depending on various factors such as salary, savings, account balance, etc.). Generally, older participants and eligible retirees have shorter time horizons to retirement and their investment risk level declines as preserving income wealth becomes more important.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2014, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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