Time and tide wait for no man
Sailors in days past observed the wisdom of leaving port at the turn of the tide, when the combination of high water and favorable current made for a smooth departure. For the captain, failure to capture this opportune moment was unthinkable; woe betide the seaman who lingered too long ashore only to watch his vessel disappear over the horizon.
The ebb and flow of the tides may seem a fitting metaphor to those in the pension world who have witnessed the rise and fall of plan funding over the past two decades. Plan sponsors have patiently borne the costs and risks of funding at the low ebb, waiting for the right combination of asset returns and higher interest rates to return. The course has been known for a long time: toward a de-risked future with less equity exposure and more liability-matching bonds. All that remained was to wait for the tide to rise.
From the recent cyclical low in early 2012, plan funding has staged an incredible comeback. Exceptionally strong equity returns have increased the value of many plan asset portfolios, while higher interest rates have reduced the present value of liabilities. In a recent report dated 9 January, economic forecasting firm ISI estimated that over the course of 2013 S&P 500 companies improved their collective funding ratio to 93% from 78%, an increase of more than $300 billion! Fully one quarter of S&P 500 plans are overfunded, and many of the rest are within sight of that once-distant goal. The tide has risen.
There are many ways to de-risk
In broad terms, the de-risking of a pension plan is straightforward: Reduce the volatility of assets and shift the portfolio to duration-matched bonds that move in tandem with liabilities. Eventually, this is designed to remove the major sources of volatility in funded status while maintaining a portfolio with sufficient return potential and liquidity to make good on benefits as they come due.
Within this broad framework, however, there are many ways to proceed, some of which may be more suitable to the current environment. Simply put, although this feels like a very good time to take some equity risk off the table, we recognize that moving wholesale into long-duration bonds with rates low, the economy strengthening and the Fed beginning to taper is not for the faint of heart.
The situation may call for consideration of more subtle forms of risk reduction that focus on lowering asset volatility – and equity risk in particular – as a temporary substitute for the more complete de-risking typically offered by long-term bonds. Although we believe a move into
long-duration bonds should eventually take place, making use of other strategies that are designed to reduce the volatility of equity portfolios or seek a greater degree of capital preservation in a rising rate environment could allow a plan the opportunity to lock in recent gains in plan funding. Figure 1 lays out several options that plans should consider:
Taking each of these options in turn, what are the key potential benefits and risks? To summarize briefly:
- Lowering the volatility of equity investments: Shifting away from broader market benchmarks toward deep value, dividend/income or long/short strategies may reduce the overall volatility of equity investments while retaining significant long-term return potential. On the downside, we believe this approach is the most modest form of de-risking, typically retaining significantly higher volatility and left tail exposure than other approaches.
- Hedging equities: The use of put options may reduce the impact of a market downturn while retaining the upside potential of the equity portfolio. The current market environment appears well-suited to this approach given the surge in equities to record highs and the low implied volatilities in the equity options market. Although the purchase of downside hedging bears a cost, it may be possible to subsidize this expense either by restructuring the portfolio elsewhere to potentially earn a higher yield or through option-selling strategies.
- Shifting from equities to alternative investments: Diversified portfolios of hedge funds, private equity and real estate may provide return potential similar to equities with lower absolute volatility and improved portfolio diversification characteristics. Manager selection risk and liquidity are key concerns, so allocations in this space should be made within the context of maintaining adequate diversification and access to capital.
- Lower duration fixed income strategies: A plan may reduce exposure to risk assets without taking on exposure to long-duration bonds that may lose value in a rising-rate environment. To avoid the return drag from holding cash, these approaches typically focus on strategies with high credit content or more dynamic, unconstrained mandates. If rates rise, these strategies may still deliver outperformance versus liabilities. The risk is that, if rates fall, the assets will not keep pace with rising liabilities.
- Liability-driven investing (LDI): In our view, the most effective form of risk reduction is to shift directly to duration-matched bonds that track the liability. Most plans are making this move in incremental stages along a glide path. For plans with sufficiently high levels of funding, we consider this the lowest risk approach. An LDI program should be carefully structured to ensure that the liability is matched effectively and that the underlying portfolio is structured in an effort to maintain sufficient return, diversification and liquidity.
Time to set sail
With improved plan funding comes the opportunity to de-risk, in hopes of putting a pension plan on a more stable footing and reducing the plan sponsor’s exposure to future volatility in earnings, balance-sheet risk and cash contributions. For plan participants, a well-funded and de-risked plan offers greater confidence with respect to the ultimate payment of full benefits. And while the temptation remains to stick with the strategy that has worked so well recently – holding on to equities and postponing a move to hedge liabilities – it serves to remember the sailor left ashore: Just as the rising tide will eventually turn, markets will not forever present so favorable an opportunity to shed risk.