When it comes to public pension plans, a lot has been written and said about expected return on assets (EROA) assumptions. Whether one believes those assumptions are reasonable and achievable or not, the fact remains: Investment decisions of public defined benefit (DB) plans are influenced by the return targets implied by their EROA. Inevitably, plan sponsors implement investment strategies that seek to maximize the likelihood of achieving those objectives.
In the end, the effort comes down to balancing asset allocation optimization, clever pursuit of alpha and sound risk management. As part of the latter element, many plans have sought to develop a dedicated allocation focused on mitigating downside risk that they expect will perform well when times get tougher. The goal is to create a pocket of resiliency that will enable plan sponsors to avoid potentially harmful decisions such as selling risk assets in a market downturn to meet liquidity needs (e.g., for benefit payments).
Traditional approaches are unlikely to succeed
From an implementation perspective, plan sponsors have employed a number of strategies in their pursuit of mitigating downside risk, including crisis risk offset (CRO) buckets and tail-risk-hedging programs (TRH). However, the most common expression remains a dedicated Treasury bond allocation (most often longer-duration U.S. Treasuries).
Nevertheless, dedicated long Treasury allocations can create important challenges for public DB plan sponsors. They have relatively low return expectations in the current market environment. For example, PIMCO expects long Treasury bond indices to return approximately 2.5% annually over the next five years. This can become a meaningful drag versus the roughly 7% EROA target used by many plans.
Consider a plan that would be invested one-third in fixed income and two-thirds in return-seeking assets (equities, both public and private, real estate, alternatives, etc.). If this plan expects to earn 8.5% on its return-seeking portfolio, it would need to achieve a 4% return on its fixed income assets to reach the 7% EROA target. With a sufficient amount of credit risk, active management and other return-enhancement techniques, it is not unreasonable to seek to build a high quality fixed income portfolio that aims to meet or even moderately exceed that 4% return target. But if our hypothetical plan allocates 10% of its total assets (nearly a third of the fixed income bucket in this example) to a long Treasury mandate for diversification and downside risk mitigation, it would have to accept a significantly lower expected return on its fixed income portfolio. And this could ultimately lead it to fall short of both the required 4% return on fixed income investments and the overall 7% EROA on total assets (see Figure 1).
Achieving downside risk mitigation without losing sight of EROA objectives
Fortunately, plan sponsors can turn to capital-efficient strategies to seek the desired diversification and lower overall portfolio risk while avoiding or mitigating the substantial return trade-off implied by a dedicated long Treasury allocation. One simple yet effective strategy consists of pairing a modestly to moderately leveraged long Treasury bond exposure with a low-volatility and low-correlation alpha engine to strive for both sufficient downside risk mitigation (from the leveraged Treasury bond exposure) and a level of return that has the potential to be more consistent with public DB plans’ EROA targets (combination of Treasury exposure beta and alpha engine).
For example, our hypothetical plan sponsor seeking to allocate 10% of its assets to a bucket focused on downside risk mitigation could invest half of the 10% (i.e., 5% of total assets) in a leveraged long Treasury bond allocation (1:1 leverage to achieve a net exposure of 10% of total assets as intended). The remaining 5% of assets could be invested alongside in a low-volatility, low-correlation alpha engine that seeks an adequate amount of excess return over Libor (for example, Libor +3%). A combined structure of this sort could provide the plan sponsor with the desired 10% long Treasury exposure while bringing the expected return potential on those assets more in line with the 4% level that our hypothetical fixed income portfolio must achieve to increase the likelihood that the plan sponsor achieves its overall EROA target. While the hypothetical example above assumes a 50/50 split between the leveraged long Treasury allocation and the alpha engine, the breakdown could be customized to reflect plan-specific return targets and/or leverage tolerance (see Figure 2).
As Figure 2 shows, a hypothetical strategy combining a 50% allocation to modestly leveraged long Treasury bonds (1:1 leverage ratio) and a 50% allocation to a low-volatility alpha engine could significantly improve estimated return expectations relative to a 100% dedicated long Treasury allocation (+1.5% estimated return) while maintaining relatively similar diversification and downside risk-mitigation potential (-0.2 equity beta versus -0.3 for the dedicated Treasury bond allocation). Even more significant estimated return benefits were achieved with a higher allocation to the low-volatility alpha engine (See option C in Figure 2). Note, however, that a higher allocation to the alpha engine would require a more meaningful amount of leverage on the long Treasury allocation to achieve the same net exposure to Treasury bonds.
To achieve its primary objective of mitigating overall portfolio risk, it is crucial that the alpha engine embedded in the strategy displays a relatively low correlation to risk in the equity market. In our modeling, we used a PIMCO Dynamic Bond Strategy representative account as a proxy for the alpha engine risk. Because of its limited correlation to equity markets, its use as an alpha engine should not jeopardize the goal of downside risk mitigation. This is supported by the fact that the equity beta remains similar to that of a dedicated long Treasury bond allocation, even as the weight of the exposure of the alpha engine increases. (Learn more about PIMCO Dynamic Bond Strategy.)
Public DB plan sponsors are rightfully seeking ways to protect against pronounced market downturns with diversifying strategies that they expect will be resilient in the face of such market environments. The current low interest rate environment suggests that traditional defensive strategies like dedicated Treasury allocations may deliver fairly low returns in the future, making implementation challenging without compromising EROA objectives. Instead, we believe plan sponsors should consider innovative strategies that combine capital-efficient long Treasury bond exposure with a low-volatility and low-correlation alpha engine. By doing so, we believe plan sponsors will be in a better position to achieve their downside risk mitigation objectives with a potentially lesser return compromise.