Two hikers are walking in the forest when they spot a bear on the trail ahead. The first hiker freezes while the other calmly sets down his pack, pulls
out a pair of running shoes, and unlaces his boots.
“What are you doing? You can’t outrun that bear!” exclaims the first hiker.
“I don’t have to outrun the bear,” replies the other as he slips on the sneakers, “I just have to outrun you.”
This old joke makes an important point about defining objectives correctly. When faced with a bear on the trail and survival on the line, there is only one
thing that matters (leaving human decency aside for the sake of a good analogy): It is not outrunning the bear; rather, it is keeping one step ahead of the
other hiker. Technically, it is not absolute speed that matters, only their positions relative to one another.
So what is the connection to investment strategy?
Pension investors often face the challenge of meeting two conflicting objectives: delivering high absolute returns and managing risk relative to
liabilities. Meeting the first objective typically means investing plan assets in return-seeking strategies that have high risk relative to liabilities.
Meeting the second requires investing in long duration bonds that effectively track liability values but also offer limited outperformance potential versus
In practice, most pensions engage in both strategies simultaneously – attempting to meet both goals in part rather than either one in full. Unfortunately,
this approach has not produced the desired result: Despite the strong absolute performance of most risk assets over the last few years, liabilities have
grown even faster. Declining interest rates have boosted liabilities, trumping strong equity markets. In retrospect, strategies focused on hedging would
have done just as well (or better) with less risk.
But that is the past. The era of surging liability values is most likely behind us, as interest rates are already low and actuarial tables have recently
caught up to the reality of longer-lived participants. How should a pension investor think about return targets and risk management today? Reaching
traditional absolute return targets in the 7%–8% range may be difficult – even more so in the context of an appropriately diversified portfolio. Perhaps a
more realistic goal is a relative one: outperforming the value of liabilities, by a smaller margin perhaps, but with more diversification and less risk.
Setting a strategic asset allocation to outperform liabilities
Consider a plan whose long-term objective is to outrun plan liabilities. The expected return on liabilities is similar to that of a duration-matched
portfolio of high quality corporate bonds. With low initial yields and the prospect of rising interest rates, expectations for liability growth going
forward should be low. This may seem encouraging after years of surging liability values, but it also poses two critical questions to investors: First, how
much should we adjust expected returns on other asset classes; and second, what does this imply for asset allocation?
Here is PIMCO’s answer to the first question, in the form of estimated 10-year nominal returns and volatilities for a range of asset classes, both in
absolute terms and relative to liabilities. A couple of important takeaways from Figure 1 below:
- We expect nominal asset returns will be lower than in recent historical periods – not just for bonds, but across most major asset classes.
- The relative positioning of asset class returns will be broadly consistent with traditional expectations (stocks higher than bonds, emerging markets
higher than developed, illiquid higher than liquid, etc.).
- Lower forward-looking returns do not imply lower forward-looking volatility, so the efficiency of traditional portfolio strategies that rely heavily on
equity will likely be diminished.
With respect to the implications for strategic (i.e., long-term) asset allocation of pension investments, the following thoughts may be useful:
- Active management is now more important. When beta returns are low, the importance of alpha increases, both on market-oriented
strategies (stocks and bonds) and alternative assets. Passive strategies may become more costly given their inability to add excess return.
- Liability hedges work in all markets. Maintaining an allocation to long duration bonds is entirely consistent with seeking
outperformance versus liabilities in a risk-focused manner, particularly if these strategies can deliver positive alpha relative to their benchmarks.
- Reduce inefficient assets first. In a lower-return world, asset classes with high tracking error to liabilities will be increasingly
hard to justify on a risk-adjusted basis. These assets should probably be the first to be reduced in the event that plan performance allows for additional
- Maintain flexibility with liquid strategies. It is important to have the flexibility to shift into hedging strategies if and when
funding improves materially. Maintaining liquid investments in the non-hedging portfolio can help provide a ready source of capital to fund increases in
liability-driven investing (LDI).
- Overlays can be a useful tool. Strategies involving derivative overlays (equity or rates) provide a measure of leverage that can help
improve risk-adjusted returns, and may allow for nimble rebalancing in response to market moves.
- Illiquidity can be a driver of return. Illiquid investments need to be treated with care, but should not necessarily be avoided
altogether given their potential for higher risk-adjusted returns. Pensions typically do not face large capital draws – except in the case of accelerated
lump-sum payouts, which are typically known well in advance.
A modest proposal
The need for performance on the asset side of the pension balance sheet remains, but the market environment will likely make achieving those returns more
challenging than ever. On the flip side, flat or rising interest rates should keep liability growth at modest levels going forward. Investors should be
cautious about reaching for high absolute returns in this environment because the amount of risk required to meet historical expectations may be excessive.
Instead, a strategy that seeks modest outperformance and lower risk versus liabilities will have more flexibility to invest across a diversified range of
asset classes and, we believe, a greater probability of success.