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 liabilities.

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 de-risking.

  • 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.

The Author

Jared B. Gross

Head of Institutional Business Development, New York

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All investments contain risk and may lose value. 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. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

This material contains hypothetical return estimates. Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved. It is not possible to invest directly in an unmanaged index.

PIMCO has historically used factor based stress analyses that estimate portfolio return sensitivity to various risk factors. Essentially, portfolios are decomposed into different risk factors and shocks are applied to those factors to estimate portfolio responses.

Because of limitations of these modeling techniques, we make no representation that use of these models will actually reflect future results, or that any investment actually will achieve results similar to those shown. Hypothetical or simulated performance modeling techniques have inherent limitations. These techniques do not predict future actual performance and are limited by assumptions that future market events will behave similarly to historical time periods or theoretical models. Future events very often occur to causal relationships not anticipated by such models, and it should be expected that sharp differences will often occur between the results of these models and actual investment results.

Stress testing involves asset or portfolio modeling techniques that attempt to simulate possible performance outcomes using historical data and/or hypothetical performance modeling events. These methodologies can include among other things, use of historical data modeling, various factor or market change assumptions, different valuation models and subjective judgments.

We employed a block bootstrap methodology to calculate volatilities. We start by computing historical factor returns that underlie each asset class proxy from January 1997 through the present date. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. This process is repeated 25,000 times to have a return series with 25,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return series for each factor to compute covariance between factors. Finally, volatility of each asset class proxy is calculated as the sum of variances and covariance of factors that underlie that particular proxy. For each asset class, index, or strategy proxy, we will look at either a point in time estimate or historical average of factor exposures in order to determine the total volatility. Please contact your PIMCO representative for more details on how specific proxy factor exposures are estimated.

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. ©2015, PIMCO.