This article originally appeared in Pensions & Investments online on 30 July 2014.
Been down one time
Been down two times
I’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:
- Lower volatility equity strategies, or hedged equity strategies
- Portable alpha strategies that use equity index derivatives backed by active bonds
- Liquid alternatives
- Emerging market bonds
- Tactical momentum-driven strategies
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 overreact
Funding 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.