- Over the last 20 years, pension plans have had to nearly triple their risk to achieve a 7.5% expected return.
- To pay out benefits during a market downturn, plans may be forced to sell their equities in a declining market.
- Instead of reducing overall equity exposure, plans can manage systematic risk using low or adaptive volatility strategies.
It’s no secret that pension plans have endured more than their share of hardships over the last couple of decades. As more employers shifted from defined benefits to defined contribution plans, pensions suddenly faced the difficult math of funding payouts for a growing number of retirees – who also happen to be living longer – with fewer and fewer active members.
Meanwhile, 35 years of declining interest rates have taken a toll. In 1995, plans could generate a 7.5% expected return with portfolios comprised entirely of fixed income. In 2005, plans would need roughly half of their assets in equity to generate such a return. By 2015, that share would swell to 88% equity.
In reaching for additional returns, plans have not only upped the ante on equities. They’ve moved into private equity, private debt, real estate, infrastructure and other asset classes that are more complex and less liquid.
Source: Kloepfer, J. V., & Moriarty, J. A. (2016). Risky Business (pp. 1-10, Publication). San Francisco, CA: Callan Associates (adapted). Data reflects historical forward-looking expectations and is no guarantee of future results.
All told, plans have had to nearly triple their risk to maintain the same 7.5% return that fixed income offered a quarter of a century ago.
The unintended consequence of this reach for higher returns is that equities are now the primary source of liquidity for pension plans. Other newer asset classes tend to be less liquid. Therefore, as volatility rises, so does the probability that pensions will need to sell equities in declining markets to fund their benefits.
With trillions of dollars in pension plans on the table, this situation could be self-perpetuating: as more plans are forced to sell equities to raise cash, it could lead to still lower security prices – all the while paving the way for even greater funding gaps down the road.
What’s more, plans typically implement a re-balancing process after an asset class declines. If stocks sell off, a plan’s equity exposure will fall below its target allocation. This would normally result in a re-balancing process that buys enough equities to replenish target allocations.
But what would be the source of funds to re-balance into equities? Plans may not have the liquidity in other parts of the portfolio to buy equities. Failure to re-balance results in a portfolio risk-reward profile that’s misaligned with the liability structure it is intended to fund.
Weighing the Alternatives
While many pensions understand the danger of reaching for higher returns, the path forward isn’t clear. Fixed income has its own issues, and few plans can afford the opportunity cost of shifting more assets to cash to fund near-term payouts.
For many plans, the solution has been to focus on fees, namely by shifting more assets into low-cost passive strategies. But passive strategies tend to go hand in hand with market exposure, a.k.a. beta risk.
A better strategy: instead of turning their backs on public equities, pension plans can dial back their market-risk exposure by rethinking the impact beta risk has on their overall portfolios. Perhaps plans should consider adjusting their asset allocations to include lower beta equity exposure as a permanent commitment.
There are plenty of equity strategies available which maintain a consistently lower exposure to beta relative to the market. Further – and perhaps a better solution – is an equity strategy which adjusts its portfolio beta dynamically to match optimally the risk observed in the equity market over time. Some have called this “variable beta.”
By adjusting allocations, plan sponsors can reach a better balance between raising cash to fund immediate payouts while generating the returns they need to sustain their plans in the future.
Intech® has a track record of offering both types of solutions.
Our low volatility equity strategies seek market-like returns over time while achieving a substantially lower risk profile than the overall equity market. These can be an attractive addition to well-funded defined benefit pension plans or later-stage target date funds within defined contribution plans.
Intech® adaptive volatility equity strategies are distinctive in the industry by offering and behaving as they are named – they adapt the portfolio’s risk profile to the observed risk in the market. Their goal is to outperform equity markets over a full market cycle while incorporating downside protection, providing an asymmetric return profile. These strategies might help under-funded plans de-risk without reducing equity exposure, or even allow an increased equity exposure throughout a target-date glide path without increasing total portfolio risk.
Plan trustees and participants should focus on the unintended consequences of attempting to reach for higher returns in their portfolios. This reach has resulted in exploding total portfolio risk and also equities becoming the default liquidity source for cash flow needs.
The longer the bull market continues (already the longest on record), the larger this danger grows. It may therefore be prudent to consider lowering equity portfolio beta risk prior to an eventual downturn.
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