BOSTON, MA – (April 23, 2013) – The most popular practice for ERISA pension funds to reduce their funded status risk has been the use of set formulas to automatically move funds from growth assets, like equities, to fixed income assets as the pension plan funded status increases.
Conceptually the “glide-path” approach to de-risking may make sense, as it provides a disciplined framework for reducing risk, and thus decreases the likelihood that plan sponsors will be confronted with unanticipated funding obligations due to adverse market conditions. However, the current environment of extremely low interest rates could, paradoxically, make the current form of this risk-reduction approach more risky, according to “Pension De-Risking in a Low-Rate Environment – A Better Solution,” a new paper from institutional investment advisor Cambridge Associates.
The Problem with the Traditional Glide Path
“In normal markets, shifting funds out of growth assets into liability matching, or fixed income, assets will reduce funding risk but also reduce expected returns and thus increase projected contributions. But in the current environment of fixed income overvaluation and historically low interest rates, the commonly accepted approach to constructing a glide path is likely to result in in a significant decline in expected returns. Therefore, the likelihood of a plan sponsor needing to make higher contributions jumps dramatically and presents a formidable financial risk,” said David Druley, Managing Director and head of the global pension practice at Cambridge Associates.
Current glide paths are typically “mechanical” in their approach to risk reduction, relying primarily on increasing fixed income assets and reducing growth assets. “The traditional glide path neglects the objective of maximizing return at each targeted level of risk,” Mr. Druley said. “The typical approach just uses one lever—the fixed income allocation—to reduce risk, and, because of that, may not generate enough return in an environment like the one we are in today.”
A “Holistic” Alternative: Use Growth Assets to Regulate Risk
The Cambridge paper calls for an alternative glide path – a “holistic” one – that achieves the competing goals of reducing funding level volatility and generating superior returns, while importantly reducing the risk of a significant decline in funding level.
This alternative glide path not only looks at the amount allocated to growth assets, as the traditional glide path does, but it also defines and controls the risk within the growth assets. It does that by utilizing growth assets that emphasize active strategies that rely on manager skill and non-traditional sources of beta (such as distressed credit, hedge funds, and private investments) rather than directional equity market exposure.
“The merits of this approach are accentuated within the current environment of extremely low interest rates,” Mr. Druley said. “Carefully moving some growth assets into strategies that derive a significant amount of returns via alpha, or manager value-add, can potentially allow a pension fund to keep more assets in the growth portfolio, operate at the same risk level as the more simple glide paths and generate higher expected returns.”
The kinds of strategies included in the growth portfolio are low-beta hedge fund strategies, very active long-only strategies and select private investment opportunities, when appropriate.
“In fact, based on our experience, this holistic approach did a better job of protecting funded status during the 2008 financial crisis. So you get the potential for higher returns and lower realized risk,” Mr. Druley added.
The report notes that because the holistic glide path approach usually involves higher exposures to alternative asset classes and strategies, it also entails implementation complexity as well as higher investment management fees.
“Employing this holistic glide path successfully requires significant experience, manager selection skill and an institutional willingness to accept implementation complexity, which requires resources,” said Mr. Druley. “Alpha is certainly a zero sum game, but our experience tells us that with the right expertise and guidance an institution can benefit from the potential for higher returns and reduced contributions.”
To receive a copy of “Pension De-Risking in a Low-Rate Environment – A Better Solution,” please contact Frank Lentini of Sommerfield Communications, Inc., at firstname.lastname@example.org or +1-212-255-8386.
About Cambridge Associates
Founded in 1973, Cambridge Associates is a provider of independent investment advice and research to institutional investors and private clients worldwide. Today the firm serves over 900 global investors and delivers a range of services, including investment consulting, outsourced portfolio solutions, research services and tools (Research Navigatorsm and Benchmark Calculator), and performance monitoring, across all asset classes. The firm compiles the performance results for over 5,000 private partnerships and their more than 65,000 portfolio company investments to publish its proprietary private investments benchmarks, of which the Cambridge Associates LLC U.S. Venture Capital Index® and Cambridge Associates LLC U.S. Private Equity Index® are widely considered to be among the standard benchmark statistics for these asset classes. Cambridge Associates has more than 1,000 employees serving its client base globally and maintains offices in Arlington, VA; Boston; Dallas; Menlo Park, CA; London; Singapore; Sydney; and Beijing. Cambridge Associates consists of five global investment consulting affiliates that are all under common ownership and control. For more information about Cambridge Associates, please visit www.cambridgeassociates.com.
Sommerfield Communications, Inc.