Defined benefit pension plans face ample challenges in the current environment of extremely low interest rates. Most agree that low yields have caused liability-hedging assets (longer-duration fixed income) to become overvalued when evaluated in isolation. However, plans are limited in how to act upon this overvaluation, given the embedded interest rate sensitivity also associated with plan liabilities and funded status risk (also known as “surplus risk”).
“To achieve superior results, we advocate a more holistic and flexible approach to dynamic asset allocation, making use of multiple risk-reducing levers.”
A plan’s interest rate sensitivity should always be taken into account; however, the current level of interest rates results in a highly asymmetric profile for future fixed income returns and, more importantly, for future changes in a plan’s liability values. These extremely low interest rates result in a reduced risk of further interest rate declines, which means there is a much lower risk of liabilities rising significantly and much lower expected returns for bond holdings. Plan sponsors that ignore this asymmetry may fail to appropriately adjust their asset allocations. As a result, the plan’s future return potential may be degraded, ultimately resulting in the need for significantly higher contributions.
Many market participants advocate de-risking plans, or “glide paths,” whereby exposures and/or risk profiles are adjusted over time based primarily on changes in the funded status. Typically, these glide path blueprints de-risk as funded status increases by re-allocating funds out of the growth assets and into the liability hedge. In normal market environments, such a shift will reduce plan surplus risk but also reduce expected returns. In the current environment of bond overvaluation and historically low yields, this glide path approach results in a significantly larger drop in expected returns that can result in the need for higher contributions into the plan.
We agree that as a plan’s funded status changes, dynamically adjusting asset allocation to maintain targeted levels of surplus risk is appropriate. We also agree that it may be appropriate to adjust the level of surplus risk explicitly at different levels of funded status. However, we believe many glide paths are too mechanical in their approach to risk reduction, with a tendency to rely too much on increasing the fixed income allocation to maintain or dampen surplus risk. By adhering to a risk-reduction process that relies exclusively on increasing the liability hedge and reducing the growth assets, the glide path structure neglects the objective of maximizing return at each targeted level of risk. To achieve superior results, we advocate a more holistic and flexible approach to dynamic asset allocation, making use of multiple risk-reducing levers.
This paper articulates an alternative solution—a flexibly constructed glide path that achieves the competing goals of reducing surplus risk and generating superior returns, while still reducing the risk of a significant decline in funded status. This glide path solution is implemented by reducing directional equity exposure (equity beta) and replacing it with strategies that are driven by alpha and “non-traditional betas” (such as distressed credit, hedge funds, and private investments). As outlined in our 2011 report Pension Risk Management, we believe pension risk-budgeting frameworks that use all levers of risk management, including structuring risk-controlled growth assets, are preferable in most market environments. However, we find the merits of this strategy particularly compelling in the current environment of extremely low bond yields.