New Approaches Tailored To Meet Needs
By: Peter Muldowney
Given the challenges faced by many Defined Benefit pension plan fiduciaries, matching assets to liabilities requires greater care. Peter Muldowney, of Mercer Investment Consulting, examines some of these new approaches.
One of the most challenging tasks for a Defined Benefit pension plan fiduciary is to select the long-term asset mix. Industry surveys indicate that most pension plans invest 60 per cent in equities and 40 per cent in bonds, leaving the impression that there is a simple, magic formula for plans regardless of their size, membership, financial strength, and level of risk aversion.
A closer look reveals different approaches to the bond component. Some have adopted closer matching to the liability characteristics by holding long and real return bonds than those that hold universe bond investments, which reflect the characteristics of bonds issued by Canadian governments and corporations.
This article discusses new approaches in asset allocation which may provide a stronger case for plan fiduciaries to rely less on industry benchmarks and more on asset mix tailored to their needs ... and a reason to break away from the pack
Understanding The Risk Factors
Setting the asset mix is about balancing risk and reward. So letʼs first define what risk is for a DB pension plan. Every pension plan has assets supporting a specific set of liabilities. Risk can be defined as the divergence in the growth of plan assets relative to plan liabilities. This divergence generally comes from two sources:
- equity risk, which is the risk that the liabilities grow faster than equity assets
- interest rate risk, which is the risk associated with how movements in interest rates impact bond assets and liabilities differently
These risks can be illustrated in Chart 1 which shows the divergence in the growth of assets and liabilities for a sample pension plan with a 60 per cent equity/40 per cent universe bond allocation. It highlights the impact that declining bond yields have had on the growth in liabilities relative to the asset growth.
Pension plan fiduciaries face two key asset allocation challenges today. The first is how to better deal with interest rate risk, particularly in light of the low bond yields. Second is how to get more out of the asset mix given the difficult financial position of many plans, which could limit the ability to take risk.
Working The Assets Smarter
Liability driven investing (LDI) is the terminology used to describe the process by which the asset allocation is set with explicit reference to the liabilities. This philosophy is not new. Some Canadian plan sponsors have been framing their asset allocation with reference to their liabilities since the early 1990s.
What is new is the arrival of an array of derivative products and strategies that allow pension plans to better manage risk by more closely matching liabilities. ʻBeta transportʼ and ʻinterest rate swapsʼ are examples of implementation approaches.
What is different about these new approaches? In the past, if you had a 60 per cent equity/40 per cent bond asset mix and you wanted to reduce risk by increasing the bond allocation to 60 per cent, it meant reducing the equity allocation to 40 per cent and indirectly lowering your expected long-term return. New approaches, such as ʻbeta transport,ʼ can allow plan sponsors to maintain the 60 per cent equity allocation, but also increase the bond exposure through ʻfuturesʼ or ʻswaps.ʼ As an example, it is possible to have 60 per cent equity and 60 per cent bonds by transporting an additional 20 per cent bond exposure.
Why would you want to do this? Adding to the bond allocation reduces interest rate risk and you may even increase the expected return of the fund. This sounds good, so why arenʼt plan sponsors rushing to adopt such an approach?
The reasons are not the challenges of understanding the complexities of futures or swaps, or the fact that these strategies result in exposures to markets that add up to more than 100 per cent, since these can be overcome through education and discussion. The challenge for plan sponsors today is being able to weigh the long-term risk management benefits of beta transport against shorter term timing concerns that interest rates will rise and result in an opportunity cost compared to not adding more bonds. There is no easy answer to this concern and the decision will depend on each plan sponsorsʼ ability to tolerate risk. The key is to understand the merits of better matching the liabilities compared to mismatching and what this means for the security of the pension benefits and the potential contributions. The direction of long bond yields will be driven by the many factors impacting the supply and demand for funds in the future rather than the level of rates we might have become accustomed to in the past.
For plan sponsors whose bond component is not invested in liability matching assets, a first step is to review the merits of better matching the bond component before considering a beta transport approach. The same timing issues as described above will apply, but a review will help put the risk factors in context.
Implementing Beta Transport
With beta transport you are borrowing cash to increase liability matching bond exposure. One option is to combine beta transport with a reduction in equity allocation and an increase in the direct bond allocation. This can provide more meaningful reduction to overall risk due to the combined benefits of lower equity risk and lower interest rate risk from both the increase in direct bond allocation, as well as the bond overlay through beta transport.
Depending on the amount of equity reduction and bond overlay, lower risk can be achieved with no change to the portfolioʼs total expected long-term return. This is made possible by the additional expected long-term return resulting from swapping the cash exposure for long bond exposure. The merits of beta transport may need to be re-evaluated if short-term bond yields become higher than long-bond yields (an inverted yield curve).
Three approaches to implement beta transport include equity futures, bond futures, and swaps. The key characteristics of each approach are:
- Equity Futures: Many Canadian plan sponsors are familiar with equity futures which were used to achieve higher foreign property exposure prior to the elimination of the foreign property rule. Instead of the futures contracts being backed by T-bills, they are backed by liability matching bonds. Since equity futures provide market returns, they are best used to replace passive equity allocation. U.S. equity futures have a number of merits compared to the Canadian and international equity futures markets including tighter tracking of the respective index. The use of futures impacts cash management since they require regular rebalancing to reflect changes in market values.
- Bond Futures: The market for Canadian bond futures is limited to the government ʼs 10-year bond. Therefore, the implementation challenge is the potential for a difference in the performance of the bond future compared to the liabilities.
- Swap Contracts: These have a number of merits over futures. First off, they allow access to the broad yield curve, providing closer matching to the liabilities. With a swap, most things are negotiable which provides flexibility with settlement – quarterly, annually, or longer – which helps rebalancing compared to futures.
Implementing Alpha Transport
The use of futures and swaps is not restricted to transporting bond allocation. It is also possible to overlay other investments in the pursuit of higher returns through an approach referred to as ʻalpha transportʼ or ʻportable alpha.ʼ In other words, through futures or swaps, it is possible to transport additional return (ʻalphaʼ) over a portfolio of assets, without necessarily altering the existing investments.
All plan sponsors can achieve broad market returns by investing in index funds. Achieving alpha is not as straightforward and finding a good alpha source is where plan sponsors considering alpha transport need to allocate their resources. The attributes to look for in an alpha source are:
- High consistency: it is better to have many small incremental positive returns than to experience fluctuating positive and negative returns in delivering alpha
- Low correlation with changes in the underlying portfolio: having a source of additional return that is unrelated to the other investments adds to the overall diversification
- Easy to understand: one challenge is that the best source of alpha may best be achieved through complex strategies.
Historically, U.S. equity small cap managers have generally outperformed the small cap index. These managers could be one source of alpha. Another source could be in an absolute return strategy such as a hedge fund. Each of these sources has its merits. The U.S. equity small cap alpha is easier to understand than a typical hedge fund strategy. However, when it comes to high consistency of alpha, it could be argued that the hedge fund strategy has stronger attributes.
There are a number of approaches to implement alpha transport and they are not restricted to the largest pension plans. A number of pre-packaged products have recently been launched and many more are expected to follow.
Facing The Challenges
The new approaches in asset allocation offer plan sponsors the opportunity to better manage risk and to enhance expected returns. The size of many pension plan liabilities relative to an organizationʼs payroll has grown to such levels that the risks are critical… and any challenges associated with the new approaches cannot be overlooked.
Peter Muldowney is the Canadian business leader for Mercer Investment Consulting.
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