Implementing a risk-controlled growth portfolio requires customization with a focus on maximizing expected return without taking unnecessary liability relative risk. Specifically, sponsors should focus on controlling the tracking error that certain market betas and exposures cause.
Historically, long-only equity exposure, along with a sprinkling of real estate and private equity, has dominated the growth portfolios of defined benefit pension plans. Furthermore, many sponsors have equity exposure that has not been effectively diversified across equity betas. Diversifying the growth portfolio across various betas and active exposures by employing a variety of strategies can create a portfolio that generates higher expected returns at a given level of expected risk.
Recall that economic and market environments that historically result in negative tail events for defined benefit plans tend to be characterized by deflationary periods of slow or no economic growth, declining interest rates rising liabilities , poorly performing equity markets, and difficult operating environments for plan sponsors.
In these environments, returns from equity betas often decline significantly at the same time that liability discount rates decline, thus magnifying negative tail events for defined benefit sponsors.
It is not hard to see that returns generated from betas that are less correlated to global equities and uncorrelated active sources of return are preferred exposures. Of course, this assumes that these exposures have attractive expected return and risk characteristics.
All things equal, plan sponsors will prefer a unit of return generated from an active exposure over a unit of return generated from equity beta exposure and should allocate their risk budgets accordingly.
Within this framework of evaluating exposures, even considering this higher hurdle, sponsors should focus on maximizing their risk-adjusted return from various sources of equity beta. Allocations to private equity and real estate can provide diversified sources of beta and potential active manager value added, and thus higher expected returns.
Additionally, allocations to private natural resources strategies may provide return enhancement, additional protection against unexpected inflation, a diversified source of beta, and potential alpha Exhibit 2. Assuming institutions believe that they, or their advisors, have the skill and resources to identify active strategies and managers that add value, sponsors should create targets for various beta exposures and for active risk exposures. Importantly, this more efficient portfolio also allows sponsors to maintain the same allocation to their growth and hedging portfolios, thus maintaining a similar level of expected return at a lower level of surplus risk.
We would emphasize that a plan oversight strategy that allocates a significant amount of risk to active exposures must extensively diversify sources of active risk, or total plan surplus risk may increase. Notes: Assumes quarterly rebalancing. The liability proxy shown in Exhibits 4—7 is simulated for year duration.
Certain changes have been made to that asset mix to allow for more granularity at the asset class level in our analysis: the 4. Notes: See Exhibit 3 for sources and portfolio compositions.
Holistic pension plan portfolio oversight is a dynamic process due to a number of factors. After setting an appropriate range of surplus risk, plan sponsors will need to adjust portfolio exposures, as these factors change to allow a plan to stay within the range of acceptable risk. Adjusting exposures can be a challenging, multidimensional process that benefits from a robust risk-budgeting framework. An effective framework enables plan sponsors to assess and adjust their exposures in one part of their portfolio with an appreciation for the implications on other parts of the portfolio and the total portfolio in aggregate.
A sponsor can create desired exposures and risk profiles by changing the size and composition of both the growth and the hedging portfolio. When changing the composition of either, a sponsor must be sensitive to how the profile of one interacts with the other—the interaction effect. The risk of the growth portfolio affects the amount that should be allocated between the hedging and growth portfolios to maintain desired risk parameters.
A secondary interaction effect occurs if the discount rate, and thus the risk-free asset, contains an embedded risk premium, such as a credit spread. For instance, if the liability discount rate is based on investment-grade credit rates, a pool of investment-grade bonds of similar maturity to the liability is only the theoretical risk-free asset when implemented in isolation Exhibit 8.
Equity beta is often strongly correlated with credit spread and, in some ways, behaves like high-octane credit. A more effective hedge would include sovereign instruments, although this will create some negative carry.
The appropriate allocation across risk exposures will vary based on market valuations. If certain betas are very overvalued, thus increasing beta risk Exhibit 9 , sponsors should re-allocate that risk to other, more attractively valued beta sources, transfer the risk to active exposures, or, in extreme cases, de-risk and move exposures to the hedging portfolio. Taking these actions will allow the plan to maintain a targeted level of surplus risk.
Notes: Based on quarterly data. The last full ten-year period was to To maintain consistent risk parameters, asset exposures also have to be adjusted as changes in funded status occur. In basic terms, the increase in surplus risk is a result of a leveraging effect that occurs when the value of assets exceeds the value of liabilities. The opposite effect occurs to a lesser magnitude when a plan moves from fully funded to underfunded. Identifying the theoretical risk-free asset, as well as acceptable levels of plan surplus and tail risk, allows for the creation of a robust risk-budgeting framework.
A total portfolio risk-budgeting framework views the growth and hedging portfolios individually and as a whole. This framework is a powerful tool for allocating risk across various beta and active exposures and for hedging out undesirable risks. However, implementing this framework is not without its challenges.
Download Report. As pressures on pensions mount, we believe financial executives are best served by re-evaluating major decisions in terms of the true tools at their disposal. Mercer is dedicated to helping Endowments and Foundations not only realize higher risk-adjusted returns, but also fulfill a higher mission.
Mercer can help financial intermediaries bolster resources, generate investment ideas, perform due diligence, and assess operational and fiduciary risks. Mercer can help provide your with all your retirement planning needs including retirement and benefits plan administration. Mercer has outlined eight initiatives to help firms position themselves and their clients for success in this ever-changing world.
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