How might you invest your DB plan in the future?

Teams were asked to determine what the economic environment would be for the next five years (2010 to 2015). They were given six economic growth scenarios, along with the asset classes that would fare well under each, as outlined in the table below:

The asset classes that protect and/or benefit from the first three scenarios are diametrically opposed to those that protect and/or benefit from the latter three. Towers Watson believes that the most likely outcome is a bumpy ride to recovery, assigning this scenario a 40% probability.

However, the other scenarios have between a 10% to 20% likelihood of occurring. The key question for each team (and real-life plan fiduciaries) was, Do you construct an asset mix strategy for the likely outcome or the most feared, worst-case outcome? Each approach has potentially different consequences for funding and expense figures, depending on the actual outcome. While never explicitly disclosed as part of the case study, the teams assumed that the plan was quite mature and that the plan sponsor covenant was average.

Teams were then brought forward to 2015, with the next time horizon of 10 years for their decisions—2015 to 2025. Each team was given the choice of setting a strategic asset allocation or one that is more dynamic. Specifically, selecting a strategic allocation meant that the team believed that, even with high governance capability, the ability to add value through dynamic allocation is both unproven and too difficult, despite the intuitive appeal. In selecting a more dynamic approach to setting asset allocation, teams were told they believed the following:

• they had the skills, processes and governance to dynamically allocate;
• they expected volatile market conditions; and
• gains would exceed costs.

It is not hard to see the appeal of a more flexible approach. However, how many Canadian plan fiduciaries, excluding the very largest funds, can answer yes to the three conditions set out above? Our team took a middle position and decided to set a strategic asset allocation with the ability to adjust the asset mix, within preset bands, for high conviction opportunities. One such opportunity that was discussed was capturing credit spreads in late 2008, early 2009. While hindsight is always 20/20, I had one Canadian client who acted decisively in April 2009 and two others who acted in June 2009.

Teams were then asked how much risk they were willing to take given the economic outlook in 2015. The options put forward were increase risk, increase risk but buy five-year puts, maintain the current risk budget, reduce risk and reduce risk but buy five-year calls.

Again, our team took a middle road and agreed to maintain the current risk budget (with the already-agreed bands that facilitated an element of dynamism). We did have a long discussion about de-risking and buying five-year calls but deemed the cost of the calls too expensive. Most teams were clustered around the middle choice with only two of the 26 teams opting for the de-risk with calls option.

The final part of the challenge was to select two investment ideas from a list of seven that we wanted to implement. The teams had the following choices:

• a private equity distressed investing portfolio;
• a currency carry fund;
• a volatility arbitrage fund;
• a passive basket of growth economy assets (GDP weighted);
• a growth economy consumption portfolio (developed equities);
• a demographic shifts portfolio; or
• a water portfolio (predicated on scarcity).

This proved rather challenging as themes can be difficult to implement and often cross different asset classes. Also, there was no time frame given to the choices—near or long term. Our team decided, therefore, that while we liked demographic shifts as a long-term theme, the distressed portfolio and a passive basket of growth economy assets were our two choices for more near-term success. We immediately eliminated the currency carry and volatility arbitrage funds as we thought the potential gain versus the increased governance and risk was too small. Water was just too amorphous for us (no pun intended!).

While we certainly enjoyed our discussions and the multiple views that were represented, it is not hard to see that industry participants have some serious choices to make in the near and long terms. The lack of information provided as part of the case study does, in many ways, simulate life.

We are often forced to make decisions in an information vacuum. How do we plan for such situations?