Pension funds are complex systems with many moving parts. A sponsor needs to be concerned about the behaviour of the assets, the behaviour of the liabilities, and how the two interact. In order to manage the return dynamics and funding stability of the plan the first step is to reduce both sides of the equation to common building blocks.
Typically asset allocation is focused simply on asset classes: equity, bonds, real estate, private equity, hedge funds, etc. But there is a great deal of overlap in what drives returns across asset classes, as they each are sensitive to a varying array of risk drivers. We call these drivers risk factors.
Equities can be deconstructed into a market beta, size, value/growth, momentum, sensitivity to volatility, liquidity, etc. Bonds can be deconstructed into duration, yield curve slope sensitivity, credit spread, mortgage spread, liquidity, etc. Credit represents an interesting crossover as it embeds varying degrees of factors that are predominant mostly in equity with others that underpin other fixed income securities. High quality investment grade has more modest exposures while high yield may have considerably more.
In a typical pension portfolio with the assets split 55% in equities, 35% in fixed income, and 5% each in private equity and hedge funds, the equity beta is slightly north of 90%. Where has our diversification gone? The answer is that the equity is much more volatile than the other components. Because equity generally has 3 to 4 times the volatility of bonds, even in a 50:50 portfolio of equity and government fixed income (no spread), the equities can contribute 75%–80% of the portfolio’s volatility.
Because pension liabilities are very long-dated with cash flows extending 70 years or more, the duration of liabilities tends to be very long, and even if discounted with high grade credit, the liability valuation has a fair amount of sensitivity to the credit spread – especially in a low interest rate environment (annual volatility of 13%–14%: duration ~70%, credit spread ~30%, based on a case study drawn from a sample of Canadian pension plans). Other factors, principally yield curve shape, contribute little to the overall total volatility.
We combine the long asset position with the short liability position to understanding the net risk attribute behaviour.
The funding ratio is critical. If the plan is 75% funded, the underfunding levers the contribution of the liabilities which now have 4/3 impact of the assets. Because the credit spread shares common drivers with the equity, the equity position partly hedges the credit spread discount in the liabilities. The dominant driver is the duration, which contributes roughly 80% of the volatility (the balance comes from equity and credit spread components not directly hedged by the equity). As the funding ratio improves, the duration impact is reduced – more assets with duration yield more hedging of the duration short – and the equity is increasingly a stand-alone risk constituting more of the portfolio volatility.
Another consideration is the net carry or yield on the portfolio. Since liabilities are long and yield curves upward sloping, the effective discount rate or yield on the liabilities is generally higher than most assets’ fixed income yield plus dividends. In a stagnant world where assets do not appreciate, the funded status of the plan slips. Equities and other risk assets must appreciate in value for the funded status to hold steady. The lower the ratio is, the faster the downward slide in funding accelerates.
Alleviating the funding deficiency or even sustaining existing levels without making contributions is not an easy task. Risk assets must rise, rates must back up, or some changes to the portfolio must be undertaken to reduce risk and increase yield. Three strategies may reduce the magnitude of funding volatility and increase portfolio carry:
- Move core bond portfolios to longer government/credit portfolios. This improves the match to liabilities and hedges some duration and credit spread while reducing the carry deficiency.
- Replace some (15%) of the equity allocation with a synthetic equity strategy: equity swaps or futures backed by long bonds. This again reduces the mismatch between assets and liabilities, but allows the sponsor to retain exposure to equities to potentially reverse the funding deficiency if they perform well.
- Move some portion of the equity portfolio (10%) to a combination of high yield and emerging market fixed income. This diversifies some of the asset risk exposure away from equities to other factors and increases portfolio carry.
The combination of these three strategies could reduce surplus volatility by some 30% and may increase portfolio carry by roughly 200 basis points (data sources include Bloomberg and TSX).*
As plans funded status change, the prescription for portfolio changes will reflect different risk characteristics and relative contributions. There is no magic policy portfolio for a pension plan! They are ever-changing and evolving, requiring constant evaluation of risk contributions, market opportunities, and positioning. The plan is a dynamic problem that requires a dynamic solution.
*The strategies provided are proxied by index returns as of March 1, 2010.
Dr. James Moore is Executive Vice-president, Newport Beach and Head of Global Liability Driven Investments Product Management with PIMCO.