Should pension plans maintain a high allocation to public market equities? In the rush to the LDI exit doors, many pension plans are reducing their allocation to public market equities, some by a material amount. Is this a prudent strategy? The answer, of course, is—“it depends”—on the plan’s benefit design, funded status, investment horizon and various demographic factors. So what are some of the arguments in favour of reducing equity exposure?
“Equities have a low duration and thus are a poor match to pension liabilities.” This argument is reinforced by actuarial valuation approaches which value pension liabilities as if they are simple fixed-income obligations (i.e., short positions in nominal bonds), instead of taking a more stochastic approach and modelling the full range of potential outcomes. Equities have a high duration in cash-flow terms in that their expected cash flows occur well into the future, but they have a low duration in mathematical terms (their values do not move in concert with interest rate movements). The reader is encouraged to review the “equity duration paradox” (as enunciated by Martin Leibowitz and others) to explore this theme. If one is seeking a “matching” portfolio, equities have no place in it.
The caveat of course if that there is no pure matching portfolio for going concern pension plans, with their inflation and demographic sensitivities. (The only perfect hedge is in a Japanese garden, as noted by Gene Rotberg). Portfolio construction is all about risk/return tradeoffs. If pension plans are sensitive to inflation or wage escalation, then real return assets are desirable. This brings us to the second argument.
“Equities are not well correlated to inflation.” The sad truth is that very few assets, if any, are well correlated to inflation. Real return bonds, which are linked to inflation not wage escalation, remain in short supply. Inflation-based derivatives are mostly linked to other markets, resulting in basis risk relative to Canadian inflation, let alone wage escalation. Pension plans are well advised to explore allocations to real estate, infrastructure and commodities to address inflation risk—a risk which certainly appears to be raising its head again if one observes the current prices of oil and food—but it seems unlikely that allocations to these asset classes will be sufficient to allow pension plan sponsors to turn their backs on lowly equity markets.
“The equity risk premium Is uncertain and volatile.” While an equity risk premium of 3% to 5% has been observed historically, the average risk premium depends on where one is in the economic cycle and the outcome is indeed quite variable. In the past, actuarial valuation techniques, which smoothed liability values, masked this volatility and allowed pension plan sponsors to take a longer-term view. New accounting standards will expose this volatility to full scrutiny. Many industry participants, including this author, have pointed out the benefits of diversifying the risk exposure away from public market equity risk premium to reduce this volatility in the future world where assets and liabilities will be marked to market.
Ironically, some of the alternative asset classes being considered as an alternative source of risk premia may still be correlated to public market equity risk (viz private equity, hedge funds with hidden beta). However these assets are not necessarily marked to market as efficiently as public markets and are thus able to take advantage of the smoothed valuation approaches. In these circumstances, the search for diversification may not actually result in a much more diversified portfolio, but simply in a portfolio that avoids the scrutiny of the new valuation requirements.
“Insurance companies reduced their equity allocations when they instituted asset-liability matching strategies.” Many insurance companies did indeed do this although some have retained the longer-term view and preserved allocations to equities and other alternative assets. The pressures on insurance companies to reduce equities were substantial: (a) capital requirements which created a return threshold of 300-400 bps (virtually the entire equity risk premium) for equities to breakeven relative to other asset classes in the search for return on capital; and (b) a mark to market tax for financial institutions which created immediate tax liabilities for unrealized capital gains on equities. The insurance industry faced pressures on its equity allocations far beyond mere accounting rules.
So what should pension plans do? Indeed plan sponsors may wish to consider reduced allocations to public market equities to reduce funding volatility. But unless they have identified other reliable sources of added value to replace the equity risk premium over the long term, they may find that they have reduced funding volatility at the cost of increasing funding costs, which will not serve anyone’s interests. Reductions in equity risk may simply be a strategy with short-term gain but long-term pain. Unless their circumstances require a shorter-term view, pension plans are long-term obligations with long time horizons and plan sponsors should act accordingly.