Session 11 – The Future of DC Investing
How today’s risk considerations will drive tomorrow’s asset allocation models.
By Chris Walker, Vice-president, Institutional Investments, Invesco
Portfolio hits or drawdowns are a major detractor from member retirement adequacy because it takes years to recoup the losses. Today’s asset allocation models aim to provide growth but do not defend a portfolio. Losses in 2008 (and before that, in 2001) are recent proof that asset allocation, target risk funds and TDFs—positioned as diversified risk-managed options—are incomplete. There are two key strategies that we can use to address this issue.
First, as with large DB plans, we need to look at adding non-correlated asset classes to the mix. Equities—which have three times the volatility of bonds—expose plan members to a high level of risk. In most asset allocation portfolios, equity risk dominates (for example, 90% risk contribution in a 60/40 portfolio). This is why TDFs and related products have taken on such large losses in the past. We must reduce the risk that a member takes but still provide the upside capture. This can be accomplished by adding another asset class.
A simple but powerful framework for assessing asset classes is to understand how economic environments affect their performance. Growth and recession are obvious factors; however, within periods of growth, inflation has a major impact on assets. During times of non-inflationary growth (e.g., the ’80s and ’90s), stocks perform best. In a recessionary environment (four years out of the last 35), long-term bonds offer protection. In periods of inflationary growth (e.g., the 1970s), commodities have historically outperformed stocks and bonds on a risk-adjusted basis. So commodities should be considered, as they’ve historically provided good returns over cash with low correlation to stocks and bonds, as well as offering an inflation hedge.
Next, we should look at the current methodology used to allocate assets. Traditional asset allocation modelling is based on the long-term mean performance of the assets. However, this model is not precise enough, as the actual range of returns is quite wide. On average, stocks have outperformed cash by 3% over the past 35 years. However, over shorter time frames—for example, a three-year period—returns can range from 30% on the upside to 20% on the downside. Those large downside swings are the drawdowns that can be so detrimental to a member’s wealth accumulation.
If the current methodology results in too much risk, why not control risk by turning that equation around? Instead of focusing on an asset allocation approach, a better way to build portfolios begins with a risk allocation strategy. Using three asset classes rather than just two, we evolve the mix, starting with risk (Figure 1, see PDF). Instead of a portfolio dominated by equity risk, we now have a portfolio with risk deployed equally across the three asset classes.
The high degree of diversification in a risk-balanced portfolio means that it can have a substantially higher Sharpe ratio (i.e., higher returns in excess of cash for the risk being taken) than traditionally allocated portfolios. It may also be able to minimize the excessive losses associated with equity-dominated portfolios, potentially without a loss in expected returns.
Compared to current asset allocation products, members get stronger risk-adjusted returns and minimal drawdowns if they can direct their savings to a risk-balanced product. By offering this type of investment option, plan sponsors can help members to generate healthy total returns, defend against substantial portfolio losses and stay on a maximum retirement income track. BC
Continued on the next page…
Session 12 – Leading Practices in Pension Committee Management
Lessons learned from The University of Western Ontario’s experiences.
