Making the most of risk
Strategic asset allocation is the key decision for pension funds. How much to allocate to equities and to bonds is and always has been the most important driver of returns for funds.
The long term nature of pension investing has dictated that funds typically review their strategic allocation every three years. However, we now believe that this should be a far more dynamic process. At the same time, we propose turning the traditional approach on its head. Pension funds should first of all not be allocating assets, but allocating the risks associated with these assets.
Why is the old approach no longer viable? There are several reasons. Three years of shrinking assets and ballooning liabilities have left pension funds painfully aware of risk.
At the same time, faster-changing conditions demand a more flexible response. This means that pension funds urgently need to increase the frequency of their asset allocation reviews. New conditions can change funding status, or offer market opportunities, such as the right trading terms for a long-term shift from equities into bonds. For these reasons, pension funds should still take the long view but sometimes act with short-term considerations in mind.
Shorter-term flexibility may also be appropriate because the sponsoring employer has become risk averse for corporate reasons. Companies are starting to recognise that the investment policy of their pension plan has a direct effect on the corporate bottom line, and also on the company’s ability to honour its pension promises to plan members. From the corporate viewpoint, the pension fund is a risk that needs to be evaluated alongside the company’s other business risks, and that should be equally subject to frequent reviews.
So the need for more dynamic asset allocation goes hand in hand with a new focus on risk. The two are tied together in the risk budgeting process. In our view, this should be the starting point for setting a strategic asset allocation.
What exactly is a risk budget and how does it work? Pension fund risks go by many names – equity risk, duration risk, currency risk, manager risk, to name only a few. It is the fund’s exposure to these risks in aggregate that make up the risk budget, and that need to be allocated, monitored and controlled. Analysing the portfolio in this way allows pension funds and their sponsors to see how much risk their fund is taking, and decide whether the risk budget is being ‘spent’ in the right areas.
The risk budget figures enable corporate representatives and fund fiduciaries to quantify the potential risk of the pension fund both in terms of risk against liabilities, and of risk of loss using value-at-risk (VAR) measures. Those risk numbers can then be ‘spent’ in different ways through varying asset allocations and manager structures. All other things being equal, a lower risk budget improves the security of members’ benefits, while a higher risk budget holds out the potential for higher expected returns – and correspondingly lower cash contributions.
This approach gives funds the opportunity to produce better investment efficiency than in the past because it encourages them to diversify their sources of risk and return. The asset class divisions that pension funds have focused on in the past still matter, but going forward it will be more meaningful to think in terms of risk exposures – to manager skill, credit and liquidity, as well as to equities and bonds.
Looking at risk versus liabilities should lead funds to regroup these risks in terms of ‘safe’ (or matching) assets and ‘growth’ assets (those with an expected risk/return above liabilities).
Thinking about asset allocation in this way opens up new horizons for pension funds in the shape of strategies and tools to manage risk and add value. Among the strategies we are particularly interested in at present are ‘ten-year’ mandates. These are long-term mandates - mainly in equities – with a target performance based on absolute returns (inflation or liabilities plus a specified return) rather than a precise benchmark. They have low turnover and are heavily reliant on manager skill. So far we have helped pension funds, with the appropriate governance structures to implement several of these mandates.
Another way of exploiting manager skill is to give selected managers the discretion to invest across a wide spectrum of asset classes, including alternative strategies, again with an absolute return performance target. This approach gives managers the freedom to add value in three key areas – asset allocation, market timing and stock selection. We appreciate that there are limited numbers of managers with these diverse skills, but our research has turned up some interesting possibilities.
We are also exploring with our clients the use of derivatives to manage risk and return. Two strategies we favour at present are the use of inflation-linked swaps to create a return and risk profile that is a closer match for a fund’s liabilities. We like the potential offered by equity options, which can reshape the equity risk and return profile of a portfolio.
All of these strategies fit well within a risk budgeting framework, and a more dynamic approach to strategic asset allocation. Critical to this process is how frequently the different elements need to be reviewed. The old asset liability model was based on the fund’s liability structure, maturity and risk appetite, for which a three-year view still works well.
However, a one-year view is more appropriate when considering changes in funding status affected by market movement of assets, or in the employer covenant that may result from a changed corporate appetite for risk.
The investment opportunity set also needs to be reviewed annually. We have been through a period of unprecedented change in the equity/bond relationship, and so it makes sense for pension funds to re-examine their strategic asset allocations in light of changing conditions. In some cases, funds may want to benefit from temporary valuation anomalies.
Pension funds that want to change their strategic allocations have several choices for making the move. The first choice is to make the change immediately and in full, which makes sense if the change is small, or requires swift action to benefit from the strategy. In general, however, it is better to phase in the change over a period of time in order to average switching terms over several dates. This helps to minimise concerns about the risk of switches at inopportune times.
Another option is to make the change at some trigger point or points in the future, depending on market conditions and funding status. This option does require a view on timing, which can be tricky, but makes sense at present for funds interested in switching from equities to bonds, as the terms are still unattractive.
Nick Watts is European head of investment consulting at Watson Wyatt