Pension investors world-wide are rethinking their approach to investment policy and are becoming more liability focused. In other words, investors are viewing their liability stream as the true benchmark, and designing investment policy accordingly. Liability-oriented investment policy can reduce swings in pension funding status and put contribution policy on a sounder footing. As plan sponsors evaluate this issue, alpha-producing strategies will become more prominent.
Liability-oriented investment policy starts with an understanding of the risks in the liability stream. Defined benefit pension obligations are usually thought of as a stream of payments over time that the plan sponsor must make. The current economic value of these obligations is calculated by discounting them using a market-based term structure of interest rates. Since the value of these obligations is tied to interest rates, the sensitivity of the liability
is tied to changes in rates as well. The value of longer-dated obligations is more sensitive to interest rate changes than shorter-dated obligations.
Because the value of pension obligations is sensitive to interest rates, it is tempting to view pension liabilities as bonds. However, while interest rates are the dominant source of risk in pension liabilities, there are other risks that pension investors must consider. For example, actual pension obligations paid by any particular plan sponsor are quite likely to differ from the actuarial projections. These differences could be due to the impact of different mortality rates, alternative actuarial models or differences in realised wage inflation, among other sources. Although the magnitude of these types of risks is likely to be small relative to the impact of interest rates, they play an important economic role in the design of liability-oriented investment policy. Principally, these types of risks drive the demand for asset classes and strategies that deliver a return above the return embedded in interest-rate-sensitive investments.
Understanding the sources of risk in liabilities offers a backdrop for thinking about the asset side of the equation. Ultimately, plan sponsors hold asset portfolios structured to help them pay pension liabilities. Once investors start treating liabilities as their ‘true’ benchmark, the structure of the asset side of the portfolio has two clear purposes: hedging interest rate risk and generating return. These dual purposes serve us well in thinking about how to structure a portfolio.
For example, suppose that a plan sponsor simply invested in a bond portfolio whose exposure to interest rate risks matched the liability stream. Clearly, this portfolio would hedge the impact of interest rate changes. Furthermore, because this portfolio would be held exclusively in bonds, the correlation between the return on the asset portfolio and the changes in value of the liability stream would be nearly perfect. However, this portfolio would suffer a serious drawback: because it is invested only in bonds, it would not generate sufficient return to compensate for the other, non-interest rate, sources of risk. Moreover, the lower return associated with the bond portfolio would generally be insufficient to cover all of the costs associated with the liability stream.
On the surface, it looks like pension investors are in a bind – trading off return generation in order to hedging the interest rate sensitivity of their liabilities. Fortunately, modern capital markets offer a solution to this dilemma. Interest rate sensitivity of liabilities can be hedged with instruments other than bonds – most notably, by using interest rate swaps.
Using instruments like interest rate swaps is quite straightforward: the capital that would otherwise be allocated to bonds can be allocated to strategies or asset classes that can generate a return above bonds. In other words, any capital that is not used to collateralise a hedging portfolio can now be used to invest in a return-generating portfolio. This is where alpha-based strategies can have the most impact.
What drives the allocations in the return-generating portfolio? As with other kinds of portfolio problems, the allocations in the return-generating portfolio are driven by the risk and return assumptions of the strategies and asset classes under consideration. In thinking about the composition of the return generating portfolio, it is helpful to discern between the returns (and risks) associated with passive exposures to the global equity markets and those associated with active strategies.
The return to passive exposure to global equities represents a real stake in the global economy. As long as investors believe that the real economy will continue to grow, it is safe to assume that over the long term, passive returns to global equities will be positive, although there is volatility in these returns over different time horizons.
Active returns (or alpha), by contrast, represent the returns to deviations from a passive exposure to global equities. These returns are generated by the use of skill to identify and exploit opportunities to deviate from a passive portfolio. Examples of the use of skill can come from market inefficiencies, the impact of institutional constraints or structural anomalies. Skilled returns are, by definition, hard to achieve.
A clear benefit to investors of skill-based strategies is that they can be uncorrelated with market movements. The implication of this is that the return per unit of risk of the return-generating portfolio can be significantly higher than that of a passive exposure to global equities, as long as the investor believes that opportunities exist that can be exploited and that they can identify skilled managers.
For example, suppose that an investor is targeting a return (in excess of liabilities) of 200 basis points. If the excess return to global equities is 350 basis points, then the investor should allocate 57% to global equities and 43% to cash. However, the return to global equities has some volatility, which we’ll fix at 16.5%. Dividing the return of 200 basis points by the volatility of 9.41% (or 16.5% times 57%) produces a return per unit of risk of about 0.2.
Let’s assume that the investor has access to skill-based strategies. These might come in the form of traditional strategies, hedge funds, private equity or overlay strategies. Suppose that in the aggregate, the investor believed that skill-based strategies can also achieve a risk-adjusted performance of 0.2. If the investor can scale up the active risk to any level, then an optimal portfolio would have 43% allocated to cash, 29% to passive equity exposure and 29% allocated to skill-based strategies. The total portfolio volatility is now 6.7%, and the return per unit of risk is 0.3. Adding skill-based strategies can have significant benefits to investors, both in terms of risk reduction and diversification.
Realistically, investors cannot always scale up their active risk levels to any level, and identifying sources of skill returns is challenging. However, this example does highlight directions investors should focus on, as many have recently decreased their long-term return expectations for global equities. Investors no longer have the same ability to achieve their portfolio return objectives by relying simply on passive market returns: they must identify new sources of return. More specifically, they should focus on finding pockets of the capital markets where skill can be employed, identifying managers who can exploit these opportunities and relaxing constraints on their ability to generate alpha.
The implication of skill-based strategies in liability-oriented investment policy design is relatively straightforward. Investors should identify the interest rate risk inherent in their liabilities and create a portfolio of interest rate sensitive instruments that best hedges these risks.
Once the capital allocation for the interest rate hedging portfolio has been determined, the investor is free to develop an efficient portfolio to match the target return (in excess of liabilities). All else equal, lower return expectations for global equities is likely to produce higher allocations to skill-based strategies.
The continued development of hedging vehicles means that this approach can be easily implemented. In today’s capital markets, it is reasonable for plan sponsors to ask their managers to manage around a more detailed description of their liability stream. The net result is a portfolio that is customised to the needs of the plan sponsor, minimising the impact of interest rates through synthetic exposures, and seeking to achieve its objectives by using skill-based strategies.
Widespread availability of new and different hedging tools means enable investors to develop long-term strategies that better match their needs. This dynamic sets the stage for skill-based strategies to pick up the slack.
Kurt Winkelmann is co-head of global investment strategies with Goldman Sachs Asset Management in New York