Traditional derisking approaches result in different risks. When it comes to mechanically shifting assets into liability-matching assets from equities and other growth assets, a plan does, on the one hand, reduce funding risk. But in the current environment of fixed-income overvaluation and very low interest rates, this can actually result in a significant decline in expected returns. Therefore, the likelihood of locking in higher ongoing contributions presents considerable financial risks and strains.
Given these risks, some plan executives are beginning to reconsider the traditional approach used to control and reduce risk, and they are re-evaluating what they are getting for the resources they are allocating to the process.
A number of plans, including larger and more sophisticated ones, are employing derisking approaches that also focus on adding alpha and unique betas — and thus increase returns and reduce pension contributions and expenses — while at the same time moving plans to a lower risk position.
Sophisticated investors are exploring derisking levers that go beyond simply increasing the fixed-income allocation. In effect, these plan executives are looking to use more levers to reduce risk, not just the single lever of systematically shifting funds to the fixed-income allocation from the growth allocation. Instead, they also are looking at levers that can help meet the objective of maximizing return at each targeted level risk.
One potentially effective approach is an alternative glidepath — a more holistic one — that achieves the competing goals of reducing funding level volatility and drawdown risk while generating superior returns. A holistic glidepath not only assesses the amount allocated to growth and fixed-income assets, as the traditional glidepath does, but this approach also defines and controls the risk within the growth assets. It involves using growth assets that emphasize active strategies that rely on manager skill and non-traditional sources of beta — such as long/short equity funds, arbitrage hedge funds and select private investments — rather than directional equity market exposure.
A more holistic glidepath with an alpha-driven growth portfolio requires more thorough governance. The holistic approach does not necessarily demand more resources or greater cost than what institutions are already deploying for the more traditional glidepath and standard risk management approaches. However, more advanced resources are needed to execute effectively. One can argue that adoption of the holistic alternative requires more thorough governance. In many cases, employing this approach will result in better allocation of resources, better risk management, much lower institutional cost and, thus, significantly improved fiduciary oversight.
During the 2008 financial crisis, the holistic approach fared better than the traditional glidepath at protecting funded status at each level of targeted risk, based on the experiences of Cambridge Associates clients. The merits are especially apparent in the current environment of low rates. Carefully moving some growth assets into strategies that derive a significant amount of returns via alpha, or manager-added value, rather than directional equity market exposure can potentially allow a sponsor to keep more assets in the growth portfolio. Furthermore, the plan can operate at the same funded status risk level as the simpler glidepaths while generating higher returns. The kinds of strategies that the growth portfolio may take on include low-beta hedge funds, very active long-only strategies and select private investment opportunities.
A holistic approach focused on generating alpha might mean greater protection of funded status level and lower contributions. The table shows the asset allocation for the average corporate defined benefit plan and Cambridge Associates' 10-year forward looking return for that “average” pension plan. In its 2012 U.S. Corporate Pension Survey, Greenwich Associates found there is a significant return gap (320 basis points) between the 10-year forward looking return of 4.1% and the average plan's targeted return of 7.3%. Being forced to cover this return gap will cause significant strains on many sponsors. For instance, if a billion-dollar plan sponsor does not adapt its strategy or generate significant alpha, it would have to make up for this return gap via contributions of $32 million a year or $370 million over 10 years.
Because the holistic alpha-focused approach does involve greater exposure to active managers, including alternative asset classes and strategies, it also entails implementation complexity and higher manager fees. And while alpha certainly is a zero-sum game, we have found that institutions that use this holistic approach, by deploying the appropriate skill and expertise, reap handsome rewards in terms of higher returns and reduced contributions at lower levels of risk.