The Forgotten 70% might be better served by building efficient portfolios that reflect their individual risk profiles, and which they can alter as circumstances and risk tolerance change.
Plans can start by defining their unique tolerance for funded status risk. This is informed by several variables: current funded status, the size of the plan relative to the sponsor's balance sheet, the size of potential contributions relative to the sponsor's expected free cash flow, and the correlation of the sponsor's operating risks with the pension plan's assets.
Portfolio construction can then begin. It should focus on controlling risk both within and between the growth and liability-hedging portfolios. Many successful plans work to diversify growth assets among non-traditional sources of beta and high-alpha-potential investments, an approach that can help them achieve a higher expected return than the typical glidepath approach — with a comparable (or in some cases, lower) level of risk.
More specifically, hedge funds and active long-only strategies can play a powerful role in the Forgotten 70%'s portfolios. Alpha-focused hedge funds that are less directly correlated with equity market returns can be especially useful for some pension plans. (Of course, stringent due diligence and manager selection are key when evaluating and allocating to hedge funds.)
In addition, plans with longer time horizons and lower current liquidity needs might benefit from growth-oriented strategies such as private equity, venture capital and opportunistic credit, which can generate returns well in excess of public equities.
For instance, a defined benefit plan that implements a passive equity and liability hedge approach — as often used by mechanistic glidepaths — might need to have a 50% allocation to low-returning liability hedging assets to balance a 50% allocation to passive equities to stay within its risk tolerance.
Unfortunately, this strategy might result in returns below a plan sponsor's performance goals, and the return gap could become larger as the sponsor adheres to the typical glidepath over time. For example, for a hypothetical $1 billion plan, the return gap of 150 basis points between a 6% and 7.5% expected return translates into $270 million shortfall over 10 years. This is the pain of the mechanistic glidepath approach, and this gap would have to be covered by increased contributions.
Using a holistic risk management approach, plans integrate high value-add managers and strategies into their growth portfolio, diversifying directional equity beta exposure and therefore allowing a higher overall allocation to growth assets. Critically, despite higher allocations to growth assets relative to the mechanistic approach, it is possible for resulting allocations to produce higher expected returns with lower expected risk.
In short, holistic risk management strategies provide additional levers to control surplus risk and generate excess returns. For the 70% of U.S. defined benefit pension plans that are accruing benefits or accepting new participants, it's worth keeping this in mind — and remembering that the one-size-fits-all glidepath approach could be a dangerous cop-out.