This dramatic improvement raises a key question for these schemes: How should they adapt their asset allocation to defend these gains? This is a live issue. U.S. equity valuations are stretched — the Shiller PE ratio is close to its dot-com era peak — and recent equity strength is concentrated in a handful of tech growth stocks. The downside risks are obvious.
We believe a combination of options strategies can provide a way for DB funds to protect their recent gains and significantly increase their chances of completing the journey toward 100% funding of scheme liabilities within five years.
The optimal asset allocation for a pension fund changes as its funding status evolves. Those that are materially underfunded tend to follow a risk-seeking allocation more weighted to equities, while those that are fully funded usually hold a preponderance of fixed income to match their liabilities. Many funds today are between these extremes: approaching funded status but not quite there yet. They need to generate further gains but do not necessarily want to maintain the full downside risk of an equity position. The closer they get to their target, the smaller their tolerance for downside risk becomes.
These funds, therefore, have a non-linear risk appetite. However, most risk-seeking assets (public and private equity, real estate, alternatives) are linear in nature: they have return distributions that are roughly symmetrical around their expected return (or if anything, negatively skewed).
To match their non-linear risk preference, pension funds must gain exposure to assets with a non-linear return profile. Our favored way to achieve this is by changing the fund's asset allocation to incorporate options strategies that are very likely to outperform in neutral or negative equity markets, albeit they may underperform in buoyant conditions.
We have identified four strategies we believe are particularly suited to protecting accumulated gains while retaining upside exposure.
Put selling is designed to replace an equity allocation with a strategy that sells put options with equivalent notional value on the same or similar underlying equity exposure. The premium income should allow the strategy to outperform if equity markets fall or go sideways.
Tail hedging invests in defensive options such as puts or calls on the CBOE Volatility Index (VIX) with the goal of achieving outperformance during severe drawdowns. These events can seriously damage funding ratios because equity values and discount rates usually decline simultaneously. Investors accept the cost of running this strategy in normal markets in exchange for the benefits it delivers during sell-offs.
Dispersion strategies sell index options, which tend to be relatively expensive due to structural demand for hedges, and buy relatively cheaper single-stock options. Pension funds can use this strategy as a form of lower-cost or positive carrying put option, as the strategy aims to earn carry from the differential in expensiveness while historically benefiting during periods of rising market volatility as the single stock volatility purchased outperforms.
Finally, funds can adopt a defensive version of trend following that focuses on risk-off trends and has performed well in falling equity markets.
In our modeling, we replace half the 50% equity allocation of our model pension portfolio with an equivalent notional value of put options and spend 0.5% of the portfolio's notional value on a tail hedge. Additionally, we shift half the portfolio's 10% allocation to alternatives to a dispersion strategy and the other half to defensive trend following.
Assuming our example portfolio has an initial funding level of 90%, we find that these options strategies increase the probability of reaching full funding in five years from 57% to 81%. However, if equity markets make annual returns of 10%-plus, the original portfolio outperforms.
DB pension funds approaching full funding status face difficult choices over how to manage the final phase of their journey. Continuing their current asset allocation is a risky bet on equity markets continuing to rise.
A significant market correction could rapidly erode pension funding ratios, as happened in 2008. It has taken more than a decade to recover those losses. However, there are ways to reduce exposure to the direction of equity markets and so increase the probability of achieving fully funded status. We believe that well-funded pension funds would be wise to consider adjusting their approach to their equity allocation at the current time.
Tom Leake is managing director and head of solutions at Capstone Investment Advisors, based in London. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.
