INVESTMENTS
M
arket returns have been
strong recently, helping
to close funding gaps
and improve pension
plans’ funding status. From March 1, 2009,
to Oct. 31, 2013, the Russell Global Index
produced a 16.72% annualized return, and
the S&P/TSX Composite Index produced
a 14.56% annualized return. Bonds have
provided solid returns as well, with the
DEX Universe Bond Index returning
5.35% since the crisis and 5.44% over the
past decade.
Meanwhile, economies are starting to
look brighter. For the first time in a
number of years, there may be synchronous
positive growth from the world’s leading
economic engines (China, the U.S., Japan
and Europe); the political circuses in
Europe and the U.S. have abated for the
time being; and central banks continue to
provide significant support for economies.
Pension funds need to take a
certain amount of risk in order to
meet their pension obligations.
But how can they do it
intelligently in an uncertain
environment?
By
THINKSTOCK
Rob Balkema and
Tom Lappalainen
However, pension plan sponsors still
have to deal with the effects of market
dislocation from the global financial crisis,
which continue on a number of fronts.
Capital market return assumptions are low,
yet return requirements remain high in
order to close plan funding gaps
and/or maintain funded ratios. Return
expectations are lower across asset classes
because interest rates are low. And
underlying structural issues that raise
questions about the strength and resilience
of even the largest and most prosperous
economies have yet to be resolved, creating
a backdrop of volatility as markets switch
between greed and fear on any hint of
good or bad news.
Since the early 1990s, the Federal
Reserve Bank of Philadelphia has
conducted a survey of professional
forecasters, asking what they believe
a traditional portfolio (60% equity,
40% bonds) could achieve in the coming
10 years. In 1992, the forecast was an
8.7% annualized return. Today, that
10-year annualized forward-looking
forecast is 5.2%. This is a significant
drop for plans whose benefit funding
return requirements have not moved in
a similar fashion.
The financial crisis brought home a new
reality to investors: what worked in the
past is no longer the best way to run
portfolios in the future. Pension investors
now have a fuller appreciation of their true
risk tolerance, yet they realize that they
may have to take on more risk than they’re
comfortable with in order to meet their
36 / January 2014 • BenefitsCanada
BenefitsCanada
BenefitsCanada
• January
• May 2012
2014 / 37
return objectives. So how can they make
sure they’re taking these risks with their
eyes wide open?
Risk Review
Pension plan investors need to consider
portfolio risk from three different
viewpoints: how much risk they want to
take, how much risk they need to take and
how much risk they can actually survive.
With low-return estimates for capital
markets, the only ways to realistically
meet return targets are to move up the
risk spectrum and/or to make assets work
harder and smarter.
In a challenging low-return
environment with a large amount of
volatility, intelligent risk-taking requires
a change in mindset, portfolio exposures,
asset class weighting and portfolio
management. With this in mind, here are
five recommendations for pension plan
sponsors to consider.
1. Change risk mentality and realign the
portfolio with the plan’s goals.
Somewhere along the way, the investment
community lost focus: tracking error and
2014
excess return became the main goal of
investors and pension committees. The
crisis quickly taught pension investors that
being down 25% in a down 26% market
was not the outcome they wanted.
Excess return or tracking errors tend to
be poor proxies for the plan’s ultimate
objective. Assets should be aligned with
what the plan is trying to achieve and
take into account its real required
outcomes. Rather than defining success in
terms of tracking error or excess return,
plans need to realign portfolios with real
return and total risk goals that align with
their mission, or create specific liabilitymatching portfolios that focus on the
final outcome.
2. Change risk exposures. Traditional
asset classes have low-return expectations,
and a 60% equities/40% bonds mix will
not provide the necessary returns or
diversification. Home-country biases have
proven to be suboptimal, yet these biases
remain in many pension portfolios because
what’s familiar is what’s most comfortable.
For real diversification, plans should
consider shifting or increasing their
exposure to diversifying assets such as
infrastructure, futures-/options-based
volatility management strategies and
foreign equity. At the same time, lessfamiliar sources—such as emerging market
debt or frontier market equity—can
potentially provide needed returns in a
low-expectation world.
3. Manage risk holistically. Focusing on
excess return at the asset class level has
also caused the investment community to
focus on managing each asset class in
isolation (e.g., this is the best Canadian
equity portfolio; this is the best core bond
portfolio, etc.). While each “slice” was
optimally constructed to meet its goal of
beating the Canadian equity or bond
index, the total portfolio focus became a
fallout of several individual optimizations
rather than one at the total portfolio level.
Portfolios need to be managed from a
total plan perspective, taking into account
both cross-strategy risk and the
devastating impact of low-probability tail
risk events and how they affect the
likelihood of meeting portfolio goals. This
means using risk management and
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hedging techniques across asset classes,
rather than relying on the simple
aggregation of outcomes from individual
portfolio sleeves.
4. Use active management intelligently.
Market returns alone are insufficient for
most investors to reach their investment
objectives. In a world where 9% returns for
equities are forecast, 1.5% excess return
seems inconsequential. With domestic
equity returns forecast to be 7% over the
next 10 years and domestic bond returns
forecast to be half of that figure, the 1.5%
is suddenly a large proportion of the total
return. Every basis point really does count.
Investors have traditionally focused on
choosing active or passive—but now they
need to choose active and passive. Skilled
investors and exploitable opportunities
undoubtedly exist, but the challenge is
identifying them in advance. Where to be
active is an important consideration, but so
is when and how.
On the when front, active strategies have
cycles, just as economies and markets do. It
is possible to invest in a successful strategy
but end up with very poor performance,
due to poorly timed entry and exit points.
Carefully timing and combining active
strategies requires a clear understanding of
performance cycles and pitfalls.
With regard to how, going passive
doesn’t just mean buying standard market
index exposures. Smart beta strategies are
best described as rules-based investment
strategies that are designed to provide
exposure to market segments, factors or
concepts. The first representation of smart
beta was the creation of growth and value
indexes, but, more recently, more complex
vehicles such as low-volatility equity have
been developed. These smart beta
strategies can be combined to create a
custom passive completion portfolio,
which, when applied in combination with
an existing total portfolio, can provide a
more precise method for managing total
portfolio risk and return.
5. Assess risk management daily.
With high market volatility driven by
unsettled economic and political times—
and the unprecedented speed with which
new information affects market prices—
opportunities are fleeting, and risks are
everywhere. Portfolios need to be nimble
through shorter idea-to-implementation
time lags, allowing for proactive risk
management in real time rather than
reactively after each quarter.
If recent markets have taught investors
anything, it’s that small exposures can
result in outsized returns—or outsized
risks. By seeking to track and control the
magnitude and direction of these
exposures, pension plans can reduce
volatility and better focus their portfolios.
Pension investors should replace blunt
equity/fixed income trade-offs with a
forward-looking solution. An intelligent
risk-taking strategy involves integrated,
purposeful and continuous management of
the total portfolio, targeting total
objectives, managing aggregate risk
exposures and using a rich tool kit of
investment capabilities.
Rob Balkema is portfolio manager, multi-asset
solutions, and Tom Lappalainen is director,
strategic advice, with Russell Investments
Canada Ltd. [email protected];
[email protected]