De-Risking Amid Low Rates? Ditch Your Glide Path, Says Cambridge Associates.

(May 7, 2013) – It’s been a rough stretch for US corporate defined benefit (DB) CIOs: As the financial crisis eased, treasury bond yields began to dive and liabilities shot in the opposite direction.

Cambridge Associates has a message for you: It (almost certainly) gets better.

Future fixed income returns will very likely be higher than current ones, and plan liabilities promise to move inversely, the consulting firm says. That’s good news for all plan sponsors, of course, and particularly those whose de-risking efforts have been stymied—or made extremely expensive—by very low interest rates.

A research paper by the consultancy argues, however, that traditional glide paths fail to take this asymmetric risk profile sufficiently into account.

“Plans that elect to increase or maximize liability hedges are doing so at extremely depressed yields and are locking in very low future returns,” the authors explain, noting that employers will be on the hook for large contributions to pad meager returns.

Cambridge Associates’ argument against hedging liabilities at present echo the criticism many CIOs have levied against full pension-risk transfers: “Ultimately, plans increasing liability hedges today are doing so at a time when funded status tail risk from potential declines in interest rates is significantly lower, as rates quite simply have less potential for further declines given their already low levels,” the paper states.

Several leading consultants have told aiCIO that a slice of their clients have such a mindset. Many have apparently taken action on it by choosing to hedge smaller portions of their portfolios than glide paths’ normal ranges dictate.

In contrast, the Boston-based firm’s new paper offers a more aggressive approach to low rate de-risking.

The consultancy calls their strategy a “holistic glide path.” Whereas the standard approach relies heavily on long-date treasury bonds to dampen volatility, Cambridge Associates argues for also switching up allocations within the risk/growth side of the portfolio to spend risk more judiciously.

“We believe higher active risk strategies, such as low-beta hedge fund exposures and select private investment strategies, are capable of offering expected returns that are more attractive from a risk/return perspective,” the authors state.

A traditional glide path portfolio at 100% funding might be 75% liability hedge and 25% public global equities, according to the authors’ example. (This is somewhat heavier on equities than consultants typically estimate for a fully funded portfolio.)

In contrast, Cambridge Associates’ sample holistic strategy contains 65% liability hedge, 8% public equities, 21% low beta hedge fund, and 8% in private investments. In the current economic environment, returns would be equal between the two if the holistic path’s plan sponsor secured 105 basis points of alpha from its hedge fund program.  

“One key challenge of a holistic glide path is that higher active risk strategies result in significant implementation complexity,” the authors caution. “Alpha generation is not easily attainable and requires a sound and disciplined investment process.”