Amy Trainor, FSA Multi-Asset Strategist, Portfolio Manager, and LDI Team Co-Chair
Many DB plans concentrate their risk in two positions: They are long equities and significantly underhedged versus their liabilities. As a result, the key market forces that affect their funded status are equity returns and interest rates. We used those two variables to define the four economic scenarios shown below. Clear Skies is the optimal scenario: With equity returns and rates rising, both risk positions would be expected to pay off. But this environment has prevailed only a quarter of the time since 1973.1
The polar opposite of that scenario is a Perfect Storm, where falling equity returns and falling rates can threaten major funded status drawdowns. Ideally, plans would have minimal equity risk and fully hedge their liabilities to produce steady liability-relative returns in all environments (especially a Perfect Storm). But that might be unrealistic for those that desire some return to help offset costs and improve funded status.
We think plans that still desire some return above their liability can mitigate the risk of a Perfect Storm by diversifying their return-seeking portfolio with “bridge strategies” — investments that combine return-seeking and liability-matching characteristics, and that may offer low equity beta and moderate interest-rate sensitivity (duration). Examples include liquid infrastructure investments and unconstrained or credit-oriented fixed income strategies. We advocate holding a mix of bridge strategies that encompass varying levels of equity beta and rate sensitivity. This provides diversification and may better balance the portfolio across the Partly Sunny/Cloudy scenarios, in which equity returns and interest rates move in opposite directions. In these environments, the effect on funded status depends on which of the two variables dominates. Our research confirms that during periods when equity returns and interest rates have moved in opposite directions, traditional equity exposure has been about equally as likely to harm plan funded ratios as to improve them.1
For illustrative purposes only. Not intended as investment advice.
It is this uncertainty about what will work best in a Partly Sunny/Cloudy scenario that argues for a mix of bridge strategies. For example, in Partly Sunny scenarios, liquid infrastructure investments may have enough market beta to participate in rising equity markets, and may benefit from falling rates given their interest-rate sensitivity. In Partly Cloudy scenarios, unconstrained or credit-oriented fixed income strategies may be attractive for their low equity beta, even with modest rate sensitivity. Absolute return strategies may also help plans navigate different environments. Whether using stand-alone or portable alpha strategies, the key is ensuring that the returns are truly market neutral.
While these approaches might give up some upside relative to traditional equities in Clear Skies, we expect they would still outperform the liability and contribute to funded ratio improvement. Regardless of the specific strategies selected, the focus should be
on taking a more holistic approach to return-seeking assets that doesn’t count on ideal conditions for its success.
Contact information:
Amy Morse, Director of Pension Strategies
agmorse@wellington.com | 1-617-951-5655
1March 1973 – December 2016. Equities: S&P 500. Liabilities: 75% Bloomberg Barclays US Long Corporate Bond/25% Bloomberg Barclays US Long Government Bond | Equities up/down identified by direction of monthly return on S&P 500; up/(down) rates defined as months where yield on US 10-year Treasury rose/(fell) by over 5 bps | PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS AND AN INVESTMENT CAN LOSE VALUE | Sources: S&P, Bloomberg Barclays, US Treasury, Wellington Management
This material and/or its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities. Investors should always obtain and read an up-to-date investment services description or prospectus before deciding whether to appoint an investment manager or to invest in a fund. Any views expressed herein are those of the author(s), are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients.
