Two hikers are walking in the forest when they spot a bear on the trail ahead. The first hiker freezes while the other calmly sets down his pack, pulls out a pair of running shoes and unlaces his boots.
“What are you doing? You can’t outrun that bear!” exclaims the first hiker.
“I don’t have to outrun the bear,” replies the other as he slips on the sneakers. “I just have to outrun you.”
This old joke makes an important point about defining objectives correctly. Leaving human decency aside for the sake of a good analogy, there is only one thing that matters for the hikers — not outrunning the bear but, rather, keeping one step ahead of the other hiker. It is not absolute speed that matters, only their positions relative to one another.
So what is the connection to investment strategy? Pension investors often face the challenge of meeting two conflicting objectives: delivering high absolute returns and managing risk relative to liabilities. Meeting the first objective typically means investing plan assets in return-seeking strategies that have high risk relative to liabilities. Meeting the second requires investing in long-duration bonds that effectively track liability values but also offer limited outperformance potential versus liabilities.
In practice, most pension portfolios engage in both strategies simultaneously — attempting to meet both goals in part, rather than either one in full. Unfortunately, in practice this approach has not produced the desired result. Despite the strong absolute performance of most risk assets over the past few years, liabilities have grown even faster. Declining interest rates have boosted liabilities, trumping strong equity markets. In retrospect, strategies focused on hedging would have done just as well — or better — with less risk.
But that is the past. The era of surging liability values is most likely behind us, as interest rates are already low and actuarial tables have recently caught up to the reality of long-lived participants. How should a pension investor think about return targets and risk management today? Reaching traditional absolute-return targets in the 7 to 8 percent range may be difficult, and even more so in the context of an appropriately diversified portfolio. Perhaps a more realistic goal is a relative one: outperforming the value of liabilities, by a smaller margin perhaps but with more diversification and less risk.
Consider a plan whose long-term objective is to outrun plan liabilities. The expected return on liabilities is similar to that of a duration-matched portfolio of high-quality corporate bonds. With low initial yields and the prospect of rising interest rates, expectations for liability growth going forward should be low. This may seem encouraging after years of surging liability values, but it also poses two critical questions to investors: First, how much should we adjust expected returns on other asset classes? And, second, what does flattening liability growth imply for asset allocation?
With regard to the first question, here’s PIMCO’s bullet-by-bullet answer (see chart 1):
• We expect that nominal asset returns will be lower than in recent historical periods — not just for bonds but also across most major asset classes.
• The relative positioning of asset class returns will be broadly consistent with traditional expectations, such as stocks being higher than bonds, emerging-markets higher than their developed counterparts and illiquid higher than liquid.
• Lower forward-looking returns do not imply lower forward-looking volatility, so the efficiency of traditional portfolio strategies that rely heavily on equity will likely be diminished.
With respect to the implications for strategic asset allocation, the following thoughts may be useful:
Active management is now more important. When beta returns are low, the importance of alpha increases, both on market-oriented strategies such as stocks and bonds and on alternative assets. Passive strategies may become more costly, given their inability to add excess return.
Liability hedges work in all markets. Maintaining an allocation to long-duration bonds is entirely consistent with seeking outperformance versus liabilities in a risk-focused manner, particularly if these strategies can deliver positive alpha relative to their benchmarks.
Reduce inefficient assets first. In a lower-return world, asset classes with high tracking error to liabilities will be increasingly hard to justify on a risk-adjusted basis. These assets should probably be the first to be reduced in the event that plan performance allows for additional derisking.
Maintain flexibility with liquid strategies. It is important to have the flexibility to shift into hedging strategies if and when funding improves materially. Maintaining liquid investments in a nonhedging portfolio can help provide a ready source of capital to fund increases in liability-driven investing.
Overlays can be a useful tool. Strategies involving derivative overlays (equity or rates) provide a measure of leverage that can help improve risk-adjusted returns and may allow for nimble rebalancing in response to market moves.
Illiquidity can be a driver of return. Illiquid investments need to be treated with care but should not necessarily be avoided altogether, given their potential for higher risk-adjusted returns. Pensions typically do not face large capital draws, except in the case of accelerated lump-sum payouts, which are typically known well in advance.
Look for Assets to Deliver Lower Returns but Not Lower Volatility
Source: PIMCO (as of June 2015)
The need for performance on the asset side of the pension balance sheet remains, but the market environment that we foresee will likely make achieving those returns more challenging than ever. On the flip side, flat or rising interest rates should keep liability growth at modest levels going forward. Investors should be cautious about reaching for high absolute returns in this environment, because the amount of risk required to meet historical expectations may be excessive. Instead, a strategy that seeks modest outperformance and lower risk versus liabilities will provide more flexibility to invest across a diversified range of asset classes and, we believe, a greater probability of success.
Jared Gross is an executive vice president and pension solutions strategist at Pacific Investment Management Co.’s New York office.
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