The Inconvenient Truth of Defined-Benefit-Pension Portfolios

In a perfect world, hedge assets would hedge, and growth assets would grow. The world isn’t perfect.


One well-tested axiom holds that pension plans should systematically reduce surplus volatility — the variability of funded status — as they reduce funding deficits. Indeed, when pension plans become better funded and reallocate more to duration-exposed fixed-income assets, they are following a course that serves as the foundation of liability-driven investing and the rationale supporting glide-path strategies. But ill-constructed interest rate–hedging portfolios that ignore the correlation with return-seeking assets are not only inefficient but can also actually increase surplus volatility as funded status improves. That’s defined benefit plans’ often overlooked inconvenient truth.

Many plan managers sort portfolios into rigidly determined buckets labeled hedge and growth, tacitly assuming that, come what may, hedge assets will hedge consistently and uniformly, and growth assets will grow consistently and uniformly. In the real world, though, investing is not that straightforward. The ideal composition of a hedging portfolio — say, a combination of Treasuries and long credit — depends on the size and the composition of the growth portfolio. Conversely, the ideal composition of a growth portfolio that combines equities and extended credit is a function of the size and composition of the hedging portfolio. The fact is that assets can manifest both hedge and growth characteristics, so sticking to static allocation mixes within either bucket can expose the total portfolio to unnecessary risks that could become more pronounced as a plan approaches full funding and adds to its hedge bucket.

The takeaway from our modeling research at J.P. Morgan Asset Management is clear and unambiguous. Plan sponsors should construct and manage pension portfolios holistically and not as two independent and uncorrelated buckets. We recommend the following:

• Underfunded plans seeking to close deficits should allocate more to return-seeking assets to generate asset returns greater than liability growth and pension expenses. Additionally, credit instruments beyond investment-grade credit — such as mortgage loans, high-yield and even credit hedge funds — would be expected to outpace liability growth but with a higher correlation to liabilities than occurs with what we call “growthier” asset classes like equities.

• Better-funded plans should allocate more to interest-hedging assets to reduce their surplus risk. Within the interest-hedging assets, allocations should increase exposure to long-maturity investment-grade credit relative to long Treasuries as they de-risk.


Portfolio managers should also consider the basic nature of pension investment assets: They earn their returns by gaining exposure to risk: broadly speaking, either economic risk or interest rate risk. Equities are almost entirely exposed to economic risk; their value will rise and fall with their earnings, which depend fundamentally on the state of the economy, and they bear negligible direct interest rate or duration risk. Treasury securities, contrary to popular perception, are not risk-free. They may have little exposure to economic or credit risk, but they are fully exposed to interest rate risk. That’s fine if the plan sponsor cares about the economic or accounting measure of their liability, which has high interest rate sensitivity. The most widely used basis for funding calculations, which averages bond yields over 25 years, does not, however.

A number of other assets occupy the wide space between growth and hedging extremes. When constructing a portfolio to reduce funded status volatility, a manager needs to evaluate the different risks associated with each asset class for a holistic allocation.

We find that increasing allocations to hedge assets in a formulaic manner — increasing the allocation to a static hedge bucket mix as the hedge bucket’s share of the total portfolio increases — does not automatically reduce volatility. To target lower funded status volatility, plans should diversify hedge allocations as they put more into their hedge buckets. Insurance companies have been doing so for decades.

Tony Gould is the global head of pensions solutions and advisory at J.P. Morgan Asset Management in New York.

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