Owing to low interest rates, pension plans that have increasingly turned to less risky, longer-duration, fixed-income assets may find themselves locking in very low future returns, says a new report out Cambridge Associates, the Boston-based investment consulting firm.
Specifically, states the report: “Many market participants advocate de-risking plans, or ‘glide paths,’ whereby exposures and/or risk profiles are adjusted over time based primarily on changes in the funded status. Typically, these glide path blueprints de-risk as funded status increases by re-allocating funds out of the growth assets and into the liability hedge.”
That works in normal market conditions, says Cambridge, but it won’t work given current market conditions, where as of December’s end, for example, 10-year Treasuries yielded 1.76 percent, nearly 5 percentage points below their 50-year average, and 30-year Treasuries yielded 2.95 percent, nearly 4 percentage points below their 50-year average.
So what should pensions be doing to ensure they’re generating enough in the way of returns? Cambridge suggests a less “mechanical” approach to risk reduction (i.e, automatically reducing risk the closer it becomes to reaching a fully funded state). Instead, Cambridge’s research suggests pensions would be wise to do more to “define and control the risk” within their growth assets, including by turning not merely to public market equities but also “active strategies that rely on manager skill and non-traditional sources of beta” including hedge funds, distressed credit, and other private investments.
Of these alternatives, Cambridge suggests “low-beta hedge fund strategies and “very active long-only strategies” among other things.
Unsurprisingly, Cambridge also warns that its “more holistic” technique isn’t exactly cheap to implement. Because the approach is “complex,” it requires “adequate resources for proper manager selection, implementation, and monitoring, as well as a robust investment process to ensure effective implementation…”
To learn more, you can read the paper in its entirety here.
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