Last year’s strong equity performance and rising interest rates helped improve the funded status of many corporate pension plans, increasing their funding ratios 90 percent or higher.
Given this improvement, many plan sponsors are now looking for ways to protect their funded status by implementing derisking strategies. Liability-driven investing (LDI) strategies have long been a popular approach for buffering against increases on the liability side of the funding ratio, which has meant moving money away from risk assets, like equities, into long-duration bonds. By increasing a portfolio’s allocation to bonds, LDI strategies may help insulate plan sponsors from more volatile asset classes.
But because interest rates may rise from their present historic lows, LDI strategies face significant obstacles. With yields at such a low starting point, there is not much room for them to move lower, especially as the U.S. Federal Reserve scales back bond purchases, economic growth accelerates and inflation moves closer to normal levels. As interest rates rise, the market value of fixed-income assets falls. A decline in the value of a portfolio’s long-duration bond allocation tends to limit the funding ratio improvements associated with falling liability.
Because of the challenges LDI faces, we at KKR Prisma decided to conduct a study to determine if absolute-return strategies could potentially be a more successful alternative. The overarching purpose of the research was to better understand the interaction of pension plan assets and liabilities under differing investment strategies in a rising rate environment. We found that reducing risk using absolute-return strategies is typically more effective at protecting and improving the funding ratio than are LDI strategies because of the following typical characteristics of hedge fund portfolios:
Low volatility. An increase in the allocation to absolute-return strategies may help smooth out returns and reduce portfolio risk.
Low equity beta. Like LDI, absolute-return strategies may help offset unstable equity markets.
Low correlation to fixed income. Absolute-return strategies tend to have little correlation to rate changes, thereby avoiding the negative effects of interest rate sensitivity.
To test the potential effectiveness of LDI versus absolute return, we analyzed three possible strategies that could help reduce portfolio risk by considering their effect on the funding ratio for an accumulated benefit obligation (ABO).
The first strategy is a typical LDI approach, which increases a plan’s allocation to long-duration fixed-income securities. The second approach that we analyzed increases the allocation to absolute return by decreasing money allocated to risk assets. And the third strategy increases the allocation to absolute return by decreasing fixed income.
We found in our simulation that in a rising interest rate environment, 80 percent of the time funding ratios improved more with an absolute-return strategy than with an LDI approach. Furthermore, absolute-return strategies reduced the portfolio’s sensitivity to equity market dislocations, which decreased the volatility of the investment portfolio, thereby helping protect the funding ratio.
We also found that reduced funding ratios are more likely to be caused by weak equity markets than by persistently low rates, so by putting money in absolute-return strategies, which are less correlated to equity markets, plan sponsors can help immunize their portfolios against equity market downturns.
That’s not to say there isn’t an environment in which LDI strategies would work. We believe these strategies are likely to be most effective if rates fall well below their present levels and remain low. We don’t think that will be the case in the near future, however. The economy is improving, the U.S. government is pulling back quantitative easing, and we’re beginning to see longer-term inflation.
As funding ratios approach 100 percent, plan sponsors will want to preserve gains through some form of derisking. Despite a perception that LDI is most effective at mitigating volatility in a plan’s funding ratio, when interest rates have more upside than downside volatility, our research shows absolute return tends to better protect against a downward move in the funding ratio. For plans that have a 40 to 60 percent allocation to equities, absolute return’s low equity beta and low volatility may help protect against equity market dislocations. We believe absolute return can serve as a risk diversifier and a return enhancer because of these characteristics. Although our examples are based on a pension plan’s ABO, the results are equally applicable to a projected benefit obligation.
There are risks to any strategy, but we believe absolute-return strategies may be an effective alternative to long-duration bonds in a rising interest rate environment and will help managers best protect their newly earned gains.
Eric Wolfe is a member of the investment committee and senior portfolio manager responsible for portfolio and client management at KKR Prisma, a fund-of-hedge-funds firm, part of KKR, where he is a managing director, in New York.
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