Pension plans have had a rough go of it lately. In their year-end 2015 reports, many plans have recently posted muted or even negative asset returns. Some are experiencing negative cash flow as benefit payments to participants exceed contributions from sponsors. For others, the cost of maintaining their plan has been on the rise.
What’s more, the market volatility during the first quarter of 2016 has moved many pension portfolios away from their strategic asset allocation targets. Periodic rebalancing of a portfolio is often viewed as an effective risk management exercise. With this strategy in mind, here are four ideas for pension plans to consider as they steer through turbulent markets:
Rebalancing policies: Doing something may be better than doing nothing. Year-to-date capital market moves have shifted some plans away from their strategic asset allocation targets and has led some plans to revisit their policies around when and how to rebalance their portfolios. We have observed that having some type of rebalancing policy, whatever that may be, and following it may be preferable to simply letting asset allocation drift with market movements. Whereas some plans may be concerned about the transaction costs involved with rebalancing or the potential to have to sell strong-performing asset classes and buy ones that have fallen out of favor, empirical evidence suggests that a disciplined policy of rebalancing can yield better Sharpe ratios for the portfolio.
The question of when: Periodically, rebalance and establish materiality thresholds at asset-class level. Although doing something may be better than doing nothing, it still leaves the question of when. There is no general consensus on an optimal rebalancing policy. Typically, rebalancing is most effective either at a periodic set time or when asset allocation drifts outside of a predetermined threshold — or both. Considering that the transaction costs involved can add up, frequent rebalancing, such as on a daily basis or with a nominal threshold, might not be the most beneficial move. Conversely, the differences between rebalancing on a monthly, quarterly or annual basis or when established thresholds are breached may be limited. All of those strategies result in higher portfolio Sharpe ratios than not rebalancing at all, with quarterly rebalancing subject to a material threshold having a slightly higher Sharpe ratio compared with other options.
Differentiate rebalancing versus a tactical shift. Amid the recently heightened volatility, muted growth prospects in some economies and increased fears of recession in the U.S., some plans are considering shifting risk exposures. Clients have expressed a desire to become more defensive, including even contemplating raising cash levels in their portfolio. Consequently, some plans may seek to hold off on rebalancing since, given year-to-date moves, more defensive positions such as U.S. Treasuries have increased in value while riskier allocations, such as public equities, tend to make up a smaller percentage of the portfolio. Rebalancing is typically viewed as a risk management exercise, whereas a tactical shift is typically an expression of an investment view.
Integrate tactical allocation into overall portfolio design. Plan sponsors seeking to hedge risk in a volatile market may want to consider embedding a tactical allocation bucket. By establishing a specific allocation to tactical strategies in the investment policy statement, the sponsor can, either directly or through the use of external managers, shift risk exposures according to their views on various markets and sectors. Strategic allocations to public equities and fixed income would then be rebalanced on schedule. Keep in mind, however, that the governance structure of many plans might not allow for quick execution of such tactical moves. If that’s the case, external tactical managers are an option to consider.
Some plan fiduciaries have been evaluating their long-term strategies, especially in regard to alternatives, hedging policies and, in light of longevity concerns, the need for liquidity in a portfolio. Although those are all important considerations, plan managers should not forget that, in the short run, a disciplined and consistent approach to rebalancing their portfolios may help bolster returns while also reducing volatility.
Michael Moran is a senior pension strategist at Goldman Sachs Asset Management in New York.
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