Four years ago we became outliers when we first explained why we expected that interest rates would remain well below 20-year averages. Today the drivers behind our rationale are widely accepted — slow job growth, changing labor demographics, accommodative central bank policies and the absence of substantive fiscal reform. Whereas “lower for longer” has become a consensus refrain, we still haven’t seen behavioral change. Pension funds, for example, have yet to widely incorporate the practical implications of lower-for-longer within their long-term portfolio construction.
A powerful phenomenon compounds the secular shift in rates: an increasingly older global population. Actuarial tables released in 2014 by the Society of Actuaries, which U.S. corporations must account for in their financial statements, quantified what many suspected — that pension funds had underestimated liabilities by an average of 5 to 8 percent. The advent of new technologies will help people live even longer, making increasing longevity a critical factor for valuing pension liabilities.
Low rates and longevity equate to difficult math for CIOs of major pension plans. Most have responded by rebalancing portfolios in sensible ways. Some have recalculated expected rates of return by asset class; others have adjusted their published expected rate of return. Many are starting to review liabilities under more aggressive longevity assumptions. Most, however, have not begun to revisit their fundamental approach to building a portfolio.
To meet the challenges of lower-for-longer rates and the unprecedented rate at which the world is aging, chief investment officers should begin to take a fresh look at portfolio fundamentals in three ways:
Consider alternatives to traditional bonds. Investors have historically seen government bonds as stable, safe bedrock for a fixed-income portfolio, turning to spread products only to enhance yields. But today global government bond returns are simply too low to form the core of a bond portfolio, and they provide little possibility for capital appreciation or protection from recession.
Spread products can provide a potential solution, particularly if CIOs are willing to look beyond corporate credit risk as the only alternative to rate risk. A wealth of opportunity lies within quasisovereigns and structured products such as asset-backed securities, commercial mortgage-backed securities and collateralized loan obligations, all of which have improved their underwriting since the freewheeling mid-2000s. Private debt associated with the corporate, commercial and residential sectors is also available.
Redefine borders and emerging markets. Faltering growth in developed economies will force investors to look beyond their borders. But institutions should question the usual categories of international investing and avoid artificial one-size-fits-all classifications such as global, international, emerging markets and BRICS.
Traditional allocation to a global or international bond index that bundles interest rate, credit and foreign exchange risks together, forcing a “take it or leave it” decision, simply no longer works. A more sophisticated approach begins by understanding the underlying risks in global equity, fixed income and currency markets and seeks high–information ratio strategies in multiple, uncorrelated dimensions of risk.
Today, with highly liquid rates and currency markets, an Australian superannuation fund can access the much broader corporate bond markets in Europe and the U.S. while avoiding currency and rate risk. A European pension no longer has to invest in or avoid emerging-markets bonds as a single category and instead can tailor its exposure with investment-grade and high-yield sovereigns, quasisovereigns and emerging-markets corporates. Investors can modulate duration exposure, hedge out forex risk, choose between domestic and foreign bonds, limit regional and country-specific exposures and even control exposure to risk factors like oil. Such global customization, designed to discard risks and optimize alpha and beta sources, will replace old classifications and become the norm.
Rethink the glide path. Many pension plans follow a glide path strategy to reduce portfolio risk as funded status improves. But headwinds of sustained low rates and improving longevity make improvements hard to come by. As “gliding” has paused or reversed, CIOs face difficult choices — for example, whether to increase risky investments in hopes of returns high enough to outpace the effects of low rates and employees who will live (and work) longer or to face making contributions.
As a middle ground within fixed income, plan sponsors now seek better returns and diversification via structured products. They are reallocating their risky assets among fundamental types of risk and unbundling their benchmarks to focus on the best information ratios and remove extraneous risk factors. This strategy will likely lead to more refined asset and liability allocations.
In sum, the tectonic shifts in global bond markets and populations ought to prompt a fundamental rethink of pension portfolio composition. Traditional allocation frameworks may have stood strong in the past, but CIOs who broaden their perspective beyond the familiar will be better prepared to face the headwinds of long-term secular trends like low rates and increased longevity.
David Hunt is president and CEO of PGIM, the global investment management businesses of Prudential Financial, and Arvind Rajan is managing director and head of global and macro at Prudential Fixed Income, a PGIM company.
