Balancing risk and reward in strategic asset allocation

One of the most important decisions a plan sponsor can make is determining the amount of risk it’s willing to take in order to achieve a desired return. This is often expressed as a strategic asset allocation or target asset mix. At a very high level, plan sponsors are seeking the balance between safety (fixed income) and seeking return (equities) assets – though, in practice, each category usually contains other types of asset classes as well.

Determining whether the strategic asset allocation is constructed to deliver an expected return or to protect the plan from adverse markets or economic situations will depend on the financial health and maturity of the pension plan, as well as the ability and willingness of the plan sponsor to take risk. Plan sponsors that are subject to solvency valuations have to fund deficits within five years, whereas those subject to going-concern valuations have 15 years to make up deficits. This difference in time horizon can also dictate a plan sponsor’s risk tolerance.

Read: 2016 Top 100 Pension Funds Report: Solvency reform on the agenda

Today’s volatile capital markets, continued low growth and low interest rate environment means determining the balance between contributions, risk and reward is increasingly complex for plan sponsors. Gone are the days when plan sponsors could rely on bond returns to achieve their target returns. As of Sept. 30, 2016, the 10-year Canadian bond yield was sitting just below one per cent, which, while at least positive (especially compared to German or Japanese yields), doesn’t offer much excitement for long-term investors. Plan sponsors are being pushed to take on more risk to achieve their target returns – but more on this later.

A long-term normalized bond yield is the function of expected growth and inflation. Historically, this has meant yields of between four and five per cent in Canada. At present, inflation is running at just over one per cent, despite the Bank of Canada’s long-term target of two per cent. Growth has been anemic, rebounding after the Fort McMurray fires, but is expected to track at about 1.5 per cent for 2016 and 1.9  per cent for 2017, according to the International Monetary Fund. Long-term forecasts by various economists and strategists rarely exceed two-per-cent growth. On this basis, a long-term normalized yield of between 3.5 per cent and four per cent seems most likely, but not for many years yet.

Read: Dismal start to 2016 signals more challenges ahead

Both growth and the level of interest rates in Canada are being impacted by slower growth in many other countries, including the United States, which has seen its growth forecast cut to 2.2 per cent by the IMF, based on a weak energy sector, strong dollar and mixed economic activity in Europe and parts of Asia. Surprisingly, despite all the fears of a marked Chinese slowdown, expected Chinese growth has been revised upward to 6.5 per cent for 2016 and 6.2 per cent for 2017.

A working paper published by the IMF in September 2016 states that “the full cycle of US monetary policy tightening will take place over an extended period … .” The report goes on to say that “the unprecedented nature of the process could generate uncertainty about the future rate path of interest rates and increased risk aversion, both drivers of global term premiums and capital flow.”

This suggests that while rates may begin their upward march later this year, a normalized long-term interest rate will be achieved over a protracted time frame. An interesting conclusion of the IMF’s paper is that a 100 basis point increase in U.S. 10-year bond yields usually leads to a 50-80 basis point increase in domestic interest rates in many of the countries studied. In the case of Canada, the impact is estimated at around 70 basis points.

Read: Private debt a good option for bond refugees

While the IMF and other sources see increased risk aversion, more accommodating interest rate policies and pressures from the slowing rate of inflation resulting in low expected asset returns, a few investors are beginning to discuss whether it’s time to increase risk in the investment portfolio. The equity risk premium is elevated in this low interest rate environment (between five and six per cent depending on your view of expected equity market returns), despite new highs on a number of equity indices. Some suggest that equities are fairly valued while others believe that after a difficult two years, high single-digit earnings per share growth is likely. A mild recovery in emerging market growth, led by China, is supportive of increased interest in the emerging market economies and securities. With many alternative asset classes deemed expensive as well, equities of all flavours are getting a renewed look, at least in the short term.

So, what does all this mean for plan sponsors still struggling with setting their strategic asset allocation? While diversity of asset mix is still the best approach, perhaps there will be some increased discussion around rebalancing in the short term for plan sponsors with a greater appetite for risk. It could also mean increasing return-seeking assets at the expense of safety assets (bonds), especially for plan sponsors not subject to solvency. For others, it may mean waiting before reducing the equity allocation.

As you can see, there’s no single approach besides having a healthy and ongoing dialogue about risk appetite and what this means as a plan sponsor.