Can an asset/liability framework meet the needs of DC plan members? It’s certainly worth the effort.

A look back reveals a remarkable but anomalous 25-year run in financial markets shaped largely by the persistent decline in interest rates. Bond returns reflect the high embedded yields and capital gains driven by falling rates. Stocks have risen on a wave of interest-rate-driven expansion of valuation levels as much as internal profit growth. Most importantly, stock and bond returns have been highly positively correlated as they respond in unison to falling interest rates.

Defind contribution(DC)plans have been held hostage by investment trends that evolved in defined benefit plans in response to this unusual return environment. High returns encouraged the management of assets in isolation with relatively little reference to liabilities. Risk came to be defined as short-term tracking error relative to benchmarks, resolved by what may be excess diversification. Policy asset allocation displaced active allocation strategies and investment mandates evolved to increasingly narrow style silos, leaving most plans dominated by their exposure to market risk yet very little active risk.

The proliferation of an increasingly complex array of narrow investment strategies coincided with the introduction of a “cafeteria” of investment options. This forced illequipped DC plan members into the role of expert administrators of their pension plans.

How appropriate is this structure for the future? The risks are significant. We face a point of inflection in financial markets as the tailwind of lower interest rates fades. Bond returns are likely to be centered on current yields of about 4%. Without lower rates to drive valuation levels higher, stock returns should mirror the rate of growth in corporate profits, suggesting longer-term return prospects of around 7%. Just as importantly, in the absence of a trend in interest rates, return correlations should revert to more normal, often negatively correlated patterns. The lower absolute level of returns will exacerbate the impact of even normal levels of volatility. All of this argues for a shift in focus from asset management to risk management, preferably in an asset/liability framework.

Is an asset/liability framework feasible for individual DC plan members? It is a challenge but worth the effort. Planning should reflect the financial risks and objectives of the individual and consider desired lifetime consumption as opposed to accumulating wealth to a specific target level. Key risks to consider include the following: financial market risk—volatility and permanent impairment of capital; interest rate risk—the key factor determining income flow upon retirement; inflation risk—real purchasing power is the issue; currency risk—relative to currency of “liabilities.”


So how do we integrate the changing dynamics of financial markets with our retirement liabilities to improve risk-adjusted returns in a typical DC plan? Here are a few key strategies to move to more of a total return, absolute risk frame of reference that should be more effective for individual plan members.

1)Adopt dynamic asset allocation strategies.

While discredited in the high-return, high-correlation world of the past 25 years, this variable holds the greatest potential to both enhance returns and manage absolute risk in the future.

2)Desperately seek alpha.

Replace market risk or beta with active risk or alpha, with more emphasis on absolute downside protection as opposed to tracking error. Even relatively simple strategies of introducing a value and or yield bias to equity portfolios tends to reinforce these qualities.

3)Expand the opportunity set.

While delivery is challenging in a DC environment, adding new strategies including real return vehicles, global fixed income and even hedge funds can increase the probability of success.

4)Manage your interest rate risk.

DC plan members are often fully exposed to interest rates, particularly those that scale out of markets into money market vehicles as retirement approaches. Every plan should offer a long-term bond alternative that allows members to hedge against changes in annuity rates.

Most DC plans require less choice but more effective strategies, likely a core of balanced funds tailored to DC “liabilities” that integrate the types of strategies considered here.

Gia Steffensen is chief investment officer at Legg Mason Canada in Waterloo, Ont.

For a PDF version of this article, click here.

© Copyright 2005 Rogers Publishing Ltd. This article first appeared in the April 2005 edition of BENEFITS CANADA magazine.


Copyright © 2020 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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