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.”
IMPROVING RETURNS
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. gsteffensen@leggmasoncanada.com
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