The economic downturn of 2008 exposed the risk in asset allocation products designed in and built for a “Goldilocks” environment of non-inflationary growth. With a changing environment, it is time to revisit the assumptions and models used in the past to construct DC asset allocation products.

Most DC plan options employ the traditional 60/40 asset allocation model, but 90% of the risk comes from stocks. As a result, traditional balanced products often perform well in periods of non-inflationary growth but perform poorly in periods that don’t favour stocks—namely, recession and inflationary growth periods. In other words, the risk in this traditional product is not balanced among the different economic environments, which affect asset class returns very differently.

Instead of balancing an asset mix based on targeted returns, the balancing of risk, or risk parity, should be the guiding principle behind asset allocation.

Instead of balancing an asset mix based on targeted returns, the balancing of risk, or risk parity, should be the guiding principle behind asset allocation. In a risk-balanced product, an equal amount of risk comes from assets representing each economic environment: recession, non-inflationary growth and inflationary growth. This process is designed to provide plan members with respectable investment returns by avoiding significant drawdowns along the way. It is an investment process worthy of consideration as the global economy recovers from a balance sheet recession and is confronted by an uncertain range of economic outcomes.

For DC plan options, target risk portfolios that offer a range of risk tolerance levels can satisfy the needs of plan members in a single, simple-to-use solution if they employ a strategic asset allocation model that balances risk by combining asset classes that should benefit from different economic environments. These portfolios should also provide tactical asset allocation to capitalize on near-term market opportunities or to mitigate risk; a strategic blend of active- and index-based solutions to further improve diversification; and currency risk management to reduce the risk of holding foreign securities in a portfolio. Target date portfolios should build a foundation based on the strategic asset allocation process just described while also offering plan members a range of investment horizons that seek to preserve capital and reduce risk.

Structuring target risk and target date portfolios this way gives plan sponsors and members more of what they expect from asset allocation solutions (multiple investments, automatic rebalancing, currency hedging, simplified reporting), combined with the innovation of the balanced risk process and its unique asset allocation process.

A changing environment requires evolution of the asset allocation models used in many DC plans today. Target risk and target date portfolios should use a balanced risk approach to asset allocation to navigate member portfolios through an uncertain investment environment and to provide better risk management. BC

Michael Cooke is vice-president, global investment strategies, with Invesco.

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

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