With interest rates bottoming out, Canadian DB plans should look beyond traditional de-risking methods— such as liability-driven investing (LDI)—and consider equities.
There are several ways to incorporate equities into a plan’s de-risking framework. Plan sponsors that want more predictability from equities in the early stages of de-risking, for example, might consider strategies that are actively managed to pursue excess returns but maintain low tracking error to their relevant benchmark. This is because the plan would still have a substantial portion of assets allocated to equities, and an actively managed equity portfolio can contribute to asset gains.
Conversely, when there’s more need to reduce absolute levels of volatility from equities, lowvolatility equity strategies could provide more market-like returns with considerably less risk.
While nuances vary, many DB plans still have much to do before reaching fully funded levels. As of June 2015, 75% of Canadian pension plans were between 80% and 100% funded, the Mercer Pension Health Index reports. For the 10 years prior, however, the Index showed that Canadian pension plans had remained either at or frequently below 100%. When combined with a 10-year bond yield rate that has remained low, de-risking has become a more challenging proposition.
With little incentive to adopt proven de-risking strategies (such as increasing fixed income allocations or extending duration), plan sponsors should consider enhancing the equity allocations in their de-risking approaches while maintaining the flexibility to ramp up fixed income allocations when interest rates and bond supply make that more desirable.
De-risking With Equities
Incorporating equities into a de-risking framework should always be based on a plan’s broader mandate and current funded status. A plan that’s already hedged most of its liabilities might consider either maintaining the current level of active risk (which comes from individual security selection, rather than market risk) in the equity portfolio or decreasing it, while still preserving potential to generate returns.
Plans with more limited time horizons and risk budgets may want to hedge by narrowing the range of equity outcomes. This also works as a financial budgeting tool. When plans first adopt LDI, they’re generally trying to constrain the range of potential financial outcomes and reduce any impact on their financial statements. But, plans focusing on risk budgeting need to consider more benchmark-aware strategies.
Reconfiguring the Equity Portfolio
To narrow the range of possible outcomes on the equity side and build a riskbudgeting facility into the de-risking process, look at strategies that actively manage relative risk. Plan sponsors should look for equity return patterns with narrower variations, efficiency in fees, potential for unique or complementary sources of return and a generally more risk-aware framework. Strategies combining fundamental and quantitative research into one approach are designed to do this.
Moreover, because there’s little overlap in the strengths of fundamental and quantitative research—the former has historically performed better at market inflection points and the latter’s been stronger in trending markets—these strategies can be used to navigate different market environments more effectively.
Alternatively, some plans may want to reduce equity risk. Perhaps the funded status has improved to the point where the plan is either close to or fully funded, and the sponsor has already substantially decreased the equity allocation. In cases where the sponsor may not be able to terminate the plan, the portfolio will need some equity risk—but not to a point where it would create substantial losses, since any loss would require a much more substantial gain to make it up. This becomes infinitely more difficult after shrinking the plan’s exposure to equities.
Lowering Volatility
A low-volatility equity approach may help reduce a plan’s downside risk. Low-volatility equity strategies have kept up surprisingly well in strong markets and shown resiliency through periods of market stress (see Figure 1, above).
Importantly, though, not all lowvolatility strategies are alike. For instance, strategies investing solely in the lowest volatility stocks tend to become highly concentrated from a sector and factor risk perspective. For example, just prior to the Japanese tsunami in 2011, the global sector with the lowest volatility was Japanese utilities—a sector that went on to sustain substantial losses.
At its essence, managing volatility is really about avoiding high volatility. An approach avoiding the highest volatility stocks, which then actively manages the remaining universe of lower volatility stocks, has the potential to perform in line with, or slightly better than, the market. And, that approach will simultaneously meaningfully reduce the beta of the portfolio. Historically, approaches that avoid the highest volatility stocks have added value over time (see Figure 2, below).
Such strategies tend to invest in companies with lower to mid-range volatility. Moreover, choosing a low-vol strategy that features both quantitative and fundamental research could help mitigate any external risks (e.g., the Lehman Brothers bankruptcy) that a purely quantitative strategy may not be able to avoid.
Thoughtfully selected, low-volatility equity strategies can help reduce a plan’s funded status volatility during periods of weaker equity returns.
Turning From Traditional De-risking
Given the state of fixed income in Canada—low supply and low interest rates—and the need to improve funded status, DB sponsors should focus on the equity allocations in their de-risking strategies. Different methods for using equities to de-risk allow plan sponsors to work within their own objectives and constraints.
Plan sponsors looking to actively manage relative risk with narrow return variation and more efficient fees might adopt equity strategies that blend fundamental, quantitative research. Or, if the priority is to lower the absolute volatility from the equity allocation, low-volatility equity strategies offer liquidity and transparency, along with alpha potential and more flexibility within a de-risking framework.
More importantly, a low-vol equity strategy could serve as an effective alternative to popular alternatives—real estate, in particular—that Canadian plan sponsors often implement in their de-risking frameworks. In fact, as of December 2014, Canadian DB plan sponsors had 10.55% of their assets invested in real estate, according to the Pension Investment Association of Canada. Alternatives come with their own issues, including limited transparency, higher costs, liquidity lock-ups and lower return expectations than equities.
Potential benefits of bringing equities into the plan’s de-risking framework are clear, whether the plan sponsor chooses to reconfigure the entire portfolio or just de-risk a portion. Any part of the risk budget freed up by these efforts could be reallocated to assets with a more attractive risk premium—which could ultimately improve returns and give its plan’s funding ratios a needed boost.
Ravi Venkataraman is head of global consultant relations and global defined contribution, and Christine Girvan is managing director, Canada, with MFS.
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