Conceptually, the traditional glide path approach to de-risking may make sense because it provides a disciplined framework for reducing risk, and as a result decreases the likelihood that plan sponsors will be confronted with unanticipated funding obligations during adverse market conditions. But the current environment of low interest rates could actually make this risk-reduction approach riskier, according to a paper from Cambridge Associates, “Pension De-Risking in a Low-Rate Environment.”
“In normal markets, shifting funds out of growth assets into liability matching, or fixed-income assets, will reduce funding risk but also reduce expected returns and thus increase projected contributions,” said David Druley, managing director and head of the global pension practice at Cambridge Associates. But Druley cautioned that in the current environment of fixed-income overvaluation and historically low interest rates, a traditional glide path can result in a significant decline in expected returns and increase the likelihood that the plan sponsor will need to make higher contributions.
The traditional glide path neglects the objective of maximizing return at each targeted level of risk, he said. It typically uses just one lever to reduce risk—the fixed-income allocation—which may not generate enough return in today’s environment.
“If increasing long-duration bonds and liability hedging assets is the sole lever being pulled to reduce a plan’s liability relative risk—which many simple glide paths embrace—then the plan is uniquely vulnerable to the overvaluation of bonds and therefore bears the full cost of locking in the lower expected return of liability hedging instruments,” Druley told PLANSPONSOR. “Additionally, with interest rates near generational lows, the liability relative risk resulting from changes in rates is highly asymmetric, with the potential for only modest increases in the liability in a worst-case scenario of the U.S. ‘becoming Japan’ (i.e., rates declining).”
A Holistic Approach
Druley calls for a holistic glide path approach that reduces funding-level volatility and generates superior returns, while also reducing the risk of a significant decline in funding level. This alternative glide path not only looks at the amount allocated to growth assets, as the traditional glide path does, but it also defines and controls the risk within the growth assets, Druley said. It does so by utilizing growth assets that emphasize active strategies that rely on manager skill and non-traditional sources of beta (such as distressed credit, hedge funds, and private investments) rather than directional equity market exposure.
The kinds of strategies included in the growth portfolio are low-beta hedge fund strategies, very active long-only strategies and select private investment opportunities, when appropriate, he said. The holistic glide path approach usually involves higher exposures to alternative asset classes and strategies, which means it entails implementation complexity and higher investment management fees, according to Cambridge Associates’ paper.
This is why Druley said there are some instances in which a traditional glide path would make more sense than a holistic one. “The traditional glide path would likely make more sense than the holistic glide path for those institutions that do not have adequate investment resources or expertise to effectively implement the approach,” he said. “Most notably, the holistic glide path relies on generating positive alpha via meaningful exposures to non-traditional betas and strategies that rely on significant manager skill, such as low beta hedge funds, private equity and private real assets. As these strategies require significant resources in terms of due diligence, manager selection, implementation and monitoring, a plan sponsor must assess whether it has the capability to execute the holistic glide path appropriately.”
If an institution cannot garner internal resources or employ external consultants or fiduciary managers that have the required expertise and track record of generating positive alpha, then it is reasonable to take the simpler and lower-returning approach, he concluded.