How to Reduce Pension Risk with Tactical Asset Allocation
It’s important for corporate pension funds to be trusted to deliver the expected returns to cover an employee’s pension, but more important for the company are the paths of the returns and the predictability of the returns to be able to plan contributions and not worry about shortfall situations and unplanned contributions. In turbulent times when financial market are under stress, the risk increases that a given asset allocation will produce results forcing the corporate sponsor to make adjustments or reserves in their balance sheet. Modern tactical asset allocation (TAA) strategies can reduce this risk when the likelihood is that the corporate balance sheet itself is under stress due to the financial situation typically seen today.
TAA strategies were first developed in the 1970s and have taken various forms since then. In most pension plans there is a freedom to deviate from the strategic asset allocation (SAA) or model portfolio, but this option is seldom used in an efficient, disciplined way. Today, one issue is that no official benchmark or index exists to replicate TAA in asset liability management (ALM) processes. This means that many pension funds, and especially their consultants, are unaware or unable to allocate to TAA in the SAA. Sometimes certain flexibility is given to its managers, external or internal, to deviate from the asset allocation to create added value. This flexibility has seldom given the added value expected and in academic research this activity has been attributed to a very low amount of added value if not even negative. So what is new?
An innovative trend today is leaving the asset class allocation to look at risk-driven allocation. Risk driven allocation is not concerned with the asset class but how an asset behaves from a risk and return perspective. A risk-driven process must fulfil certain criteria and procedures, and the idea is to build a portfolio based on modern optimal portfolio theory. In an ideal situation, there are few constraints to achieve the optimal return for a given amount of risk.
What makes a risk-driven allocation different from an asset class allocation is not which asset class is permitted to be used but the aggregated risk from different single investment opportunities. In any investment process a certain return is required or wished for and then the asset allocation is a mixture of assets expected to yield this return.
In risk-driven allocation the purpose is to use a defined risk budget and create an asset allocation aiming for maximum expected return over time with an objective to never exceed this risk. In any portfolio creation, the asset allocation is based on a view that expected returns will be delivered at a given risk. In reality, the market configuration changes instantly and only in a tactical application can such assumption deliver the desired results. The combination of starting with a defined maximum risk level and adding an investment process that has the objective of tactically adjusting to market changes adds a new entry to the toolbox of pension funds.
By allowing a shift in the focus not only between equity and bonds but also within an asset class separates the old TAA from today’s state of the art TAA. A risk-driven allocation can identify assets with exposures to equity, fixed income, cash, geographical, small, medium, large cap and sector as risk and returns allowing any combination as long as the pre-defined risk is respected. This allows for a selection of the best available expected positive returns while respecting a risk of negative result aggregated over time in line with the mandate given by the sponsor.
In principal it is, but it requires a systematic and consistent approach sustainable over time that not very many corporate pension funds can comply with. Why? It requires skills and resources that often are scarce or too costly. Quantitative approach is a solution but again it requires resources not always available for corporate plans. However, there are companies offering these programmes today and they aim to adapt portfolios according to the evolution of the market. Most of these programmes work TAA by using a quantitative solution as it gives decision capabilities that are difficult to have in a human manager solution. I think that a 100% quantitative investment process is the best way to manage a TAA. Only a rule-based mathematical model gives the exceptional decision capabilities needed to run a sustainable TAA programme.
The success of a TAA mandate can depend on many things but the most important is that decision-making techniques and the frequency of portfolio rebalancing must be appropriate to the investment universe and the instruments used. Most of the time when a TAA strategy fails to deliver it’s not because it fails to react but that it cannot execute according to its investment process. A proven capacity is vital for a TAA mandate to decide how much of the strategy can be implemented into a strategic asset allocation. In a diversified portfolio relatively small amounts of TAA can change the long-term results and the exposure to long extended drawdowns and the risk of shortfalls. In some cases a 3-5% allocation of TAA to the overall asset allocation can add important value while a larger allocation like 10-20% can give the entire portfolio an absolute return profile.
The first thing a corporate plan needs to understand is what the present asset allocation risk return characteristics are, how market shocks and longer trends can affect the pensions performance positively and negatively, and hence the future contributions of the corporate sponsor. These sorts of studies, which are not ALM studies but risk studies and are focused on the asset side, can be obtained at no or low cost from several market participants. A high allocation to equity assets implies high risk to long extended drawdowns like 2000-2003 and low allocation means lower returns.
A long-only TAA has considerable advantage, as it is easier to fit into a traditional asset allocation framework. A high risk level of a long-only TAA implies that returns similar to equity returns can be achieved if equity returns are positive and, therefore, a TAA can be a substituted for part of the equity allocation. A low risk level long-only TAA implies returns similar to bond returns and, therefore, a TAA can be a substitute for part of the bond allocation. Many users of long only TAA programmes substitute part of both bonds and equity to create an ongoing rebalancing between the two assets to seek a more optimal portfolio allocation depending on the market evolution.
My experience is that a long-only, no leverage quantitative risk-driven TAA mandate aiming to physically adapt the asset allocation, and by doing this adapting to market behaviour and evolution, is an effective and efficient approach. It can improve the risk profile while maintaining exposure to asset classes that can provide the necessary long-term expected returns. It can also give the pension plan the returns of equity or part of the equity market returns when equity is in a bull market and be completely out when equity is in a bear market. Similarly, it can seek comfort in bonds or cash.
