This dramatic improvement raises a key question for these plans: how should they adjust their asset allocation to defend these gains? It’s a live problem. U.S. equity valuations are strained – the Shiller PE ratio is near its peak in the dot-com era – and recent equity strength is concentrated in a handful of tech growth stocks. The downside risks are obvious.
We believe that a combination of options strategies can provide DB funds with a way to protect their recent gains and significantly increase their chances of completing the journey to 100% funding of plan liabilities within five years.
The optimal asset allocation of a pension fund changes as its funding status changes. Those who are significantly underfunded tend to follow a risk-seeking allocation that is more weighted to equities, while those who are fully funded tend to hold a preponderance of fixed income to match their commitments. Today, many funds fall between these extremes: they are approaching funded status but not quite there yet. They need to generate additional earnings but don’t necessarily want to maintain the full downside risk of a position in stocks. The closer they get to their goal, the lower their tolerance for downside risk.
These funds therefore have a non-linear risk appetite. However, most risky assets (public and private investment, real estate, alternatives) are linear in nature: they have return distributions that are roughly symmetrical around their expected return (or, where applicable, negatively asymmetric) .
To match their preference for non-linear risk, pension funds need to gain exposure to assets with a non-linear return profile. Our preferred method of doing this is to change the fund’s asset allocation to incorporate options strategies that are very likely to outperform in neutral or negative equity markets, although they may underperform under adverse conditions. favorable.
We have identified four strategies that we believe are particularly suited to protecting accumulated gains while maintaining upside exposure.
Put the sale is designed to replace an equity allocation with a strategy that sells puts of an equivalent notional value on the same or similar underlying equity exposure. Premium income should allow the strategy to outperform if the equity markets fall or move sideways.
Tail blanket invests in defensive options such as put or call options on the CBOE Volatility Index (VIX) with the aim of outperforming during sharp declines. These events can seriously damage funding ratios, as equity values and discount rates typically decline simultaneously. Investors accept the cost of executing this strategy in normal markets in return for the benefits it provides during massive sales.
Dispersion strategies sell index options, which tend to be relatively expensive due to the structural demand for hedges, and buy relatively cheaper stock options. Pension funds can use this strategy as a form of low-cost or carry-carry put option, as the strategy aims to take advantage of the cost differential while historically benefiting from periods of increasing market volatility, as the volatility shares purchased outperform.
Finally, funds can adopt a defensive version of trend following which focuses on risky trends and has performed well in declining stock markets.
In our modeling, we replace half of the 50% equity allocation of our model retirement portfolio with an equivalent notional value of put options and spend 0.5% of the notional value of the portfolio on a tail hedge. . In addition, we are shifting half of the portfolio’s 10% allocation towards alternatives to a dispersion strategy and the other half towards defensive trend following.
Assuming our example portfolio has an initial funding level of 90%, we find that these option strategies increase the likelihood of achieving full funding in five years from 57% to 81%. However, if the stock markets achieve annual returns of more than 10%, the original portfolio outperforms.
DB pension funds approaching fully funded status face difficult choices about how to handle the final phase of their journey. Maintaining their current asset allocation is a risky bet in equity markets which continue to climb.
A significant market correction could quickly erode pension funding ratios, as happened in 2008. It took more than a decade to recoup these losses. However, there are ways to reduce exposure to the direction of equity markets and thereby increase the likelihood of achieving full funded status. We believe that well-funded pension funds would be wise to consider adjusting their approach to their equity allocation at this time.
Tom Leake is Managing Director and Head of Solutions at Capstone Investment Advisors, based in London. This content represents the views of the author. It was submitted and edited according to the Pensions & Investments guidelines, but is not a product of the P&I editorial team.