Equity Risk Exposure in DB Pension Plans: How Defensive Equities Can Fit into an LDI Strategy
Defined-benefit pension plans that implement a liability-driven investment (LDI) framework1 for their assets often face challenges on their way to a fully hedged portfolio. On the one hand, they must continue to seek returns in order to reach fully funded status; on the other, they’re under pressure to reduce liability-hedging risk. Recent research by State Street Global Advisors found that plans which are able to tolerate a degree of risk and have an interest in alpha generation (not just in drawdown mitigation) could benefit from benchmark-unconstrained defensive strategies, which carry a dual risk-and-return mandate.
Defensive Equity Strategies
Defensive equity strategies actively explore the market’s full opportunity set, constructing portfolios which seek to maximize return per unit of risk. Defensive strategies are built on empirical evidence that risk is not symmetrically rewarded in the market, and that a low-risk portfolio with an alpha-seeking component can create a compelling return stream while performing well in both up and down markets. Interestingly, our research found that drawdown profiles for a representative global defensive equity strategy were comparable to those for the MSCI World Minimum Volatility Index, despite the defensive strategy’s alpha-seeking component. This suggests that defensive equity strategies, like low volatility strategies, can help to protect against large drawdowns.
60/40 Portfolio (80% Funded)
Many pension plans in transition toward a fully hedged end state subscribe to a diversified 60% equity/40% fixed-income allocation for their portfolios. Most of that equity allocation is directed to market-capitalization weighted index exposures, which provide the potential for higher returns compared to fixed income. At the same time, these equity investments also expose the portfolio to capital-market risk.
For a hypothetical 60/40 portfolio2 with a funded ratio of around 80%, we calculated the effect of introducing a representative global defensive equity strategy.3 Our analysis of the reallocated portfolio shows a meaningful reduction in risk compared to the base-case portfolio. We found that overall portfolio risk was reduced by over 13%, while returns remained roughly the same, leading to an improvement in risk-adjusted returns of nearly 14%. Correlation to liabilities also improved substantially. Moreover, these results were achieved with a 1.45% reduction in risk contribution from equities.
60/40 Portfolio (De-risking)
We also calculated the effect of introducing a representative global defensive equity strategy into a de-risking portfolio that is nearing fully funded status and has moved its fixed-income portfolio to long credit in an attempt to hedge the liability risk.4 Adding the defensive equity strategy5 improves the set of outcomes for the pension plan as measured by risk-adjusted returns, total volatility, correlation to liabilities, and maximum drawdown over the examined period; it reduced the risk contribution from equities by 3.18%, resulting in a 12% improvement in the total risk of the portfolio, despite the increase in the risk contribution of fixed income. The inclusion of the defensive equity strategy resulted in an improvement of 6.5% in maximum drawdown over the examined time period and meaningfully improved the overall correlation of the portfolio to liabilities.
Based on our research, we firmly believe that equity risk can be a key contributor to future DB plan returns. Our analysis shows that plans could benefit from a close look at how efficiently they’re spending that risk to meet their return objectives. A focus on on risk-adjusted returns can help plans to maximize the benefits they realize from their equity exposures.
In sum, our research demonstrates that defensive equities can be a highly effective tool for DB plans as they seek to progress toward fully funded status and fully hedged liabilities. We believe they should be seriously considered as an important component of a broader LDI strategy.
1 A liability-driven investment (LDI) strategy strives to link the asset and liability sides of the investment balance sheet, rather than focusing exclusively on the asset side. An LDI strategy is particularly useful in situations – as in the case of defined-benefit plans – in which future liabilities can be predicted with reasonable accuracy.
2 Original 80%-funded portfolio exposures: S&P 500 35%; Russell 2000 5%; MSCI EAFE 15%; MSCI EM 5%; US Aggregate Bonds 35%; High Yield Bonds 5%.
3 Adjusted 80%-funded portfolio exposures: S&P 500 15%; Russell 2000 5%; MSCI EAFE 5%; representative defensive equity portfolio 30%; MSCI EM 5%; US Aggregate Bonds 35%; High Yield Bonds 5%.
4 Original De-risking portfolio exposures: S&P 500 35%; Russell 2000 5%; MSCI EAFE 15%; MSCI EM 5%; Long Credit 40%.
5 Adjusted De-risking portfolio exposures: S&P 500 15%; Russell 2000 5%; MSCI EAFE 5%; Representative defensive equity portfolio 30%; MSCI EM 5%; Long Credit 40%.