A dynamic, glide path-based approach to asset allocation has been widely embraced throughout the corporate pension sector. Glide paths designed to meet the particular needs of a sponsor entity provide a disciplined approach to incrementally reducing surplus risk and contribution volatility. As funded status improves, gradually reducing allocations to “return-seeking assets” and increasing exposures to “liability-based assets” enable a plan to balance return needs as well as mitigate contribution shortfall risk.
Plan sponsors have enjoyed strong equity market returns amid relatively low volatility through the recent bull market — however, funded status improvements have been fleeting due to declining discount rates. Until recently, adopters of a glide path approach have generally been in a one-way, de-risking mindset — and State Street Global Advisors has been supportive of this approach.
The recent crisis has proven to be a glide path game-changer, as many plans have seen declines in YTD funded status greater than any experienced during the last 10 years. Recent events have spurred conversations with plan sponsors about the options for “re-risking,” particularly if funded status has fallen below specified funding trigger levels. In this piece, we’ll explore some key considerations that plan sponsors should bear in mind, as well as some practical approaches to re-risking while continuing to meet investment policy objectives.
The majority of sponsors we work with establish glide paths to automatically de-risk their asset allocations when they reach certain funded status “triggers.” The target asset allocation at certain funding triggers is approved by the sponsor and codified in the Investment Policy Statement (IPS). When the governance structure delegates the oversight and implementation of asset allocation to State Street, this allows us to quickly lock in the gains once a trigger has been reached, which narrows the range of future outcomes. Throughout the recent bull market, a number of our clients reached de-risking triggers based on market returns, contributions to take advantage of tax code changes, or both.
When markets sold off sharply in 2020, plans with higher portions of return-seeking assets found their asset allocations mismatched to their current funded status. Some found themselves falling back below prior triggers. The sell-off, combined with market dislocations and the opportunities they presented, has led to an increased number of discussions around re-risking.
There is an asymmetric bias for most investors (and pension plans in particular). Adverse and negative outcomes are disproportionately painful compared with the perceived benefits of favorable upside experience. And when re-risking is not codified in an IPS, the adjustment of strategic target allocations requires a difficult, deep discussion on costs and benefits. Specifically, when assessing whether to re-risk a plan, State Street factors the following considerations into its decision-making process.
How well funded is the plan?
Plan status: Is the plan open, closed, or frozen?
Pension obligation in relation to company balance sheet: What is the sponsor’s tolerance?
What is the plan’s contribution policy?
What are the sponsor’s return hurdles and time horizon?
What approvals are needed, and how time-sensitive are they?
Strategic asset allocation targets and associated glide path triggers are client-approved and codified in the Investment Policy Statement. A decision to re-risk by adjusting strategic target weights can be challenging from a governance and timing perspective, as supporting analysis must be produced, discussed, and approved by the client in order to amend the IPS. In the recent crisis, we were able assess the new market environment and potential actions using an expedited asset/liability analysis and recommend changes to the asset allocation through the IPS. But those changes can take time to execute, and when the markets are moving quickly time can cost money.
Tactical Asset Allocation
If we determine that it makes sense for a plan to add risk, there are several ways we can effectuate changes to a portfolio risk profile. A core component of our advisory services is the use of tactical asset allocation, whereby the portfolio can be positioned around the strategic policy benchmark, within allowable ranges, to manage risk or take advantage of market opportunities. For those clients that use our tactical asset allocation services, we can tilt the portfolio across and within asset classes quickly without a change to the IPS. Tactical views and positions are made with a six to 12 month horizon driven by quantitative and fundamental valuations and outlook. For a client with a 60% Risk Asset and 40% Fixed Income allocation, allowable ranges codified in the IPS may allow for a +/-10% shift from the strategic allocation. Therefore, positioning the portfolio across and within allowable ranges can provide the ability to re-risk, or de-risk, given market opportunities and dislocations.
From an implementation perspective, with client approval we can adjust the portfolio risk and return profile synthetically, using derivative overlay strategies in lieu of moving physical assets — which can be more difficult to trade from a liquidity and cost perspective in volatile markets. Derivative-based solutions are flexible by design and can complement the use of physical assets, particularly more liquid indexed or ETF-based vehicles. In traditional balanced, multi-asset portfolios, equity beta and term structure (i.e., duration) are the major drivers of risk and return. Utilizing equity derivatives (futures or total return swaps) and interest rate derivatives (bond futures or total return swaps) allows us to shift the risk and return profile in a more seamless and cost-efficient manner through an overlay.
There are also subtle ways to shift the risk posture of the portfolio within asset classes. Our portfolio construction team can incorporate the use of low beta or minimum volatility equities strategies for our pension clients as an effective way to add risk while providing downside protection. We have also found that derivative strategies (equity collar strategies) are an effective way to adjust the risk profile of a public equity portfolio. Increasing allocations to public equity along with an equity collar can improve downside protection and dampen overall volatility thereby offering a better risk adjusted return. Also, within fixed income, portfolios can be modestly re-risked by shifting Treasuries into long corporate securities. Or, incorporating Treasury futures to replace a portion of physical Treasuries and free up capital with which to buy corporate bonds, given the opportunities presented by recent widening in credit spreads. This allows clients to take advantage of more attractive credit spreads while at the same time increasing their credit spread duration and hedge ratio to their plan liabilities.
The Bottom Line
Implementing a de-risking glide path is good governance and generally allows for quick execution during volatile markets, assuming there is a robust monitoring system in place. When it comes to re-risking, very few pension plans embed a discretionary component into their IPS from a strategic standpoint, so the decision to do so needs to factor in considerations that are unique to each pension. State Street works with our clients to ensure that each has a customized solution that can be quickly and efficiently executed.
About State Street Global Advisors
Our clients are the world’s governments, institutions and financial advisors. To help them achieve their financial goals we live our guiding principles each and every day:
Start with rigor
Build from breadth
Invest as stewards
Invent the future
For four decades, these principles have helped us be the quiet power in a tumultuous investing world. Helping millions of people secure their financial futures. This takes each of our employees in 27 offices around the world, and a firm-wide conviction that we can always do it better. As a result, we are the world’s third-largest asset manager with US $2.69 trillion* under our care.
*This figure is presented as of March 31, 2020 and includes approximately $51.62 billion of assets with respect to SPDR products for which State Street Global Advisors Funds Distributors, LLC (SSGA FD) acts solely as the marketing agent. x FD and State Street Global Advisors are affiliated.
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