Liability-driven investment (LDI) strategies have been around for some time now. The main idea behind LDI strategies is that pensions should invest in long-term fixed-income securities in order to match their long-term liabilities. The theory is certainly sound; if a pension is able to accurately match all sensitivities to the yield curve of both assets and liabilities then its future income statements would not be subject to future interest rate moves. But a reduction in volatility of future cash requirements does not necessarily mean a reduction in future cash requirements.
For instance, underfunded plans may simply be locking in large future cash requirements if they were to move to an LDI strategy. This would be caused by the need to make up their funding deficit through future contributions. Further, even some well-funded plans may lock in large future contributions, which is due to the potential discrepancy between the assumed earned rate on assets in the actuarial valuation (current funded status) and the actual rates available in the market currently. Locking in future contributions may be feasible, or even preferable, to some well-funded pension plans. But for others the need for growth remains.
Growth assets such as equities are necessarily accompanied by an increase in volatility. Generally speaking, asset allocation strategies comprising equities have focused on notions of the long-term expected returns and volatilities of these assets, along with their correlations with each other and other portfolio assets. But such methods have ignored short-term fluctuations in these expected values. For instance, at the beginning of the financial crisis in September 2008, short-term realized equity volatilities were around three times their historical average levels. Accordingly, portfolio volatilities were much higher than targeted and, as most of the volatility was on the downside, much pain was felt.
Therefore, the need for asset risk management, as part of a comprehensive risk management process, is greatest in those plans requiring investment in growth assets. As such, this has become a hot topic of discussion among investment advisors, risk professionals, fund managers, and academics.
The need for portfolio growth should not be viewed as a license for unmitigated risk-taking. Equity risk management strategies involving the purchase of put options have been around for some time, but they are very expensive and rigid in the long term and require precise market timing in the short term. Another fund strategy, risk parity, seeks to create a fund with equal risk contributions from different asset classes. Given the lower volatility of bonds, however, this necessarily means large bond allocations, which may not be desirable given the current interest rate environment. Ideally, a pension plan would benefit from a futures overlay strategy that combines formula-driven volatility management plus capital protection to help mitigate equity risk. The Milliman Managed Risk Strategy offers exactly that, and when combined with an effective LDI strategy, the pension portfolio becomes well positioned for (responsible) growth!