Pension management is not about volatility, but risk to the funding level. A pension that is underfunded is facing a significant liability risk that will have to to be financed in some form. A pension with 100% funding rate does not have to add any money to the pension and has the option of closing while still meeting its funding obligations. The plan choice does not have to be made, but it is a clear option and presents no funding liability. Clearly a firm that is at 100% funding can eliminate this liability and focus on its core competencies.
After a period of excess funding in 2000 and again in 2007, pension are below 100%, but the gap is closing. The question is whether they learn how to deal with this funding risk appropriately. Greater stock allocations was the solution for getting out of the underfunding since the financial crisis; however, those are the risks that could put pensions back in the same problem.
The problem is actually much worst than just funding shortfall. There is a big difference between the portfolio composition for endowments and corporate defined benefit plans. The corporate pensions have taken their risk through greater stock and bond allocations. Endowments have taken more of their risk through hedge funds. Given the higher traditional asset weights, there is little room for error with corporate endowments. The corporate pension funds for Russell 300 companies feel they can generate more return than endowments. Corporate pension fund median return expectations are 9-9.5% while endowments are expecting 7.5-8%. Given the current low rate for fixed income, these assumptions still expect high equity returns. For corporate pensions, the math suggests that double digit equity returns are required to meet expectations.
These pensions risks requires some strategies that will generate relatively high rates of return with low correlation. More importantly, if there is high beta exposure, there needs to be some assets that will perform well in down markets as protection against funding risk. The list of high performing diversifying assets is relatively small after you account for the low carry in fixed income.
Managed futures may be one of the view alternatives that fill this void. The negative correlation in down markets, the high annual return, and the inherent diversification are all reasons to hold some exposure to managed futures when the hurdle funding rate is high. Managed futures may have fallen out of favor over the last few years given an expected pension rate of return of 9%, but the strong performance in 2014 and the continued diversification benefit may require pensions to take a second look.
The problem is actually much worst than just funding shortfall. There is a big difference between the portfolio composition for endowments and corporate defined benefit plans. The corporate pensions have taken their risk through greater stock and bond allocations. Endowments have taken more of their risk through hedge funds. Given the higher traditional asset weights, there is little room for error with corporate endowments. The corporate pension funds for Russell 300 companies feel they can generate more return than endowments. Corporate pension fund median return expectations are 9-9.5% while endowments are expecting 7.5-8%. Given the current low rate for fixed income, these assumptions still expect high equity returns. For corporate pensions, the math suggests that double digit equity returns are required to meet expectations.
These pensions risks requires some strategies that will generate relatively high rates of return with low correlation. More importantly, if there is high beta exposure, there needs to be some assets that will perform well in down markets as protection against funding risk. The list of high performing diversifying assets is relatively small after you account for the low carry in fixed income.
Managed futures may be one of the view alternatives that fill this void. The negative correlation in down markets, the high annual return, and the inherent diversification are all reasons to hold some exposure to managed futures when the hurdle funding rate is high. Managed futures may have fallen out of favor over the last few years given an expected pension rate of return of 9%, but the strong performance in 2014 and the continued diversification benefit may require pensions to take a second look.
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