Every pension plan is unique and requires a customized investment strategy to mitigate risk and maintain the plan's financial health, which is commonly quantified in the plan's funding ratio. Having worked with plan sponsors to manage their corporate pension plans over the past two decades, we have identified some general best practices for strategic asset allocation.
In Revisiting Pension Asset Allocation, we share a framework for reducing funding ratio volatility through the management of risk drivers. The two main risk factors for a pension plan are market risk, or adverse outcomes for return-seeking assets, and interest rate risk, or how changes in interest rates adversely impact the relationship between assets and liabilities. Further, we divide interest rate risk into the primary components relative to both the risk-free rate and credit spreads.
Our asset allocation process addresses market and interest rate risk by setting target values for three areas of strategic asset allocation.
1. Return-seeking asset allocation target. The proportion of assets allocated to return-seeking assets has a major influence on long-term risk and return. Exposing a plan to market risk helps to capture the equity risk premium—the assumed return on equities above the risk-free rate—which targets funding ratio improvement over the long term, but higher allocations to return-seeking assets come at the cost of additional risk. Appropriate allocations to return-seeking assets can range from 0% to 70%, and depend on the plan's funding ratio, plan status, participant demographics, and how the plan's financial results correlate with the underlying business of the sponsor.
Pension liabilities are valued using market yields on high-quality corporate bonds and therefore are sensitive to changes in interest rates. A plan manages this risk through a strategy known as liability-driven investing, or LDI. Changes in interest rates can be separated into two components: movements in the underlying risk-free rate and movements in credit spreads. We see a benefit in separately analyzing and allocating assets to manage these risks.
2. Interest rate hedge ratio target. The interest rate hedge ratio reflects how fluctuations in interest rates impact both the plan's assets and liabilities. Plans often look to offset interest rate risk though investment in long-duration Treasury and corporate bonds, as well as derivative securities such as Treasury futures. In Vanguard's view, a plan's interest rate hedge ratio should be at least equal to its funding ratio.
3. Credit spread hedge ratio target. The credit spread hedge ratio quantifies the portion of liability risk resulting from changing credit spreads that is expected to be offset by the liability-hedging portion of the investment portfolio. Plans often invest in long-duration high-quality corporate bonds to protect against credit spread risk. Due to credit spread risk being a lower order risk than interest rate risk, and other factors further explained in the research, our view is that a plan's credit spread hedge ratio can be lower than its interest rate hedge ratio and approximately equal to the interest rate hedge ratio multiplied by the allocation to liability-hedging assets.
The figure below illustrates the transition of a hypothetical plan's asset allocation from return-seeking assets to liability-hedging assets as the plan's funded status improves. During this process, both the interest rate and credit spread hedge ratio increase, and surplus value at risk decreases.
Sample glide path for a hypothetical pension plan
Notes: Projected benefit obligation (PBO) is commonly used in the pension investment process as a market-based measure of plan liability. Other U.S. Generally Accepted Accounting Principles (GAAP) liability measures, including accumulated benefit obligation (ABO) and present value of benefits (PVB), may also be useful for this purpose, depending on the plan sponsor's objectives. The VaR in the funding status value at risk (VaR) entry measures a 5th-percentile outcome (where 5% of outcomes are worse but 95% are better) over a one-year time horizon. Measurement date for VaR calculations is May 31, 2021. Because of rounding, VaR figures may not add up exactly. See the Notes section at the end of this article for important details on our forecasting and risk models.
Sources: Vanguard and MSCI BarraOne.
Managing asset allocation as funding ratio improves
Pension plan asset allocation can be managed dynamically using glide-path investment strategies based on a plan's funding ratio and design. The role of glide-path strategies is to decrease the return-seeking allocation and increase the management of interest rate and credit spread risk as the plan's funding ratio improves and the plan's goals transition from funding ratio growth to funding ratio preservation.
In Revisiting Pension Asset Allocation, you'll find more about how targets can be used as the foundation for a robust and customized asset allocation and risk management process. To discuss strategies for your pension plan, contact your Vanguard investment consultant.
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Notes:
- All investing is subject to risk, including the possible loss of the money you invest. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
- Investments in bonds are subject to interest rate, credit, and inflation risk. U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest. Futures trading is speculative in nature and involves substantial risk of loss. Futures are not suitable for all investors.
Value at Risk (VaR) and MSCI BarraOne information
Value at Risk (VaR) estimates in this paper were made using MSCI Barra's multi-factor asset-liability risk model. The MSCI Barra models are intended to help investors understand sources of risk and return within securities and portfolios of securities. The models pertain to risks present in the equity, fixed income, currency, commodity, and other alternative markets. As a predictive model, this model may not achieve this intended purpose, especially over shorter-term periods. The model may not account for all risks actually present, and may incorrectly infer the magnitude of the risks and the degree that they will influence security returns in the future. The model is continually updated based on MSCI Barra's ongoing research. The model itself is not to be construed as advice of which securities to own or the degree of return that will be earned by any security in the future. The model may be applied in the course of providing advice by Vanguard Investment Advisers, Inc. In this report, it is intended to ease communication related to the sources of risk and return within a portfolio of securities from a variety of asset classes.