Pity the pension-fund manager. Cash pays close to zero in many developed economies and ten-year Treasury bonds offer a yield of 2.3%. But many managers need much higher returns if they are to pay the benefits they have promised. That forces them to pile into equities, despite the risks of big bear markets like 2001-02 or 2008-09, not to mention minor scares like mid-October’s wobble.
The problem afflicts firms that maintain “defined-benefit” pension plans, which pay retirement incomes linked to a worker’s final salary. A plunge in the stock market creates a big deficit in the pension scheme and a nasty hole in the sponsoring company’s balance-sheet. That can weigh on the share price: a new study by Llewellyn Consulting found that a £100 increase in the pension deficit of a FTSE 100 company reduces its market value by £160.
The alternative approach, of avoiding risk altogether, may be no more palatable. The company would have to invest in inflation-linked government bonds that offer very low real returns. There would need to be a big increase in contributions to ensure benefits were paid.
The holy grail would be a combination of equity-like returns with reduced volatility. It is unattainable, of course. But it may be possible to get part-way there.
Redington, a consultancy firm, says the latest compromise, which is being adopted by many clients, revolves around a “volatility-control index,” such as the one created by Standard & Poor’s. The approach aims to keep the volatility of an equity portfolio (the amount by which it fluctuates) constant at, say, 10%. If market volatility falls below that level, then investors take more risk by borrowing money to invest in equities. When volatility surges above that level, investors sell shares and hold more cash.
The effect is to produce a portfolio with a much smoother ride than a conventional investment in the stock market (see chart). Of course, there are no free lunches: in return for eliminating the downside, some upside can be lost as well. Such a strategy will underperform in a steadily rising market, but can make up the shortfall and more in bear markets.
There is a further risk. Sometimes, bad news can appear from nowhere. Low volatility, in other words, can be a sign of complacency. To protect against such events, investors buy put options on the volatility-control index. That gives them the right to sell their holdings at a given price. Put options on a portfolio that tracks the broader market are very expensive; options on the volatility-control index are much cheaper, because it tends to move less sharply.
Nevertheless, the cost of these options (around 0.68% a year) does reduce returns. That may be a price worth paying, however, for a firm worried about its balance-sheet. The biggest peak-to-trough loss this approach produced in the past 20 years was 28%, compared with a 56% loss for an unhedged investment in the S&P 500.
Those with good memories may also feel that the strategy is reminiscent of “portfolio insurance”—an earlier attempt to reduce risk. This required institutional investors to protect themselves against stock market falls by selling contracts in the futures market. Some people believe this tactic led to “Black Monday” in October 1987, when the Dow Jones Industrial Average fell almost 23% in one day. As the market dropped, investors sold futures, causing the price to plummet; the decline in the futures price triggered a further sell-off in the underlying equity market, triggering more futures sales and so on.
Something similar could happen with this controlled-volatility approach if it were adopted by a large chunk of the pension industry. If the market became more volatile, such investors would sell equities, making the market more volatile still, necessitating further sales and so on.
For the moment, however, that is unlikely to be a problem, since the approach is still new. The adoption of these strategies also suggests that pension funds are taking a more sophisticated attitude towards investment risk, instead of just placing their chips on equities and hoping for the best. In a similar vein, some funds have attempted to hedge their longevity risk (that workers live longer) and the inflation risk (that wages, and thus benefits, rise faster than expected).
What such strategies cannot do is create higher returns out of thin air. Public-sector pension funds in America that are still counting on long-term returns of 7-8% when the risk-free rate is so low, are living in fairy-tale land. Indeed, their best hope might be to buy some magic beans.
© The Economist Newspaper Limited, London (November 1, 2014)