Dealing with Pension Plan Deficits

In January, it emerged that Shell UK had become the latest—and probably the last—company in the UK’s FTSE 100 Index to announce it was closing its defined benefit (DB) pension scheme to new members. The news points up a dilemma facing the trustees of many large corporate pension providers.

On the one hand, pension funds still have billions in liabilities to meet over several decades, so they have to maintain risk in their portfolios. On the other hand, their pension funds’ increasing maturity gradually decreases their capacity to take risk. This is not a problem perhaps if, like Shell, the fund is in surplus, but the reality is that most are in deficit.

Trustees know that managing risk is no longer an aspiration—it’s a necessity. For most, the question boils down to whether they should navigate the plethora of de-risking solutions now available, and if so, how? Should they opt for a buyout or a buy-in? Implement longevity hedges, or take out employer-covenant insurance?

In our view, many of the solutions being offered are overly costly and complex. We think that trustees should take the advice of Albert Einstein. As he said, “Everything should be made as simple as possible but no simpler.”

Most DB pension schemes facing unfunded liabilities could implement a straightforward, low-cost investment strategy that would allow them to plug their funding deficit and de-risk the plan over time. They could achieve this by combining a series of liability-driven investment funds employing prudent leverage with a well-diversified series of return-generating strategies. The combination would reduce risk by matching a scheme’s assets more closely with its liabilities, while diversifying its sources of return.

For such an approach to be effective, a scheme should partner with an investment manager or consultant who is able to ensure that the investment strategy adheres to three key principles:

  • Be time-varying. A pension scheme’s capacity for risk diminishes as its time horizon shortens, so the asset allocation should be preset to change as the scheme matures.
  • Be path-dependent. The need for risk decreases as the scheme’s funding level improves, so triggers should be set to ensure that the scheme’s investment in return-generating assets is automatically reduced as its funding ratio improves.
  • Be market-responsive. The risk taken should reflect expected rewards, so that the scheme’s asset allocation adjusts dynamically as market risk and return opportunities change.

A strategy that adheres to these principles would enable trustees to be proactive rather than reactive, capture de-risking opportunities without delay and align the objectives of the investment manager with those of the pension scheme.

Really, what could be simpler than that?

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Patrick Rudden is the Head of Blend Strategies at AllianceBernstein.

Patrick Rudden

Patrick Rudden was appointed Head of Blend Strategies in 2009. Prior to this appointment, he was head of institutional investment solutions within the Blend team. Rudden served as a senior portfolio manager for value equities services for over eight years, having joined the firm in 2001. He has published numerous articles and research papers, including, “What It Means to Be a Value Investor”; “An Integrated Approach to Asset Allocation” (with Seth Masters); and “Taking the Risk Out of Defined Benefit Pension Plans: The Lure of LDI” (with Drew Demakis). Previously, Rudden was a managing director and head of global equity research at BARRA Rogerscasey, an investment consulting firm. He earned an MA from Oxford University and an MBA from Cornell University. Rudden is a CFA charterholder. Location: London

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2 thoughts on “Are Bonds Really Less Risky than Equities?

  1. Hi Patrick,

    Fascinating study. Thank you for sharing it. I was wondering, when you show real returns of stocks broken down by capital gain and dividend yield, are you subtracting the rate of inflation from the capital gain or from the dividend yield or both? In other words, are you showing nominal yield and real capital gain? Or real yield and nominal capital gain? Or some type of adjustment in between. Thanks again for sharing.

    • The methodology applied by the authors of Triumph of the Optimists: 101 Years of Global Investment Returns is to measure real equity total returns and real equity capital gains. I show the dividend yield as the difference between the two. For example, the real equity total return from 1900 to 1910 was 6.8% annualised; the real equity capital gain was 2.0% and we show the difference between the two of 4.8% as the real yield. Incidentally, the returns to the world equity series comprises a seventeen-country, common-currency (US dollar) index and hence real returns are after US inflation.

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