Equities can offer better risk-adjusted returns than hedging strategies alone

Despite the volatility seen in markets since 2020, trustees are keen to take more risk with their investments. But does it make sense to take risk with growth assets – or by under-hedging their liabilities? And how do trustees know how much risk to take?

| 5 min read

Since the financial crisis, central banks have kept interest rates at, or close to, historic lows. This has created a significant problem for trustees of defined-benefit (DB) pension schemes, as low interest rates limit future investment returns on defensive fixed income assets and inflate liabilities.

To counter this, pension funds offering DB promises may be tempted to move up the risk spectrum. This can be achieved by relaxing portfolio hedging constraints and under hedging a portfolio – or by increasing a fund’s exposure to equities and riskier investments.

A wide range of inflation possibilities

The attraction of under-hedging is that many commentators believe that this low interest rate environment will not continue for much longer. Inflationary pressures are building which may – or may not – prove to be temporary. A significant concern in markets is that rates will rise rapidly in anticipation of higher inflation over the coming years. This is especially true in the US, where the Federal Reserve intend to continue running their economy hot to repair the economic damage caused by restrictive measures introduced to deal with the Cocvid-19 pandemic.

The US central bank is looking through what policymakers believe is a temporary rise in inflation caused by supply-side constraints as economies reopen from lockdowns. This, they argue, will ease as the economic situation normalises. If interest rates do start rising then pension funds will be better off if they under-hedge their liabilities. In a survey of professional trustees for Charles Stanley Fiduciary Management, the most popular risk-taking move was to relax liability hedges and increase interest rate risk.

Yet this situation is not clear cut. Global consumers are in a strong position with debt servicing costs at multi-decade lows and a glut of savings as we emerge from pandemic related lockdowns. This is likely to result in a significant increase in demand. Wage inflation is also a major concern, particularly in the US, and there is a risk that these temporary factors become structural.

This means there is now a wider range of possible inflationary scenarios than there has been for many years. Attempting to predict the future path of interest rates – and doing in a way that actually beats live market pricing – is always a major challenge. In such an environment, a strategy that bets on whether long-term interest rates will rise or fall becomes increasingly tricky.

Instead of attempting to outwit the market by predicting future interest rate moves, we believe a diversified portfolio of growth assets has a greater probability of producing attractive risk-adjusted returns over the long-term. Professional portfolio managers have the expertise to manage the risks presented by investing in equity markets on a day-to-day basis, and to balance this through a diversified portfolio of growth assets including infrastructure, property, alternatives and credit strategies.

How much risk can trustees afford?

While professional portfolio managers can deal with the day-to-day management of risk in an equity portfolio, it is up to trustees to determine the size of their fund’s exposure to equities – the ‘risk budget’. This will be different for any pension scheme as it is based on the financial strength of the sponsor company and the trustees’ own appetite for risk.

Ultimately, a DB pension scheme can take risk with their investments so long as the company behind it has enough cash to plug the deficit if there is one – and is willing to use it. But trustees will always prefer to fill the gap with cash from the sponsor – if it’s available. So, while any pension scheme needs to take some risk to keep up with its liabilities if there is a deficit it’s better to get the company to plug it for zero risk than to take investment risk. A sensible balance between the two – some additional cash from the sponsor aligned with some investment risk – is the typical combination. By using tried-and-tested analytical tools, trustees can quantify the risk they are running – and determine whether they can afford to take more or need to take less.

Whatever the risk budget, a professionally managed growth portfolio can help provide these risk-adjusted returns without trustees themselves having to be experts in investment. Under-hedging can add value where risk budgets allow, particularly for pension schemes with distant funding targets. But, given the high degree of uncertainty that persists around interest rates we believe risk budgets are likely to be better spent on the dynamic management of an equity-based growth portfolio, designed to give trustees and sponsors the risk-adjusted returns they need to plug funding gaps.

Source: Charles Stanley / Censuswide. Research was carried by Censuswide among 55 professional trustees of UK DB pension funds. The survey was completed between 21/07/2021 – 04/08/2021.

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Equities can offer better risk-adjusted returns than hedging strategies alone

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