Dynamic AA helps underfunded plans curb risk

Last week Russell Investments released new research arguing some pension plans should consider liability-responsive asset allocation – asset allocation that changes depending on the plan’s funded status. In this in-depth interview Amanda White explores the concept with one of the report’s
authors, director of investment strategy, Bob Collie, including why until now such dynamic asset allocation has been difficult.

Liability-responsive asset allocation is a type of dynamic asset allocation. But instead of a change in opinion of the asset classes triggering a different allocation, it is the funded status of the pension plan, which affects the risk-reward trade-off that the asset allocation choice represents, that acts as the trigger.

Under the approach, the plan sets an asset allocation policy to reflect its current circumstances, but also specifies various policies that apply at different funded levels. As the plan’s actual position varies, the asset allocation is adjusted in accordance with this schedule.

Put simply, liability-responsive asset allocation is creating a process where the policy varies with the funded position.

For example, if a plan decides to allocate 60 per cent of its portfolio to return-seeking assets when its funded status is 70 per cent, but knows it would allocate just 20 per cent if its funded status was 110 per cent, then this allows the plan to track its funded status and dynamically adjust the asset allocation.

According to Bob Collie, director, investment strategy at Russell Investments, pension plans in the US are in the process of establishing these programs, and because the idea is a simple one it can apply to a fund of any size.

Liability-responsive asset allocation is a concept that allows pension plans to fine-tune their investment policies to better reflect their changing circumstances.

The analysis outlined in the report authored by Collie and his colleague, senior investment strategist, James Gannon, shows that for an increasing number of defined benefit pension plans in the US, the expected benefit of an equity-oriented investment strategy reduces as the funded status improves, because of the risk of trapped capital in the event of a favourable investment experience.

“This alters the risk-reward trade-off that underlies the asset allocation decision. Other things being equal, the stronger a plan’s funded status becomes, the more cautious the desired policy should be. Liability-responsive asset allocation allows a plan to adopt an appropriate level of equity investment at a particular funded status, while also allowing
for automatic adjustment of that strategy if funded status changes materially.”

Collie says that by setting the rules in advance, actions can be made quickly and effectively without further decisions being required from the governing board.

“The difference between this and how boards may have acted in the past, is you make the policy up front so that if you hit a certain target you make the change – so at any board meeting you would have to make an active decision or have a discussion to not do it,” he says, likening it to the automation of rebalancing programs.

One of the reasons this concept is now able to be more easily implemented is it is easier to make actuarial estimates of the funded level at more periodic intervals.

“With the technology available now we can be watching estimates in funding status, and can come up with estimates as frequently as monthly or quarterly. The relationship between the yield curve and liability is well understood,” Collie says.

Russell is not prescriptive on particular asset allocations for certain funding levels.

While in some cases, typically for frozen plans, there are certain situations where Russell would, at the very least, tell plans what direction to move in, for the most part the level of risk still depends on the capacity of the board.

However Collie says the market volatility of the past year, and massive jumps in funding levels, has made plans more risk aware.

“It is interesting where we sit now, that there is a focus from funds on 70 or 80 per cent funding levels, that are thinking when they get back to 100 per cent status they want to be more cautious and make sure this doesn’t happen again,” he says.

But he warns that if funds are trying to close the funding gap with their investment program, they still have to take risk, and that risk has to be rewarded.

“It is still the risk/reward trade-off that closes the funding gap,” he says. “But this type of asset allocation makes sure there is control on the risk taken, and that the risk you take is the risk you need.”

For the full Russell report, see the research section of this website.