Featured Solutions June 2013 Your Global Investment Authority Efficient Pension Investing Oh Lord, help me to be pure. But not yet! St. Augustine Defining purity for a pension strategy is a tricky thing. Matching assets and liabilities, reducing risk these might be seen as the equivalent of a pure and balanced approach. But for many pensions today underfunded relative to liabilities, or with open and active plans such an approach would condemn the sponsor to higher contributions for years to come. On the other hand, return-seeking, risk-taking strategies these offer the prospect of building up capital without costly contributions. (Though we should not overlook the nasty habit they have of backfiring.) Jared Gross Executive Vice President Product Manager Mr. Gross is an executive vice president in the Newport Beach office, a product manager for liability driven investment products and a member of the investment solutions group. He focuses on asset allocation and asset-liability management strategies for pension funds and other institutional investors. Prior to joining PIMCO in 2008, he was a senior relationship manager in Lehman Brothers' pension solutions group, working with large corporate and public pension plans in the U.S. He held a similar position at Goldman Sachs. Mr. Gross also spent five years in Washington, D.C.: two years as an advisor to the executive director on investment policy at the Pension Benefit Guaranty Corporation and three years at the Treasury department, focusing on debt financing and management and domestic securities market issues. He has 19 years of investment experience and holds an undergraduate degree from Williams College. Purity, in the form of full hedging of liabilities, may very well have to wait for those plans that need to outperform their liabilities today. But we can keep an eye on risk while we go about the difficult process of seeking returns. Let s propose that a more realistic goal would be to achieve the highest risk-adjusted return on assets relative to liabilities. What follows is a simple framework to help pension investors achieve this goal. Start from the liability For a pension, the liability is the ultimate benchmark, both with respect to risk and return. Investments will have returns that may be higher or lower than the liability, and risk (volatility) that may be higher or lower than the liability. Figure 1 maps a variety of asset classes onto an asset-liability efficient frontier. The Y-axis shows returns; the X-axis, risk versus liabilities.
FIGURE 1: MAPPING A PENSION FUND S EFFICIENT FRONTIER Source: PIMCO. Sample for illustrative purposes only. There are a few key takeaways. The first is that the least-risky investment will typically be a long-term bond portfolio with risk characteristics identical to the liability. A customized liability-driven investment (LDI) strategy can provide this solution. Intermediate bonds and cash generally exhibit both higher risk and lower returns relative to liabilities and are therefore unattractive from a strategic standpoint. Risk assets, such as absolute return (hedge funds) and equities, generally offer higher returns but potentially much higher volatility. Their use may be necessary insofar as a plan seeks to outperform. Very well-funded plans may have little or no need for outperformance, instead choosing to lock-in funding by shifting most or all assets to liability-matched bonds. Seeking efficient pension portfolios In practice, of course, pension investors don t construct asset allocations in a vacuum, but rather relative to specific objectives such as targeted rates of return or levels of funded-status volatility. Given the multitude of investment options available, however, it is usually the case that there are many allocations that could be designed to achieve a single goal. It is therefore useful to identify a portfolio strategy that meets the objectives most efficiently. Pension efficiency can be measured by adapting a basic investment concept: the Sharpe ratio. Traditionally, the Sharpe ratio is used to evaluate the risk-adjusted returns of individual investment strategies. Excess returns over a risk-free rate are divided by the volatility; the higher the ratio, the better. JUNE 2013 FEATURED SOLUTIONS 2
Pension plans can apply the underlying logic of the Sharpe ratio to evaluate strategy at the total plan level. The transformation into what is also known as the liability-adjusted Sharpe ratio is straightforward: FIGURE 2: THE PENSION SHARPE RATIO Key Inputs Sharpe Ratio Pension Sharpe Ratio Return Asset return Portfolio expected return Risk-free rate T-bill yield Liability discount rate Volatility Asset-price volatility Funded-status volatility Source: PIMCO The total plan has an expected rate of return that is the weighted average of the expected return of all assets in the portfolio. The risk-free rate is the natural growth rate of the liability, represented by the liability discount rate. The volatility of the total plan is the funded-status volatility. Each of these measures can be observed (or estimated) without much difficulty. In our experience, the most significant efficiency gains in pension strategy have come from shifting from intermediate bonds to long-term bonds (higher return, lower risk) and introducing lower-volatility substitutes to equities in the returnseeking portfolio (similar return, lower risk). Consider a hypothetical example: A plan starts out with a traditional 60/40 allocation of stocks and bonds, then shifts its fixed income to long-duration liability-matched bonds, and then diversifies its equities into alternative assets (see Figure 3). The increase in the pension Sharpe ratio shows that both strategies may be more efficient: The first switch from core bonds to LDI reduces estimated volatility with a higher return potential, while the second switch from stocks to alternatives achieves the same level of estimated returns with significantly lower risk potential. JUNE 2013 FEATURED SOLUTIONS 3
FIGURE 3: POTENTIAL IMPROVEMENTS ON THE CLASSIC 60/40 PORTFOLIO 40% Bonds 40% LDI 30% Stocks 30% Alts 40% LDI Estimated return 6.0% 6.9% 6.0% Discount rate 4.0% 4.0% 4.0% Estimated surplus volatility 14.2% 12.3% 9.5% Plan Sharpe ratio 0.14 0.23 0.21 Source: PIMCO. Hypothetical example for illustrative purposes only. Stocks Equally weighted blend of S&P 500, Russell 2000, MSCI ACWI Ex US; Bonds Barclays U.S. Aggregate Index; Alternatives HFRI Fund Weighted Composite Index; LDI Barclays Long Credit, Barclays Long Gov t and Citigroup 20+ Strips indexes blended to match the liability risk factors (duration, credit spread duration and curve risk profile). Surplus volatility is the measure of the dispersion between the performance of assets and liabilities. Return estimates for equity and hedge funds are based on capital market assumptions compiled from various consultants using median return. For fixed income indexes, yield to maturity was used. How efficient is further de-risking? The two portfolio shifts we discussed above could fairly be described as lowhanging fruit because they produce material improvements in the Sharpe ratio with only limited changes in the structure of the asset allocation (the split between return-seeking assets and bonds remains at 60/40). Indeed, many plan sponsors have already made moves in this direction. Going forward, however, most pension plans envision additional de-risking by shifting assets from the return-seeking category into LDI strategies. Given the loss of return this may entail, it s reasonable to ask if these changes would actually make the strategy less efficient. Fortunately, it appears that this would not be the case at least until the final stages of de-risking. As Figure 4 shows, expected return does decline, but the potential drop in volatility would be significant. (And frankly, plans that are taking the final step to completely de-risk are likely to be more focused on the absolute level of risk than the incremental efficiency of the plan.) JUNE 2013 FEATURED SOLUTIONS 4
FIGURE 4: EVALUATING THE PROGRESSION INTO LIABILITY-HEDGING STRATEGIES Portfolio 40% Bonds 40 %LDI 20% Stocks 80% LDI 100% LDI Estimated return 6.9% 6.0% 5.1% 4.3% Discount rate 4.0% 4.0% 4.0% 4.0% Estimated volatility 12.3% 8.3% 4.5% 1.8% Plan Sharpe ratio 0.23 0.24 0.25 0.14 Source: PIMCO. Hypothetical example for illustrative purposes only. Stocks Equally weighted blend of S&P 500, Russell 2000, MSCI ACWI Ex US; Alternatives HFRI Fund Weighted Composite Index; LDI Barclays Long Credit, Barclays Long Gov t and Citigroup 20+ Strips indexes blended to match the liability risk factors (duration, credit spread duration and curve risk profile). Here endeth the lesson St. Augustine might well sympathize with the very real dilemma of balancing a short-term need for return with a long-term desire to de-risk. We hope that most pension plans will eventually reach a level of funding where the dilemma fades to insignificance, and where the transition to de-risking becomes relatively painless. Until then, however, the best option may be to choose a strategy that keeps close account of both risk and return. FIGURE 5: STRATEGIES DESIGNED TO IMPROVE PENSION EFFICIENCY Shift core bonds to LDI Customize fixed income benchmarks Use overlays to increase duration Identify lowervolatility equity substitutes Use portable alpha strategies Source: PIMCO May provide a better hedge to key liability risk characteristics (duration and credit spread) while simultaneously increasing yield potential (and expected return on assets). Allows bond portfolios to adapt to changes in funded status and asset allocation, providing the potential for more effective hedges and lower portfolio risk over time. Allows a more complete hedge of interest rate risk while keeping assets allocated to return-seeking strategies such as stocks or alternatives. Can include directional exposure to interest rates via swaps and futures, or non-linear exposure through the use of swaptions and collar strategies. Designed to allow the return-seeking portfolio to seek outperformance versus liabilities with potentially lower levels of volatility. These commonly include low-volatility equity strategies, hedge funds, levered fixed income, high yield bonds and emerging markets non-dollar bonds. Designed to increase the ability of plan assets to deliver excess return versus market benchmarks by combining more than one desirable asset class in one investment. For defined benefit pension plans, an effective portable alpha strategy is long-duration fixed income backing equity futures. JUNE 2013 FEATURED SOLUTIONS 5
Newport Beach Headquarters 840 Newport Center Drive Newport Beach, CA 92660 +1 949.720.6000 Amsterdam Disclaimer Past performance is not a guarantee or a reliable indicator of future results. Absolute return portfolios may not necessarily fully participate in strong (positive) market rallies. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Portable alpha is an actively managed strategy employed by portfolio managers to separate alpha from beta by investing in securities that differ from the market index from which their beta is derived. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Expected return is an estimate of what investments may earn on average over the long term and is not a prediction or a projection of future results. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods. The "risk free" rate can be considered the return on an investment that, in theory, carries no risk. Therefore, it is implied that any additional risk should be rewarded with additional return. All investments contain risk and may lose value. Return assumptions are for illustrative purposes only and are not a prediction or a projection of return. Return assumption is an estimate of what investments may earn on average over a ten year period. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods. To calculate volatility we employed a block bootstrap methodology. We start by computing historical factor returns that underlie each asset class proxy from January 1997 through the present date. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. This process is repeated 15,000 times to have a return series with 15,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return series for each factor to compute covariance between factors. Finally, volatility of each asset class proxy is calculated as the sum of variances and covariance of factors that underlie that particular proxy. Hong Kong London Milan Munich New York Rio de Janeiro Singapore Sydney Tokyo Toronto Zurich pimco.com
No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. Barclays U.S. Long Credit Index is the credit component of the Barclays US Government/Credit Index, a widely recognized index that features a blend of US Treasury, government-sponsored (US Agency and supranational), and corporate securities limited to a maturity of more than ten years. Barclays Long-Term Treasury consists of U.S. Treasury issues with maturities of 10 or more years. Citigroup STRIPS Index, 20+ Year Sub-Index represents a composition of outstanding Treasury Bonds and Notes with a maturity of at least twenty years. The index is rebalanced each month in accordance with underlying Treasury figures and profiles provided as of the previous month-end. The included STRIPS are derived only from bonds in the Citigroup U.S. Treasury Bond Index, which include coupon strips with less than one year remaining to maturity. The index does not reflect deductions for fees, expenses or taxes. The HFRI Fund Weighted Composite Index is comprised of over 2000 domestic and offshore constituent funds. All funds report assets in USD and report net of fees returns on a monthly basis. There is no Fund of Funds included in the index and each has at least $50 million under management or have been actively trading for at least twelve months. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index. This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Munich Branch (Company No. 157591), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Services Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam, Italy and Munich Branches are additionally regulated by the AFM, CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, and BaFin in accordance with Section 53b of the German Banking Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Services Authority's Handbook and are not available to individual investors, who should not rely on this communication. PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. PIMCO Asia Pte Ltd (501 Orchard Road #08-03, Wheelock Place, Singapore 238880, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. PIMCO Asia Pte Ltd services and products are available only to accredited investors, expert investors and institutional investors as defined in the Securities and Futures Act. PIMCO Asia Limited (24 th Floor, Units 2402, 2403 & 2405 Nine Queen s Road Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. PIMCO Australia Pty Ltd (Level 19, 363 George Street, Sydney, NSW 2000, Australia), AFSL 246862 and ABN 54084280508, offers services to wholesale clients as defined in the Corporations Act 2001. PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and Investment Trusts Association. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1 o andar, Rio de Janeiro RJ Brasil 22210-030. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. 2013, PIMCO. Newport Beach Headquarters 840 Newport Center Drive Newport Beach, CA 92660 +1 949.720.6000 Amsterdam Hong Kong London Milan Munich New York Rio de Janeiro Singapore Sydney Tokyo Toronto Zurich pimco.com