DC Plans And The Error Of All-Equity Allocations

It’s rare that an academic paper makes it onto the pages of the financial press, but a study by three professors of finance, entitled ‘Beyond the Status Quo’, has done exactly that. The article argues that, rather than following traditional lifestyle models (in the UK we call them “glidepaths”) – the system by which DC pension plans gradually move their members from riskier towards less risky investments as they near retirement (as shown in the chart below) – investors would do better to be fully invested in stocks both for the full duration of their plans and, indeed, subsequently, once they are in retirement. As the paper puts it, “Americans could realize trillions of dollars in welfare gains” by adopting an “all-equity strategy” for their retirement savings.

The paper drew a degree of scorn, some of it justified. One of the things I’m keen to encourage is a narrowing of the gap between academic research into financial markets – which tends to be dryly theoretical (my friend Cam Harvey is a notable exception) – and the work of market practitioners. ‘Beyond the Status Quo’ at least attempts to do so and, while I disagreed with many of its conclusions, it was both more sophisticated and more thoughtful than some of the criticism suggested. Certainly, it prompted significant discussion in this week’s Tuesday Markets Meeting.

We at Man are thinking more and more about DC pension plans and the challenges they face. While the headlines in autumn 2022 would have made you think that the gilts crisis was all about the potential meltdown of Defined Benefit plans with their LDI funding requirements, the spike in bond/equity correlations also had significant repercussions for DC plans. It was a striking example of something we call sequencing risk – the way that member outcomes are particularly exposed to investment underperformance as they approach retirement.

Lifestyle models and glidepaths are smoothed processes, but we know that market drawdowns aren’t smooth – volatility appears in clusters. While the move from equities into bonds is intended to protect investors against drawdowns, this only works if we presuppose low or no correlation between stocks and bonds. As the chart below, from BofA, shows, it’s only in very recent history that stocks and bonds exhibited negative correlation. For much longer, the two asset classes have moved together in price, and they moved sharply downwards together in 2022.

When we were talking about this in our meeting, my colleague Edward Hoyle, who runs Total Return Strategies for Man AHL, mentioned that he’d written a paper on exactly this point – the exposure of DC pension funds to tail events. In his paper, he initially presents data that would seem to support the work in ‘Beyond the Status Quo’. In most periods, an allocation to stocks would indeed outperform bonds. This shouldn’t surprise anyone – equities deliver, on average, higher returns than fixed income: over the past 100 years or so about 8% vs about 3% after inflation. But equities also suffer more frequent and significant drawdowns and exhibit higher average volatility. All of this is, of course, totally obvious. What Edward did in his paper, though, was to look specifically at what these observations meant for DC plans over the long term.

Edward subjected a model UK and US DC pension portfolio to a series of tail risk events. While these are rare, they are not so rare that investors should be behaving as if they never occur. You can see in the charts below that stocks in both the UK (LHS) and the US (RHSRHS) offer much less protection against tail risk than more conservative assets and asset mixes. In the US, an unlucky generation will get almost 5 years’ less income holding stocks than a 25/75 stock/bond mix (which is typically what a pension plan might have around the time of retirement). Glidepaths are not perfect, but they at least attempt to reflect the fact that exposure to a diversified portfolio should offer some protection against drawdowns.

The clear message here is that diversification and risk management are more important than ever as we move into this new regime. We are working closely with our DC pension clients to help them understand the risks that lie over the horizons of their plan members and how intelligent and evolved allocations to alternatives can help them to navigate this uncertainty. I would characterize the 100% equity approach as an acceptance of defeat, even an abrogation of duty. Risk management should always be the driving and primary impulse behind asset allocation for pension funds.

I was struck, when working through the variety of responses to ‘Beyond the Status Quo’, that it was – obliquely – closely linked to previous articles I’ve written about the hangover from the period of copious liquidity, ultra-low rates and low-single-digit inflation that was the 2010s. Just as the majority of market participants have spent their careers in this artificially stimulated environment, most academics have only known a period of long and consistent performance from stock markets. If you lived in a world where stock market drawdowns were a once in a generation event, of course you’d suggest maxing out your exposure. Risk management, though, should – as Edward’s paper does – consider not only the past, but also how the future may differ from that past. It’s very easy to fall into familiar patterns of thought, to absorb the pervading atmosphere. It’s much harder to think critically and analytically about the future path of returns and the potential risks to which they will be subjected. My strong suspicion is that 100% equity allocations in pension funds will be viewed in years to come as just another indication of an investment world that found it hard to move on from the long free lunch of the 2010s.

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