For many defined-benefit pension plans, the big story of 2013 was a dramatic improvement in funded ratios, driven by a surge in equity prices and rising interest rates. Not surprisingly, many liability-driven investors are now turning their attention to de-risking. We believe the changing picture in fixed income strategy has particular relevance for them.

Our case rests on a re-examination of the allocation approach favored by a majority of liability-driven investors. The prevailing practice is to divide the portfolio into two “buckets.” One bucket seeks returns and typically contains equities and other growth assets. The other bucket seeks to hedge liabilities, using fixed income instruments. The setup is a convenient one, especially for institutions building glide paths for de-risking. But this separation of duties can also limit a plan sponsor’s view of the overall mission.

Ultimately, sponsors are accountable for managing the plan’s surplus risk—that is, the volatility of its funded status. They need to keep both sides of a complicated equation in focus: liabilities (the value of which moves with interest rates, time and other factors) and assets (which move with markets, contributions and time).

The return-seeking portfolio should make the best possible use of the risk budget. Diversification within the return bucket is a priority—but to date this diversification has rarely extended to fixed income, which is usually seen as belonging in the hedging bucket. Current market conditions make it worthwhile to rethink this.

  • A de-risking investor may want to reduce equities somewhat from previous levels, following the sharp rise in global equities.
  • Meanwhile, the challenging fixed income markets that are frustrating benchmarked fixed income strategies are creating opportunities for flexible strategies to earn attractive risk-adjusted returns—making them worth considering for inclusion in the return-seeking portfolio.

Here are some of the issues that liability-driven investors should consider when assessing investment strategies for possible inclusion in a return-seeking portfolio:

Unconstrained Fixed Income LDI Tale of Two Buckets Table