How to Solve the ‘Equity Dilemma’

So how can they balance the need to keep an equity allocation high enough to ensure participants have enough retirement savings, with the need to keep the allocation low enough that they have greater protection from market risk? The answer is a low-volatility strategy in a portfolio’s equity sleeve, Mike Raso, senior vice president and director of institutional retirement at Old Mutual Asset Management, told PLANADVISER.

This strategy offers both downside protection and upside participation for investors, Raso said. Greater downside protection, especially near the end of a participant’s accumulation cycle, must be built into the equity sleeves of retirement plans to avoid a repeat of the 2008 financial disaster’s effect on retirees, according to Old Mutual’s paper, “The Target Date Equity Dilemma.”

While plan sponsors cannot control the contributions and time components, they can control investment volatility, which is why target-date funds (TDFs) are ideal beneficiaries of a low-volatility strategy, the paper explains. It outlines three main approaches to lowering the volatility of an equity sleeve in the TDF:

• Utilizing defensively oriented value managers;
• Hiring managers who use a quantitative approach to produce a portfolio designed to have the lowest expected volatility for a given set of constraints; and
• Utilizing alternatives (such as commodities, managed futures, real estate and hedging strategies) in conjunction with traditional equity strategies to smooth returns and create a low-volatility effect.  “We’re really starting to see real estate make its way into customized TDFs,” Raso said. “Commodities are making their way, too.”

(Cont’d…)

Traditionally, alternatives have been the first approach to lower a portfolio’s volatility, but they come with a higher price and can have liquidity constraints in a TDF structure, according to the paper. The development of systematic portfolios focused on lower volatility, as well as defensively oriented managers, have become popular, lower-cost options to solve the volatility problem, the paper said.

Raso said customized TDFs, traditionally seen in large and mega plans, are beginning to “come downstream” to smaller plans. “I think everyone can benefit from them,” he added.

Although cost is still a hindrance for smaller plans to adopt custom TDFs, Raso said he thinks they will become more cost efficient as a result of fees being compressed following the passage of regulations like 404(a)(5) and 408(b)(2).

Creating customized TDFs allows plan sponsors to cater to their specific participant demographic. Selectively implementing de-risking and/or risk-budgeting through low-volatility strategies will empower sponsors to create better solutions for their plan participants and help them fulfill their fiduciary duties, the paper concluded.