As pension systems close the books on another June 30 fiscal year, an all too familiar theme is rearing its ugly head: pressure to lower investment return assumptions. Pensions have long time horizons, and aggressive changes in long-term outlook should be rare, but many of the key building blocks used by asset allocators to forecast expected returns have moved lower.

  • Treasury yields. For the fiscal year ending 6/30/19, 30-year yields fell over 50 basis points, while 10-year yields fell over 80 basis points. With lower Treasury yields, expected fixed income returns fall.
  • Inflation. CPI has tracked slightly below expectations, and break-even inflation is noticeably lower than a year ago. Lower inflation expectations directly translate to lower expected nominal returns.
  • Equity valuations. Pressure on forward-looking returns appeared to have subsided with a late 2018 selloff, which made valuations more attractive. But fiscal 2019 turned into another strong year for equity returns, with the S&P 500® up just over 10%. When equities grind higher, they often look more expensive in long-term valuation models, and an expectation for multiple compression reduces forward-looking returns.
The prospect of lower expected returns introduces a critical decision: Should investors take more risk in their portfolios to help meet their goals, or should they accept a lower outcome and plan accordingly? Adopting more conservative assumptions increases pension liabilities, decreases funded status, and leads to higher contribution requirements, which may not be feasible.

To avoid this, plan sponsors may be tempted to further tilt the portfolio toward return-seeking assets, but there are more options than simply adding to the equity allocation and shouldering additional volatility. Instead, consider increasing the equity allocation while decreasing beta. One market segment worth evaluating is options-based equity, which provides equity-like returns with the added benefit of tail risk management. This solution strikes a nice balance, by reducing pressure on long-term baseline return assumptions while helping to manage downside outcomes.
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