How risk parity strategies could enhance risk-adjusted returns, and maintain growth prospects while lowering the probability of falling to a dangerously low funded status.

In this paper, we argue that risk parity strategies have a role to play for defined benefit pension plans that face the challenges of under-funding, low core bond yields and low expected returns from risk and growth assets. In general, we show that adding risk parity can enhance risk-adjusted return, and particularly downside risk-adjusted returns, relative to traditional asset allocations. Investors that are willing to give up some potential for funded status to meaningfully exceed 100% may be able to lower the probability of funded status falling below 80% using risk parity.

Moreover, while we seek to show that risk parity has what we view as a clear role for underfunded plans, we also argue that the flexibility of the strategy can give it a useful role to play regardless of current funded status.

Executive Summary

  • Risk parity identifies the portfolio with the highest expected risk-adjusted return and applies leverage to achieve the desired level of return.
  • Using risk parity, it has been possible to achieve the returns of a traditional 60/40 portfolio with lower volatility and lower drawdowns and left-tail losses
    • As a pro-rata replacement for an equity-bond mix, risk parity can help a portfolio respond to pension plan liability movements and mitigate losses during the worst equity market sell-offs.
    • As a replacement for equities, risk parity makes a portfolio better matched with liabilities and a better mitigator of downside equity and credit risk.
  • Within the analysis, we show the impact of adding risk parity to:
    • An 80%-funded pension plan
    • A 90%-funded plan
    • A 105%-funded plan
    • For the 90%- and 105%-funded plans, we also show 10-year Monte Carlo simulations comparing allocations with and without risk parity
  • In general, adding risk parity means giving up some potential for funded status to meaningfully exceed 100% in order to lower the probability of funded status falling below 80%.
  • While we seek to show that risk parity has what we view as a clear role for under-funded plans, we also argue that the flexibility of the strategy can give it a useful role to play regardless of current funded status; for example, an 80%-funded plan may choose to allocate 10 – 15% to risk parity taken pro-rata from its current asset allocation, whereas a 105%-funded plan may choose to allocate 5 – 10% taken mostly from equities.

Funded status flightpath for a 90%-funded plan, with and without risk parity

Asset Allocations

Source: Bloomberg, Cambridge Associates, FactSet, Neuberger Berman. Asset return inputs are expected returns derived from Neuberger Berman’s capital market assumptions. Asset risk inputs are derived from historical return data between December 31, 2006 and April 30, 2020. Input data as of April 30, 2020. Indices used: Bloomberg Barclays U.S. Treasury 3M, 20-30 Years Indices; U.S. Corporate Credit A & Above 10-20, 20+ Years and BBB 20+ Years Indices; Bloomberg Barclays U.S. High Yield Index; S&P 500 Index; MSCI World ex U.S. Index; MSCI EM Index; Cambridge Associates LLC U.S. Private Equity Index; NCREIF Open End Diversified Core Equity (ODCE) Index; HFRI Global Hedge Fund Index; Credit Suisse Leveraged Loan Index. The model risk parity strategy is described in the note to figure 1. For the model pension plan liability proxy, see the Appendix.

Download The Full Paper