Following President Biden’s Executive Order on Climate-Related Financial Risk1, the US Department of Labor (DOL) has announced the publication of a Request for Information (RFI)2 in which it is seeking public comment on what actions, if any, it should take under federal law to protect retirement savings and pensions from risks associated with changes in climate. The RFI will help to inform any potential future policy work. Insight will be responding to this consultation and we will discuss our response in the next edition of this publication.
Figure 1: Plan funded status continued to improve over the quarter4
With monetary policy now set to reverse course, and geopolitical uncertainty stemming from the Russian invasion of Ukraine, there is the potential that equity markets may experience greater volatility in the years ahead.
Drawdowns are far more painful in the “decumulation” stage
As outflows from pension obligations exceed income from investments and contributions – they become cashflow negative – the timing of returns becomes very important.
The scenario: Consider a hypothetical $1bn portfolio invested in the S&P 500 Index in 2000 and held for twenty years, resulting in an average return of 6.1% per annum.
Cashflow neutral: During this time, an investor with no cashflows would have earned a cumulative profit of $2.240bn regardless of whether the returns were consistent or were initially poor but then accelerate dramatically returns (actual experience).
Cashflow negative: If the investor was forced to withdraw $50m each year, the cumulative profit would have been $1.330bn assuming the average return of 6.1% per annum. However, actual experience of initial falls followed by dramatic rises would have resulted in a much smaller cumulative profit of $0.302bn (or 78% less).
Therefore, the timing (or “sequencing”) of returns is an additional risk for cashflow negative investors.
An intelligent equity hedging strategy can potentially reduce the impact of negative equity returns, and the additional sequencing risk, reliably and at a lower cost than traditional put option strategies.
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Below, we feature some of our latest research which may have an impact on pension fund investment strategies.