July 20, 2012 (PLANSPONSOR.com) – Risk parity is increasingly being used by defined benefit plans to protect against downside risk, but “there’s no reason DC sponsors shouldn’t use it,” says David Glutch, client portfolio manager, Global Asset Allocation at Invesco.
In a Webcast hosted by PLANSPONSOR and its sister publication aiCIO, Glutch explained that risk parity is an alternative form of portfolio management that allocates capital based on the underlying risk of asset classes, rather than anticipated returns. Risk parity will balance asset classes so no class dominates; investors win by not losing, he added.
Risk parity is an important consideration for defined contribution (DC) plans because target-date funds (TDFs) are predicted to become the largest recipient of DC contributions and assets from investors in general. The “to” versus “through” retirement debate is important, but it is not the core issue, Glutch contended. The issue should be the asset allocation framework and embedded assumptions; equity dependence is still an issue. TDFs struggled in 2008 due to an over-reliance on equity exposure. Near-date TDFs are highly sensitive to equity drawdowns, but there is also still a lot of equity in later-date TDFs.
Some argue that participants who continued investing in TDFs are now back to even, but being back to even is not a good thing, Glutch said, this assumes that TDF investors are young enough to take that risk, and it assumes no disruption in income.
With TDFs, the industry needs to think of a better way to construct asset allocation to address the downside risk. The objective for a TDF should be to preserve value in any economic environment as well as outperform cash at all times; this has significant ramifications for choosing asset allocation, Glutch contended. One must understand how asset classes behave in three economic environments: recession, inflation, non-inflationary growth.