Flipping the script: Our updated market outlook and the derisking/rerisking decision

Each year in our annual ROA guide, we share our strategic (30 – 40 year) capital market assumptions (CMAs) to help US corporate DB plans set their own return on asset assumptions. However, with more plans seeing improvements in their funded status recently and thinking about the implications for their investment portfolios, we wanted to share an important update on our intermediate CMAs, which reflect a time period of approximately 10 years. In this note, we explain what’s changed in our intermediate CMAs and why, and we offer thoughts on what it might mean for plans contemplating either derisking or rerisking moves from here.

Equities and bonds trade places in our intermediate outlook

At the end of 2022, a year that brought a synchronized sell-off in equities and bonds, the aggregate funded ratio for US plans was steady but stuck at just 97%.¹ What a difference two years can make! Today, plans generally find themselves in a much stronger position, with many in surplus — at the end of 2024, the aggregate funded ratio for US plans was 105%. The investment outlook has also evolved in a number of ways, including two major changes: 

1. Expected returns for risk assets have, broadly speaking, compressed as a result of higher valuations and lower spreads.
2. Longer-duration assets appear more attractive as the yield curve has (mostly) un-inverted and steepened.

As a result of these changes, our latest intermediate CMAs (as of 31 December 2024) forecast a higher expected return for long bonds (5.6%) than for global equities (5.1%). This is an important change from our September intermediate CMAs, which forecast a compressed but still positive equity risk premium relative to long bonds, and it suggests that plans may want to consider whether they will be well rewarded for taking additional equity risk relative to hedging assets. 

Figure 1 offers a then-and-now comparison of some of the underlying changes driving the shift in our intermediate CMAs.

Figure 1

Figure 2 offers a broader picture of how our intermediate CMAs have shifted during this two-year period. Expected returns are little changed for cash, global bonds, and shorter-duration investment-grade corporates, but have shifted more further out on the risk-taking spectrum (x-axis) for reasons noted above.

Figure 2

Of course, forecasts come with uncertainty and we would highlight a couple of risks to ours:

• Our lower global equity CMA is driven primarily by a lower expected US equity return (the US accounts for roughly 67% of the MSCI ACWI), but US equities have outperformed many industry forecasts in recent years.
• Recent yield increases have been partially driven by expectations of higher inflation and/or inflation volatility, and it is not unreasonable to think inflation fears could again push yields higher.

Next step derisking?

These CMAs, especially in combination with higher funded ratios, may support derisking —a choice we’ve seen a number of plans make in recent months.

With credit spreads near long-term tights, a prime question for derisking plans is whether to allocate to credit or Treasuries. We think fundamentals and technicals could support spreads staying range-bound for longer, but plans concerned about valuations in long credit could consider the following approaches:

• Intermediate credit — Spreads are currently not quite as tight relative to history as they are at the long end. 
• Private investment-grade credit — Recently, the spread to public investment-grade credit has been above its longer-term average, making this a potentially attractive time to add to or initiate an allocation. (Read more on the topic here.) 
• Treasuries and STRIPS — Plans concerned about credit valuations may be able to use Treasuries and STRIPS to derisk and leg into credit more opportunistically over time.

As plans derisk and approach their “end-state”, they may also want to consider refining their liability-hedging strategy. Please see our recent paper on advanced topics in LDI implementation. 

Rerisking on the table?

Some plans have asked for our views on rerisking their asset allocation, due in many cases to structural changes that have increased their liability or altered their risk tolerance. We suggest basing this decision on two key questions: 1) What is the desired incremental return and time horizon to meet the plan’s objectives? 2) Does the plan have the risk tolerance to seek this higher return? 

Our updated CMAs add another wrinkle to this decision. And even if a plan has a somewhat different return forecast than ours, the overall environment of high equity valuations and higher rates certainly makes it reasonable to consider the possibility of a reduced equity premium. With that in mind, plans looking for opportunities beyond core equities might want to consider the following:

• Low beta or market neutral hedge funds may be appealing to plans worried about a repeat of the 2022 equity/bond sell-off. Our colleagues explain why the backdrop for hedge fund performance may be improving. 
• Rotational return-seeking fixed income strategies, such as multi-sector credit and opportunistic strategies, have flexibility to access areas of the credit market that might offer more attractive spreads than US credit, and their (generally) lower equity beta may provide some cushion in an equity sell-off.
• Defensive equity approaches favoring factors such as low beta, income, and quality have lagged the broad market, but that may provide an attractive entry point for plans seeking equity exposure at lower risk. Our Fundamental Factor Team shares views on constructing a defensive equity portfolio. 

Finally, plans seeking core equity exposure might want to consider two ideas beyond core large-cap benchmarks:

• Small-cap equities — The valuation gap of US large cap over small cap is near its widest level since 2000, presenting a possibly attractive point to capture future returns — or, potentially, lower downside risk should equities sell off across the board. (Read about common small cap “myths.”) 
• Extension (130/30 or 140/40) strategies — These approaches may offer higher alpha potential (given their ability to short stocks) and help navigate narrow equity markets. Read more here.

¹ Year-end 2022 funded ratio based on year-end 10-K filings of Russell 3000 companies with a December fiscal year end. 2024 estimate based on funded-ratio and discount rates estimated by Wellington Management based on change in high-quality corporate bond yields (Bloomberg US Long Credit Aa) since 31 December 2023 and performance of equities (MSCI World), bonds (blend of Bloomberg US Long Government/Credit and Bloomberg US Aggregate), other investments (blend of HFRI Fund Weighted Composite Index, MSCI All Country World, and Russell 2000), and real estate (NCREIF Property Index). Actual results may differ significantly from estimates. Results presented at the aggregate Russell 3000 Index level. Sources: FactSet, Wellington Management. 

Not actuarial or legal advice. Refer to actuary and counsel for advice specific to your plan. 

Important disclosures: Capital market assumptions

Intermediate capital market assumptions reflect a long-term time period of approximately 10 years. If we developed expectations for different time periods, results shown would differ, perhaps significantly. Additionally, assumed annualized performance and results shown do not represent assumed performance for shorter periods (such as the one-year period) within the 10-year period, nor do they reflect our views of what we think may happen in other time periods besides the 10-year period. The annualized return represents our cumulative 10-year performance expectations annualized. The assumed returns shown do not reflect the potential for fluctuations and periods of negative performance.

This analysis is provided for illustrative purposes only. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares, strategies, or other securities. References to future returns are not promises or even estimates of actual returns a client may achieve. This material relies on assumptions that are based on historical performance and our expectations of the future. These return assumptions are forward-looking, hypothetical, and are not representative of any actual portfolio, or the results that an actual portfolio may achieve. Note that asset-class assumptions are market or beta only (i.e., they ignore the impact of active management, transaction costs, management fees, etc.).

The expectations of future outcomes are based on subjective inputs (i.e., strategist/analyst judgment) and are subject to change without notice. As such, this analysis is subject to numerous limitations and biases and the use of alternative assumptions would yield different results. Expected return estimates are subject to uncertainty and error. Future occurrences and results will differ, perhaps significantly, from those reflected in the assumptions. ACTUAL RESULTS MAY DIFFER SIGNIFICANTLY AND AN INVESTMENT CAN LOSE VALUE. Indices are unmanaged and used for illustrative purposes only. Investments cannot be made directly into an index.

This illustration does not consider transaction costs, management fees, or other expenses. It also does not consider liquidity (unless otherwise stated), or the impact associated with actual trading. These elements, among others, associated with actual investing would impact the assumed returns and risks, and results would likely be lower (returns) and higher (risk).