Breach of allocation bandwidths: when and how to rebalance?Financial risk management for pension plans in times of the Coronavirus - blog 2
Welcome to blog two of the three-part blog series regarding financial risk management for pension plans in times of a crisis.
Last week we shared the first of the four challenges that pension risk and strategy managers face. In this blog, we touch upon the second additional key challenge i.e. breach of allocation bandwidths: when and how to rebalance.
2. Breach of allocation bandwidths: when and how to rebalance?
Extreme market movements cause significant changes in the asset allocation proportions and potentially result in breached allocation bandwidths. In normal circumstances, portfolios are rebalanced annually or monthly or when bandwidths are exceeded. Often, different rules could apply, based on the liquidity of the assets.
A key question that Pension schemes and asset managers should ask themselves is whether the current extreme situation justifies a deviation from their rebalancing strategy. Aspects to consider are limited liquidity and potential high transaction costs, but also a more subdued economic outlook could be taken into account, to inform rebalancing decisions. The consequences of these effects may conflict with the rationale of a rebalancing strategy built on cyclicality in normal market circumstances.
If the pension plan wants to deviate from its normal rebalancing strategy, several options could be implemented:
- Spread transactions out over a longer time horizon.
- Reduce the size of the transactions by rebalancing to the edge of the bandwidth.
- Rebalance on a best effort basis restricted by costs.
- Consider buy and hold, by temporarily postponing rebalancing and avoiding knee jerk short-term decisions. It is sensible to build in a go or no-go framework before the rebalancing implementation to evaluate the latest market conditions. If volatility and illiquidity suddenly increase, it might make more sense to delay or even cancel the transaction.
Rebalancing decisions should be in alignment with the risk appetite and the decision on how to act in relation to the risk budget. Loranne van Lieshout further elaborates on these items in her blog on rebalancing for Dutch Pension plans.