A Powerful 3 Step Strategy: Increase Expected Return on Pension Assets at the Same (or Lower) Level of Funded Status Risk

by and | Apr 24, 2019 | Derivatives, Featured, TalkingPoint

It is possible for pension plan sponsors to increase expected returns on assets by 100 to 300 basis points (1-3%) per year for the same or lower funded status risk. The process and steps are spelled out below. Follow along and you’ll see how to increase expected returns, potentially cutting years off of the time required to reach full funding while also decreasing the pension expense reported in the financial statements.

The 3 steps are as follows:

STEP 1 Hedge Uncompensated Interest Rate Risk: Shift physical return-seeking assets to liability hedging assets (long-term bonds), significantly reducing funded status risk.

STEP 2 Replace That Same Funded Status Risk With Return-Seeking Synthetic Equity: Use derivative contracts to add return seeking risk.

STEP 3 Consider Shaping The Potential Outcomes Of The Return –Seeking Assets To Reduce Funded Status Volatility: Take advantage of the asymmetry in pension investing (limitations of uses of surplus and asymmetric impacts of positive vs. negative outcomes) to sell off some potential equity upside in order to protect some downside.

The chart above shows that a 90% funded plan with 60% conventional return seeking /40% liability hedging assets (asset and liability duration =12) can boost annual expected returns by 190 basis points with a 42% reduction in funded status risk (standard deviation drops from 10.4% to 6.0%). The projected funded status in 5 years increases by 15.8% with the 3 step strategy vs 7.2% without it (assuming that service cost is funded annually if the plan is not frozen).

 

Assumptions
Bond Yield4.0%Equity Return7.5%Yield Volatility0.5%
Discount Rate4.0%Equity Volatility18.0%
Allocations shown are (Equities/Inv. Grade Bonds). A "*" indicates shaping the equity portfolio as described in step 3.

Further commentary/rationale on Step 1 – hedging interest rates

The largest risk exposure for many pension plans is to interest rates: the value of the plan’s assets will not change in value as much as value of the plan’s liabilities for a given change in long-term interest rates. In other words, most plans’ liability hedge ratios are well below 100%. Taking this risk may or may not pay off, but there is no economic expectation that a plan will generate return from taking interest rate risk. Interest rate risk is generally a by-product of investing in assets, such as equities, that do not match liabilities. Taking interest rate risk is therefore different to taking equity risk (in isolation): it is akin to gambling on a coin-flip as long-term interest rates are equally likely to go up or down. Investing in equities or other return-seeking assets come with an expectation that they will generate returns. The best way to match liabilities and reduce interest rate risk is to hold a bond portfolio whose cash flows match (even if only roughly) the future payments that the pension plan is expected to make.

Further commentary/rationale on Step 2- taking back risk on a compensated basis

The primary issue with increasing exposure to long-term bonds is that these bonds come with an expected return that is, at best, in-line with liability discount rates. We don’t generally expect to meaningfully outperform liabilities with a liability hedging bond portfolio. To outperform liabilities and close a deficit, we need to take investment risk, and equity risk is an efficient risk to take.
We have reduced funded status risk significantly in Step One. We can bring the asset return risk level back up by taking equity risk synthetically by using derivatives. The expected return on equities using derivatives is the plan’s normal equity expected return assumption (say 7.5%) less an implied cost of funding that is included in all equity derivatives. This cost of funding is the short-term risk free rate, which is currently about 2.5%. Thus the expected return on the equity risk taken in this way is 5% (7.5% less 2.5%).

If a plan starts at 60% Return-Seeking (equity) assets and 40% Liability Hedging assets, its expected return would be 60% x the Return Seeking expected return (7.5%) plus 40% x the Liability Hedging expected return (4% is a good assumption), or 6.1% in total.

If we move all physical assets to Liability Hedging bonds and then take equity risk synthetically equivalent to having a 60% position in equities, then our math is: 100% x 4% plus 60% x 5% = 7%. The expected return is higher, and the funded status risk lower, than today.

Further commentary/rationale on Step 3- shaping returns

*Physical equities is represented by the MSCI World Index as the straight diagonal line; estimated option pricing as of 1/31/2019 using River and Mercantile data and pricing models

Pension investing is asymmetric. Surplus (at some point) has limited value, but shortfalls need to be made up. In addition, positive outcomes (ie, funding holiday, reported pension income) are generally not valued as highly as negative outcomes create pain (ie, unexpected large cash contributions/ accounting surprises, government and participant disclosures, loan covenant violations, credit rating issues, etc.) Therefore, trading off some very high potential returns for mitigation of downside risk can be appealing. To give a sense for how these risk/return trade-offs happen in practice, the chart above shows that, using current option pricing, total equity returns over three years above 28% (so about 8.5% per year) can be sold to finance protection for the first 25% of losses, again over three years. If the markets are down more than 25% after three years, then the plan will participate in losses again from that point. Using these kinds of “shaped” equity strategies can provide fiduciaries with the confidence to hold more equity risk than might be otherwise comfortable. These strategies enable fiduciaries to be much more precise about what risks are to be taken, and what risks are to be avoided.

Conclusion

There are more efficient and effective ways of controlling pension plan funded status risk than what is currently the norm. Minimizing interest rate risk can be done without sacrificing expected returns. The use of derivatives significantly improves the risk/return tradeoffs for pension sponsors by increasing the expected returns per unit of funded status risk. Many larger plan sponsors already use derivatives to enhance pension strategy (most commonly to extend bond durations) and can use the strategies described in this article to enhance expected returns with no additional (or reduced) funded status risk. While this seems too good to be true, the strategic use of derivatives changes the game and potential outcomes.

 

Contact Dave Rosenblum at david.rosenblum@riverandmercantile.com or Tom Cassara at thomas.cassara@riverandmercantile.com to arrange a free illustration for your plan that shows the potential impact of our 3 step strategy.

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