De-risking – Is Less Equity Better?

by | Aug 5, 2019 | bytesize, Defined Benefit, Derivatives

Is holding less equity as a plan gets closer to its funding goal the right thing to do? We decided to dig into this question to see what the potential outcomes could be for plan sponsors and see how what we call structured equity could factor into the answer. (For background, see our November 8, 2018 article entitled “Pension Investing – Next Generation of Glide Paths”).

Structured equity, is equity exposure, but with the downside risk managed using equity index options. In our paper we discussed various ways in which risk can be managed and for the analysis below, we use a simple zero premium strategy which would provide protection for equity market losses up to 10%, while limiting gains above 9% over one year. Let’s take a quick look at the returns comparing two allocations. The first asset allocation is a typical portfolio consisting of 20% equities and 80% long-duration fixed income designed to match pension liabilities. The second portfolio has 40% in equities (synthetic) and 100% in liability matching fixed income, but with the equity position hedged using structured equity as described above.

As the table above shows, the structured equity portfolio will produce positive results for returns between -20% and 18% a year. It will equal or exceed the 20% equity portfolio until returns either exceed 18% (or two times the upper limit) or fall two times below the lower limit (negative 20% in above example).

Thus a pension plan should be better off with the structured equity approach for one year returns between -20% and 18%, assuming they increase their gross equity exposure while hedging.

The degree to which equity upside is sold to fund downside protection can be fully customized and tuned to reflect a plan’s de-risking objectives. For pension plans that are on de-risking glide paths (and even for many that may not be), it is clearly sensible to consider giving up some upside in scenarios where equity markets have very high returns, and to absorb increased downside in situations where returns are very poor. By changing the risk/reward trade-offs, plan sponsors can produce a higher likelihood of reaching their funding objectives more quickly.

The above results can be materially improved by also optimizing interest rate risk management and through the active management of the equity hedging.

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