Improving Expected Returns: Corporate Defined Benefit Plans

by | Nov 6, 2019 | bytesize, Defined Benefit, Derivatives

Many corporate defined benefit pension plans utilize interest rate derivatives and/or Treasury STRIPS to manage interest rate risk. They also typically have large allocations to active fixed income managers as part of their liability-matching bond portfolios. Conversely, many plans invest in passive equity strategies as they do not believe that alpha can be reliably obtained by long-only equity managers.

Plans that invest in the above manner could improve returns by 50-100 basis points (0.5-1.0%) per year, without taking additional funded status risk, by making relatively simple changes. Specifically, plan sponsors should :

  • Sell passive equity allocations and invest the proceeds in actively managed, long duration fixed income (a mix of credit and Treasury) designed to match plan liabilities;
  • Enter into equity derivative contracts that replicate the passive equity exposure that has been sold; and
  • Reduce the amount of interest rate derivatives or Treasury STRIPS used to account for the additional long duration assets now held.

By allocating in this way, the plan may get the following benefits:

  • 25-50 basis points of active management alpha from their long duration bond managers, versus zero from passive equity; and
  • An additional 25-50 basis points due to the long term credit risk premium net of all defaults – investing in physical credit versus using interest rate swaps or Treasury STRIPS allows this risk premium to be harvested.

The net improvement in expected return is therefore 50-100 basis points, or $5-10m per year of additional gains from a $1bn allocation, while maintaining a similar funded status risk profile.

An additional benefit of this strategy is that the synthetic equity position can be customized or “shaped” to provide a precise range of outcomes that a plan is seeking. For example, potential future upside that is not needed could be sold to provide downside protection. This could lead to holding a larger equity position with similar funded status risk, resulting in a larger expected, long term dollar return.

Plan sponsors who are implementing a de-risking process, and who believe in the potential for alpha and a credit risk premium, should consider this allocation strategy as it can be significantly more efficient than using interest rate derivatives to manage duration.

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