Pension De-Risking – The Next Evolution in Reducing Funded Status Risk
How much expected return is your pension plan getting per unit of funded status risk?
1.0 Long Bonds (LDI)
2.0 Lump Sum Cashout Windows
3.0 Retiree Annuity Buyouts
4.0 Equity Derivatives
The evolution of pension plan de-risking continues. Pension de-risking version 1.0 started nearly two decades ago with the advent of what is now called liability driven investing (LDI). Favorable legislative changes prompted de-risking phase 2.0, the payment of lump sums to terminated vested participants. More favorable pricing for annuities combined with increases in PBGC premiums has driven version 3.0, the purchase of annuities for retirees.
However, many plan sponsors have avoided moving more quickly to de-risk using strategies 1-3 because of the negative impact that each of these can have on a sponsor’s reported profits as well as expected cash contributions to close a deficit. We are now poised for de-risking version 4.0, in which plan sponsors will utilize modern risk management tools to significantly reduce funded status volatility while maintaining expected returns.
For most pension plans, the dominant investment risk is interest rates: if interest rates fall the deficit will rise and vice versa. In a traditional LDI strategy, the only way to control interest rate risk is to hold long-term bonds that match pension liabilities. But every $1 invested in bonds is $1 that can’t be invested in equities or other assets expected to outperform liability growth over time. Therefore, conventional de-risking, by moving 10% of assets from equities into bonds for example, requires a reduction in expected return, with associated reduction in reported profits, increase in expected cash contributions or time required to close a deficit.
It is possible, however, to utilize equity derivatives to create the ability to hold more assets in long-term bonds (reducing risk), while still retaining equity exposure (we refer to this as “synthetic equity”). This can be done in such a way that risk can be reduced or maintained while the expected return stays the same or increases. Risk and return can also be “shaped” very precisely. This is important for frozen pension plans as there is a definite asymmetry of risk and return: there is only so much upside that a plan can use, while the plan sponsor is exposed to all downside. Equity options allow long-term equity upside that is not needed to be traded for downside protection. This allows more equity exposure to be carried for longer in the de-risking process, helping to maintain expected return, reduce expected cash contributions and/or reduce the time over which a deficit is expected to close. We refer to this shaping as “structured equity”1.
Some investors have been leery of utilizing derivatives due to a lack of comfort or understanding. This is being overcome through education and because the case for their utilization by frozen pension plans is so strong.
Even open plans with long-term investment horizons and little concern for short-term funded status changes can benefit from the use of derivatives. Synthetic equity can increase expected returns outright, if so desired, while maintaining or reducing funded status risk. Structured equity can be used as well to express investment views or to take advantage of market conditions.
Increasingly, plan sponsors are looking at measures of funded status volatility for a given expected return to gauge the efficiency of a given investment strategy. We created a simple metric to measure the expected return per unit of funded status risk, using one standard deviation of funded status as the risk measure. We refer to this metric as the Pension Sharpe Ratio (PSR). For example, a plan with a 14% annual standard deviation of funded status and a 7% expected return would have a PSR of 0.5; a plan with a funded status volatility of 6% and a portfolio expected return of 6% would have a PSR of 1.
We analyzed the actual investment strategies for the 1,070 US qualified DB plans that have over $200 million in assets using Department of Labor (DOL) data. The average pension plan in this sample (with admittedly imperfect DOL data) has a PSR of 0.71.
We then assumed all the investment strategies were modified to increase liability matching assets while using synthetic and structured equity, keeping expected returns the same. This would increase the average PSR to 1.31. Plan sponsors who adopt de-risking 4.0 can enjoy significantly better investment efficiency than those that do not.
Let’s illustrate this with an example. Consider a plan that is 90% funded, with a current asset allocation of 60% equities and 40% liability-duration-matching bonds. Such a plan would have an expected return on assets of 6.1% using our capital markets assumptions, and a funded status volatility of 10.4%, using our assumptions for asset and interest rate volatility and correlation, meaning our Pension Sharpe Ratio for this plan would be 0.59. A significant portion of the funded status volatility for this plan comes from interest rates. Therefore, by shifting the plan’s physical assets to 100% liability matching bonds, the plan could eliminate much of the funded status risk. However, the plan would also be giving up expected return, and would largely be “locking in” a funded status of 90%; contributions would be required to fill in the vast majority of this remaining funding gap. This is De-Risking 1.0 – trading funded status volatility for higher contributions and lower expected returns. This strategy reduced risk, but makes the plan much more expensive on both a cash and an accounting basis even though the PSR increases to almost 7.5 (very low risk but also low return).
With De-Risking 4.0, the range of possibilities is much wider. As a first alternative, we move the physical asset allocation to 100% liability matching bonds, while also entering into synthetic equity contracts for 60% of the assets (matching the equity exposure the plan already has).
This strategy increases the expected return from 6.1% to 7.0%, while reducing funded status volatility from 10.4% to 6.8%. This means we’ve reduced funded status risk while boosting expected returns! (see Alternative 1 in the chart below)3
Additionally, depending on the plan sponsor’s risk appetite, the synthetic equity exposure could be “shaped” using structured equity techniques. As a second alternative, we could sell off enough potential upside such that over-funding (which isn’t useful) becomes quite unlikely. The value generated from this sale can be used to reduce the risk limit on the low end of our two-standard-deviation funded status range to about 85% (see Alternative 2 in the chart below).
*Please see endnotes for important information about the above chart4
In the chart above, the expected funded status for the plan in one year is shown as the diamond for each strategy, while the tan bars show the range of potential funded status within one standard deviation of expectations, and the thin lines show the range of potential funded status within two standard deviations of expectations. As you can see, the Pension Sharpe Ratio increased from 0.59 under the current strategy to 1.78 under the Alternative 25.
One of the benefits of these strategies is that they are highly customizable. De-Risking 1.0 essentially provided a one-dimensional line between equities and liability matching bonds, and the only lever plan sponsors could pull would be selecting where on that line their plans’ allocations would fall. Synthetic equity and structured equity allow sponsors to move in three-dimensional space, finding the unique combination of equity exposure, downside protection, and interest rate hedging that meets their needs. The strategies we’ve shown in this chart can be mixed and matched in almost infinite permutations; these examples are simply intended to illustrate the increase in power and flexibility that equity derivatives provide.
As pension plan sponsors look for the next strategy to de-risk their pension plans, equity derivatives are the compelling choice. They can be structured in a way to lower funded status risk without sacrificing expected returns. Implemented correctly, this de-risking strategy 4.0 can put a plan sponsor on an efficient path for the future. As we’ve seen, these “new” de-risking strategies could allow your pension dollars to work twice as hard, and help you achieve your goals and objectives for your plan.
1Some readers will note that it is possible to accomplish a similar effect by using interest rate derivatives to extend the duration of a liability-matching portfolio while retaining physical assets in equities. However, it is more efficient to hold physical assets in bonds and equities synthetically and this also provides greater ability to customize a solution (using shaping) for a given plan. Long term bonds, especially credit, are the asset of choice for a pension plan to “buy and hold’ – they are expensive to trade and ultimately provide the best match to liabilities.
2Assumptions and Methodology
We reviewed publically-available information from DOL 5500 filings as well as PBGC filings to estimate expected return, return volatility, and liability volatility. Particularly, we used the Form 5500 Schedule R Line 19 responses to estimate asset expected return and volatility. We assumed the “stock” portion of the portfolio had an expected return of 7.50% and a standard deviation of 18%. We assumed “investment-grade debt” yields of 4.00%, and a bond yield standard deviation of 0.5%. We estimated debt duration as the midpoint of the duration reported. We grouped high-yield debt and real estate with “other”. We assumed “other” had an expected return of 5.00% and a standard deviation of 12%, and a correlation coefficient with “stocks” of 70%. Finally, we estimated liability duration based on differences between PBGC and 5500 Schedule SB liabilities and interest rates, and assumed a liability discount rate standard deviation of 0.55%. These assumptions allowed us to estimate an expected return and standard deviation of funded status.\
We then constructed a hypothetical portfolio that moved all “stock” assets to “investment-grade debt,” and then added sufficient collared synthetic equity to maintain the same expected return as the actual portfolio. This hypothetical portfolio thus had a smaller funded status standard deviation while maintaining the same expected return, thus improving the “Sharpe ratio for pension plans” defined above.
3Note: this outcome is predicated on multiple assumptions including expected asset returns, correlation between assets and between assets and liabilities and volatility assumptions. This should not be construed as investment advice.
4The strategies shown in this chart do not constitute investment advice and are highly simplified. The impact of various investment strategies will be different for different pension plans and will depend upon, among other things, the plan’s funding level, current asset allocation and funded status. In addition, assumptions about expected returns on assets, asset and liability correlation and volatility will all influence the outcome of any investment strategy. Past performance is an unreliable indicator of future returns.
5See note 3 above.
IMPORTANT LEGAL INFORMATION
INVESTMENT ADVISOR: Investment advisory services are provided by River and Mercantile LLC (dba River and Mercantile Derivatives or River and Mercantile Group), an investment advisor registered with the US Securities and Exchange Commission and the National Futures Association. Derivative portfolio collateral management is provided by River and Mercantile Investments Limited (dba River and Mercantile Derivatives or River and Mercantile Group), a UK-based affiliate of River and Mercantile LLC regulated by the Financial Conduct Authority.
PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RESULTS.
SECURITY INDICES: This presentation includes data related to the performance of various securities indices. The performance of securities indices is not subject to fees and expenses associated with investment funds. Investments cannot be made directly in the indices. The information provided has been obtained from sources which River and Mercantile LLC believes to be reasonably reliable but cannot guarantee its accuracy or completeness.