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Synthetic Equity and Pension Plan De-risking
by Ryan McGlothlin & James Walton
Buy bonds without impacting expected returns
Pension plans typically de-risk by buying liability matching bonds and selling equities. Although this is a perfectly valid approach, it results in a direct tradeoff between the desire to reduce funded status volatility versus maintaining higher expected returns. Derivatives, however, provide plan fiduciaries with additional flexibility versus simply allocating between these two asset types. A derivative strategy we call ‘Synthetic Equity’ can be used by pension plans to maintain expected returns and retain equity exposure, yet still reduce funding level volatility.
Consider a plan that is 70% funded, with a 70% allocation to equities and 30% allocation to liability matching bonds. We examine a shift to 70% Liability Matching Bonds, as might be made under a traditional de-risking of the investment strategy. In a third strategy, we combine this approach with use of equity derivatives to ‘get back’ the equity exposure that was forgone to buy bonds:
1: Current strategy
The current strategy has a large amount of equity and interest rate risk.
Expected returns for such a strategy could be 6%. We estimate the volatility of the funding level to be 19% per year, which means approximately two-thirds of the time the funding level will remain within around +/- 19% of its current level over one year. This is large variation and is due to the exposure to equities and interest rates.
2: Buy bonds, sell equities
Traditional de-risking both reduces equity exposure and reduces the negative impact of falling interest rates on funding level. A switch to 30% equities, 70% bonds (a move of 40% of assets from equities to bonds) softens the impact of equity and interest rate moves.
The volatility of the funding level will be significantly lower at around 9% (around half the previous level). The sizable shift in the asset allocation has reduced the impact of market shocks: however, there is a reduced expected return on assets, indicatively to 4.9% pa (a reduction of 1.1% pa). This will have an adverse impact on the plan’s pension expense. Also some potential for equity market upside is forgone.
3: Synthetic equity
In this strategy, the same shift in physical asset allocation to bonds occurs as described above (a 40% shift from equities to bonds). However, additional equity exposure is obtained by entering into a derivative contract which enables expected returns, and equity market upside, to be retained. The plan’s funding level sensitivity to interest rates is reduced through the purchase of more bonds.
How does synthetic equity work?
Synthetic equity is a contract with a market value, initially zero, that will rise as the equity market rises, and falls as the equity market falls. In its simplest form, this rise and fall will provide the returns to the plan as if the plan had retained the 40% invested in equities, i.e. the overall portfolio equity sensitivity the plan experiences is back up to its original 70%.
The plan assets now have the equivalent sensitivity to markets as a portfolio with a higher market value than was the case before. Ignoring liabilities, this would be a riskier strategy, but with liabilities that exceed assets, this approach actually reduces funding risk compared to the current strategy.
It is also possible for the synthetic equity exposure to be designed with less drawdown risk than conventional equity holdings, i.e. with some downside protection, but forgoing some upside exposure.
Impact on returns
The funding level volatility of this strategy would be 12%, which is a little higher than the traditional de-risking strategy but much lower than the current strategy. Importantly, the expected return of the current strategy is maintained. To summarize:
‘Glide paths’ refer to the strategy where a plan de-risks by selling return-seeking assets and buys bonds, at pre-agreed funding levels or levels of interest rates.
The key benefit of a glide path is that funding improvements can be locked down to a degree if and when improvements occur. Glide paths ensure some de-risking in the future, and this reduces the need for governance by pre-agreeing what that de-risking should look like.
However, a glide path will do little to protect the plan from adverse market shocks that occur before any improvement happens. Using derivatives, such as synthetic equity, enables risk to be reduced immediately, if desired.
Derivatives should be regarded as an additional tool in the toolbox – they can replace or compliment an existing intention to de-risk.
Lower risk, same return – too good to be true?
There is no magic. This synthetic equity strategy that we’ve described will outperform the current strategy in some scenarios and underperform in others. Underperformance occurs when interest rates rise much faster than the market expects and equity markets fall significantly. While a plausible scenario, we note that it has been more common, historically, for equity market falls to be accompanied by falls in interest rates as investors move to US Treasuries for safety.
The reasons many plans get comfortable with the synthetic equity strategy is:
- expected returns can be maintained, and
- the scenario where the strategy does relatively poorly (a rise in interest rates) is likely to be a welcome scenario overall for plan funding.
This rationale is an example of a holistic approach. There is no strategy that guarantees outperformance in all scenarios, and it is impossible to predict with any certainty what investment markets will deliver in future. However, we can say the example strategy that we’ve described is expected to maintain the same level of return as the current strategy on average. In situations where it will not, we ensure the plan would still be comfortable and not regret the overall outcome.
In summary, most plan sponsors are moving towards liability matching bonds to de-risk and to eventually terminate their pension plan. Synthetic equity can be used to retain equity market exposure and expected returns throughout this process.
Interest rate derivatives are also used by plans to reduce risk. We prefer strategies that incorporate equity derivatives because, like for like,
- A higher yield is possible;
- Investment returns will more closely match accounting liabilities
Both interest rate and equity based derivatives strategies can be designed to have a de-risking impact. Both enable pension plans to gain exposure (to equities or interest rates) to a greater extent than is possible with physical assets alone.
The ‘Synthetic Equity’ strategy presented herein is very similar to the more well-known strategy of using interest rate derivatives:
- With synthetic equity, physical bonds are held and equities are accessed using derivatives;
- With a traditional interest rate derivative strategy, physical equities are held and some interest rate exposure is obtained using derivatives.
In both strategies, the aggregate equity exposure and interest rate exposure can be similar. The difference is which asset type is accessed through derivatives.
So why use equity derivatives? Equity derivatives can replicate passive physical equity investments very closely. However, interest rate derivatives yield less than corporate bonds (the matching asset for pension plans) and are only partially effective at matching their performance.
Industry Since: 1997
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Ryan is responsible for developing client investment and risk management strategies. He is the co-head of River and Mercantile’s US business. Prior to joining River and Mercantile in 2007, Ryan spent several years working for Barclays Capital in London where he focused on financial risk management for institutional investors. He began his finance career as an investment banker in Houston advising companies on capital raising and M&A transactions. Ryan holds an M.B.A. from the University of Chicago Booth School of Business and a B.A. (Honors) from the University of Texas at Austin.
Industry Since: 2004
Bio: Click Here
James works with clients on financial risk management, develops investment strategies and new investment solutions. James joined River and Mercantile from Legal and General, a UK-based insurance and fund management group, where he performed a number of investment roles on both sides of the Atlantic. This included ALM, credit strategy, illiquid assets and risk functions relating to retirement business and, most recently, James led the development of the investment strategy backing US Pension Risk Transfer business which began in 2015. James started his career at Aon as an ALM consultant to defined benefit pension plans where he also developed Aon’s LDI, strategic asset allocation processes and analytics. James is a qualified actuary and holds a first-class Masters degree in Physics from The University of Oxford.