Liabilities in Focus: Forcing Plan Managers to Fundamentally Alter Their Strategies

Mitigating individual pension plan’s risks at the expense of enhancing systemic risks: Re-leveraging Defined Benefit Plans’ for the greater good of the hedge fund industry

The ratification of the Pension Protection Act of 2006 in conjunction with expected FASB reforms have increased the transparency of pensions’ funding status while calling for the elimination of actuarial smoothing.

The goal of the Pension Protection Act is to insure the adequate financial support of plans’ funded status. The Act primarily imposes companies to contribute to their pension plans the normal cost of the plan (i.e. service cost) plus the “under-funded” amount amortized over 7 years with interest. Pension plans’ funding formula has also been altered and is now to be used in determining funded status and contribution requirements. In parallel, ERISA funding credits would be based on actual returns on plan assets as opposed to expected rate of return on assets. Additionally, actuarial smoothing techniques have been limited under the new act, thereby increasing volatility of cash contributions.

The conjunction of major regulatory changes in the pension and insurance space around the world, and historically low risk aversion levels that led to compressed risk premia brought additional emphasis on the importance of asset-liability management (ALM). Pension plans’ portfolio structure will be deeply affected by the new legislation, as feasible asset allocations will now be determined after full liability cash flow risk immunization, and as a function of the marginal risk/return to plans’ surplus risk. While the liability-driven investment framework results in a focus shift away from maximizing plan returns and towards minimizing liability cash flow risks, portable alpha redeployment acts as a counterbalance, providing the necessary excess return for sponsors to minimize their contributions.

The Pension Protection Act effectively obliges pension plan managers to break away from the conceptual anchor that constitutes the classical asset optimization framework. Plans’ liabilities are now the new focal point of pension plan managers, where the purpose of plans’ assets is to fund their associated liabilities. In this context, assets’ return dynamics should primarily be geared towards offsetting the dynamics of the plans’ liabilities.

The paper will first investigate the different approaches available in implementing liability-driven solutions and will secondly explore the yield enhancement potential presented by portable alpha strategies.

I/ Liability Driven Investments: Capital efficient solutions to mitigate interest rate risks. The dynamics of plans’ assets/liabilities differential as primary focal point

Traditionally, plan sponsors have been using the asset side of their portfolio to mitigate their liabilities. The lax legal environment in which US pension plans acted to this point resulted in only partial immunization of their plans’ interest rate risks and high exposure to other market risks (equity beta) for return enhancement. More stringent regulations are now constraining plan managers to focus on liabilities’ sensitivity to interest rates; resulting in higher overall allocations to fixed income products. As a result, the immediate consequence of the reform has been to center liabilities at the heart of the asset allocation process. As partial immunization has now become a prerequisite, the optimization framework has been propelled into the asset-liability space, where plan managers’ expected return and risk measures are relative to their liability benchmark.

Optimizations in surplus space and Liability Driven Investment (LDI) strategies can be implemented following two different approaches. The first approach consists in combining traditional fixed income securities such as long-dated bonds and strips, while the second approach relies primarily on derivative instruments _i.e. a combination of Zero Coupon and Inflation-linked Swaps which allow institutional investors to create customized benchmarks mimicking the risk and return profile of their expected cash-outflows.

Pension plans are presented with two investment options:

§ The first option is to select and invest the plan’s assets in a combination of traditional fixed income indices that provide a suitable fit to the key rate duration of the plan’s liabilities,

§ The second option is comparable to the first, but the liability immunization is further complemented by overlaying derivatives (futures/forwards/swaps/structured products and options), or by introducing strips to better replicate the liability cash flow stream. The latter solution offers marginally more flexibility and makes for a more efficient use of capital.

While the conventional approach is appropriate for duration (level) immunization, the method leaves exposure to changes in the shape of the curve (curve duration) and to convexity misalignments.

§ Curve duration mismatch risks _the sensitivity of a portfolio to a steepening of the yield curve_ cannot be hedged efficiently due to the difficulty of matching the distribution of future cash outflows. The very long duration of plans’ liabilities make closer term structure match difficult to achieve, as current securities available in the bond market do not provide sufficient interest rate sensitivity. This risk can be efficiently mitigated for portfolios following an LDI program by paying swaps in the front end of the curve and hedging via receiving swaps in longer dated maturities.
§ Convexity represents the most complex risk to offset, as most current securities are not convex enough compared to plans’ liabilities. This convexity mismatch risk can be mitigated in an LDI framework by using swaps, swaptions and structured products to accurately track cash flows.
§ Additionally, dynamic interest rate hedging programs to prevent drifts in terms of duration (level), curve duration (slope) and convexity differentials can be efficiently implemented by initiating an LDI program.