Pension plan glidepaths have been successful in the past decade. Many plan sponsors, given the equity bull market, have seen their pension plan’s funded status improve and have crossed at least one trigger during that time.
But as experience with these glidepaths has increased, there is more recognition of areas of concern. The first concern is that, while hitting a trigger lowers portfolio risk by moving assets from growth to hedging, it doesn’t help to protect the amount of assets still in the growth portfolio from a market downturn. Second, at the later stages of many glidepaths (higher funded status levels), there is too little growth allocation to allow a plan to reach a higher funded status in a relatively short period of time without additional cash contributions from the plan sponsor.
The challenge is how to address both of these issues; how can we better control downside risk as well as maintain a greater allocation to the growth portfolio throughout the glidepath in order to reduce expected contributions and reach the goal in a desired time period?
Both of these issues can be addressed through the use of risk management tools such as equity index put and call options. These tools can be added to a portfolio to manage equity risk in a cost effective and customized way, while also allowing the interest rate hedging portfolio to increase.
Trading off potential upside for downside protection
Pension plans typically have asymmetric risk profiles: the benefit of $1 of additional upside, past a point, is worth far less than $1 of loss that is borne by the plan sponsor. Most plan sponsors, especially those with frozen plans, should be happy to sell off potential future investment returns above a point in exchange for increased downside protection. Such protection can be achieved by buying equity put options, which could be paid for by selling equity call options, forming a “collar” on equity returns. The result is a contractually defined set of returns with less upside and downside when compared to holding indexed equities.
Managing the interest rate risk
This strategy can also address interest rate risk. If a plan sponsor wishes to reduce interest risk they can either increase duration of the hedging portfolio or increase the amount of hedging assets, or both. One way would be to increase the hedging assets and then gain equity exposure synthetically with an equity collar strategy, with a payoff profile similar to that described above. For example, a pension plan could hold 100% of its physical assets in liability-matching long-duration fixed income and have 40% of its asset value exposed to the equity markets synthetically. This could provide 100% hedging against interest-rate moves while providing a very well-defined equity risk-return position. This would also result in an increase in the expected return on assets vs. a traditional 40% growth/60% hedging position.
The increase in expected return happens due to the use of leverage. The portfolio gains the expected return of investing in 40% equities, offset by the cost of financing the position (and adjusted slightly based on the specific option parameters), plus the expected return of the fixed income. Looked at from an asset-only perspective, this style of investing would be more risky than a traditional 40% growth/60% hedging portfolio. However, this strategy is less risky when risk is looked at from an asset/liability perspective.
Putting it together and rebuilding a glidepath
When you put these strategies together, by having more assets in fixed income and shaped equity returns, we find that you can support a larger growth portfolio, with a higher expected return while reducing the overall funded status risk.
A glidepath can be constructed using this strategy. Instead of moving the growth/hedging allocation as a plan’s funded status increases, the revised glidepath would keep the existing growth/hedge allocation the same while revising the collar as the funded status improves by selling off more unneeded upside to produce more downside protection. This approach tightens the range of expected returns as the funded status improves, while keeping more assets “at work” for the plan, which should lower the amount of contributions the sponsor will ultimately need to make and/or reduce the expected timeline to reach the funding goal.
The chart below shows the range of outcomes after five years using a stochastic model and assuming an initial 85% funded pension plan invested 60% in growth assets and 40% in hedging assets.
Addressing potential concerns
Two concerns typically raised with derivative structures are collateral risk and regret risk. Positions can be fully collateralized with collateral movements made daily, thus mitigating counterparty risk significantly. Collateral would typically be held in either cash or U.S. Treasuries (for U.S. asset owners). Regret risk can occur in a significant rising equity or interest-rate environment. While true that this strategy may underperform in such an environment vs. a more traditional portfolio, one can design the interest-rate hedge to still take advantage of a rising rate scenario and a well-designed collar structure would typically sell off only the upside not needed anyway.
Current glidepath structures and thinking have helped to improve the governance and decision-making process of plan sponsors over the past decade. They have helped to reduce portfolio risk in a very structured way. However, there are concerns that current glidepaths still have meaningful downside exposure and/or can leave a sponsor with a prolonged time to reach their final goal due to the growth exposure being too low.
By accessing equity markets synthetically and/or overlaying an option strategy on the growth portfolio, plan sponsors can increase hedging assets significantly, reducing interest rate risk, and keep the allocation to growth assets relatively constant throughout a glidepath. Putting this all together can lead to a lower time frame to reach your target with less volatility along the way.
Thomas Cassara is a managing director in River and Mercantile’s New York office. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I’s editorial team.