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Jared B. Gross
Pension plan sponsors have broadly embraced the notion that they should take less risk relative to liabilities as they seek to reduce the financial implications of funded status volatility. In practice, many plans are accomplishing this through a gradual shift away from return-seeking strategies that rely heavily on exposure to equity risk, and toward strategies that use long duration fixed income as a direct hedge to the liability. Many plans are following a “glide path” strategy that links improvements in the funded status of the plan to specific shifts in the asset allocation, with an ultimate target of 80%, 90% or even 100% fixed income.
Matching Risk FactorsIn our view, the first of these goals is relatively straightforward for most typical pension liabilities. The fixed income manager needs to construct a portfolio that matches the liability across four key risk factors:
Using a mix of liquid fixed income market sectors including (but not limited to) corporate bonds, Treasuries and interest rate derivatives, we believe it is possible to identify a portfolio benchmark that is a close fit for these risk factors. In practice it may not be possible to precisely match all four risk factors simultaneously, so it is worth prioritizing them to some extent. The first two factors – duration and credit spread – tend to be the most significant in terms of their ability to drive changes in the value of the liability and thus we believe should be the priority in any liability-driven investing (LDI) strategy.
In our experience, approximately 15%–25% of the liability present value can result from longer-dated cash flows that are discounted at yields that are effectively non-investable. In the example above, the incremental yield applied to this segment of the liability can exceed market yields by as much as 100 basis points.
A. Target a level of overfunding in the plan that allows a fully risk-factor-hedged portfolio to offset the yield gap.B. Allow active management of the fixed income portfolio to target excess return sufficient to make up the gap.C. Sacrifice some elements of risk matching (such as convexity and curve risk matching) to allow the portfolio to concentrate in higher yielding assets.D. Allow the credit portion of the portfolio to move down in credit quality (and up in yield) to a degree sufficient to make up the gap.E. Maintain some degree of exposure to higher risk/return assets, such as equity, so that over time performance can potentially stay ahead of liabilities.F. Allow for the use of leverage.G. Implement some combination of the above.
Conversely, the rationale for holding equities, which tend to deliver return primarily through price appreciation (not dividends) and typically have high levels of volatility, for the purpose of offsetting a yield differential, is limited, in our view – particularly if period-over-period downside risk is meaningful to the sponsor.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2015, PIMCO.
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