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Liquidity Management and Arbitrage: An Opportunity for Defined Benefit Plans

Markets offer the prospect of defeasing near-term liabilities at a discount.

A number of plan sponsors have explored pension risk transfer strategies over the last few years. Among these, lump sum programs aimed at terminated vested participants (or retirees to a lesser extent) have been the most popular. The main catalyst has been the ability to transfer the liability and its associated risk at a lower cost than the plan sponsor would have to recognize had it kept it on its balance sheet.

The arbitrage opportunity resulted primarily from the use of an outdated mortality assumption as well as lagged discount rates used to calculate participants’ lump sums. Yet a number of factors may significantly reduce the ability of plan sponsors to take advantage of this arbitrage opportunity in the future:

  1. Lump sum calculation rules may soon start to reflect updated mortality assumptions;
  2. A large portion of the liability suitable for lump sums has already been paid out over the last few years;
  3. The advantage arising from the use of lagged discount rates would vanish if interest rates rise.

Nonetheless, investment markets now offer a similar opportunity for plan sponsors to defease a portion of their near-term liabilities. Indeed, given prevailing spread and yield levels in credit markets, investors can build cash flow matching portfolios for near-term liabilities that considerably outyield the discount rate applied to these upcoming benefit payouts. As a result, plan sponsors can immunize their short-term benefit payments at a lower cost than their accounting or economic value.

Short-term liabilities: A different kind of risk

Historically, most LDI strategies have focused on matching the plan liability duration and other risk factors. Implicitly, this means LDI portfolios are more heavily tilted toward matching longer-dated cash flows – and for good reason, given that these carry considerably more risk than those projected to be paid in the short term.

However, the liquidity risk associated with the payment of near-term cash flows should not be ignored. These benefit payments are typically met by maintaining a small cash allocation within the plan and/or liquidating assets perceived as more liquid (equities or bonds, for example). In this case, though, the plan sponsor faces either the risk of having to raise liquidity at an inopportune time (e.g., after equity or bond market declines) or must accept minimal compensation on its cash allocation.

Is there a better way?

Plan sponsors have a better alternative: They should consider cash flow matching the first few years of upcoming benefit payments, thus significantly reducing (or nearly eliminating) the liquidity risk associated with those cash flows.

Consider a plan seeking to “quasi-immunize” the liability cash flows projected to be paid over a three-year period from mid-2017 to mid-2020. Figure 1 shows a potential structure for the cash flow matching portfolio, while Figure 2 shows how its expected coupon and maturing principal income would compare with the liability benefit payments.

As shown in Figure 1, the cash flow matching portfolio would dramatically outyield the discount rate on those near-term liability benefit payments (4.4% versus 1.6%). This would ultimately enable the plan sponsor to “quasi-defease” $500 million worth of liabilities with a $448 million investment, representing a 10% discount. In addition, the immunization strategy should significantly reduce the operational burden of raising and managing liquidity to cover those benefit payments.

Figure 1 features two tables. The first one details the weight and yield of three different near-term U.S. credit and high yield indexes. The second table gives the market/present value and yield of liability present value and a cash flow matching portfolio, including the net benefit for the plan. Data as of 31 March 2016 are detailed within.

Figure 2 shows the portfolio cash flows extending slightly longer than the liability benefit payments. This is intentional and recognizes that high yield bonds (which make up 40% of the cash flow matching portfolio) often get called before maturity; some portfolio cash flows would therefore be received earlier, filling some gaps between the orange and blue bars in prior years.

Figure 2 features two bar graphs. The first one shows six time periods, roughly a year each, of cash flows and liabilities. For one-year periods ending in June 2018, 2019 and 2020, the liabilities are slightly more than the cash flows a crossover portfolio of three U.S. credit sources. But cash flows from the periods beyond June 2020 and before July 2017 make up the difference. This is shown as a bar graph below, which shows total liability payments of $527 million, compared with cash flows of $546 million from the crossover portfolio of bonds.

Given its meaningful exposure to high yield securities, the defeasance strategy must factor in potential defaults and implementation costs. Portfolios such as these have experienced annual default-related losses of less than 0.4% since 2000, according to our analysis of Moody’s data; transaction costs under current market conditions would amount to roughly 0.25%. Therefore, the yield buffer (the 2.8% excess yield of the portfolio over the liability discount rate) provides a meaningful margin of safety compared to the anticipated combined impact of defaults and transaction costs (of 0.65%). That said, investing in lower-quality securities requires careful risk management and therefore skill in credit selection is essential.

Don’t come up short

As plan sponsors face increasing liquidity challenges in several markets, we believe the time has come to pay more attention to short-term liabilities. In the current market, investors have a unique opportunity. They can:

  1. Defease near-term liabilities at a significant discount relative to their accounting or economic valuation;
  2. Reduce considerably the liquidity and market timing risk associated with meeting near-term benefit payments;
  3. Lessen the operational burden and resource commitment associated with raising and managing liquidity to cover benefit payments.
The Author

Rene Martel

Head of Retirement

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Past performance is not a guarantee or a reliable indicator of future results. All investment s contain risk and may lose value. Investors should consult their investment professional prior to making an investment decision.

This material contains a hypothetical simulation. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical and forecasted performance results have several inherent limitations. Unlike an actual performance record, these results do not do not reflect actual trading, liquidity constraints, fees, and/or other costs. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated or forecasted results and all of which can adversely affect actual results. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

Barclays U.S. Credit Index is an unmanaged index comprised of publicly issued U.S. corporate and specified non-U.S. debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. The Barclays High Yield Index is an unmanaged market-weighted index including only SEC registered and 144(a) securities with fixed (non-variable) coupons. All bonds must have an outstanding principal of $100 million or greater, a remaining maturity of at least one year, a rating of below investment grade and a U.S. Dollar denomination. It is not possible to invest directly in an unmanaged index.

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