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The arbitrage opportunity resulted primarily from the use of an outdated mortality assumption as well as lagged discount rates used to calculate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
- Lump sum calculation rules may soon start to reflect updated mortality assumptions;
A large portion of the liability suitable for lump sums has already been paid out over the last few years;
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 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.
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:
Defease near-term liabilities at a significant discount relative to their accounting or economic valuation;
Reduce considerably the liquidity and market timing risk associated with meeting near-term benefit payments;
Lessen the operational burden and resource commitment associated with raising and managing liquidity to cover benefit payments.