Following the significant drop in funding ratios in 2014, corporate defined benefit (DB) plan sponsors might consider re-risking their asset allocation
as dictated by their glide path or in an attempt to shore up the plan’s funded status. As tempting as this may seem, the incremental funding ratio risk
that would result may be too much for many plan sponsors to handle, especially after the roller coaster ride of the last few years. But what if plans
could re-risk while maintaining their exposure to liability hedging assets to achieve the dual objective of managing funding ratio risk and increasing
Despite strong equity returns in 2014, the combination of lower interest rates and new mortality tables (which extended projected life spans and boosted
liabilities) decreased the funding ratio of many U.S. corporate plans by 8% to 12% on average during that year. Unless sponsors had locked-in the 2013
gains from favorable equity markets and higher discount rates, their funded status is now likely back to the level experienced right after the 2008
financial crisis (see Figure 1).
The primary justification for investing plan assets in equities lies in the expectation that over the long run equity returns will outperform liabilities
and therefore improve a plan’s funded status. But the lack of improvement in funding ratios despite last year’s 14% jump in the S&P 500 suggests that
corporate plans must adjust their approach to equity investing to better fit the asset-liability context.
Smart equity investing for pension plans
Historically, the contribution of equity allocations to funding ratio improvements has been disappointing. However, this is not necessarily due to weak equity returns, but instead because equity returns have not kept pace with liabilities (see Figure 2).
A potential remedy would be to earn equity performance on top of a return that is commensurate with the rate of growth of the plan’s liability – in other
words, overlay equity performance on top of liability returns. To achieve this, plan sponsors can gain exposure to equity markets using derivatives
instruments, which require little capital commitment. The capital freed up by not purchasing physical equities can then be invested in long duration bonds
that serve as collateral for the synthetic equity exposure. This approach should enable sponsors to realize their equity returns on top of long duration
bond returns (minus the financing rate embedded in the equity derivatives position).
To the extent that long duration bonds are a good proxy for long-dated pension liabilities, the plan sponsor would effectively earn equity returns over its
liabilities (minus the financing rate). In 2014, this approach would have enabled plan sponsors to realize the full benefit of strong equity markets and
have funding ratios move in the right direction.
Simple is beautiful
With the structural use of derivatives, collateral management requirements and the need to frequently rebalance the equity overlay and underlying bond
exposures, the implementation of the strategy may appear intimidating.
However, PIMCO’s StocksPLUS LDI Strategy is designed to bring the concept of an equity overlay to an LDI (liability-driven investing) framework while
streamlining and simplifying its implementation. The strategy combines synthetic equity exposure and underlying, actively managed long duration bonds in a
single portfolio where PIMCO handles all aspects of collateral management. Beyond the simplified implementation for plan sponsors, StocksPLUS LDI provides
many other potential benefits:
- Improved duration and credit spread match with liabilities while maintaining an allocation to the equity market (i.e., injecting duration beneath equities)
- An underlying long bond portfolio that should more or less match liabilities, enabling the plan to earn equity market returns over the liability return
- Potential for higher long-term expected return with reduced risk relative to liabilities:
Expected equity market return
+ Expected long bond return
= StockPLUS LDI expected return
- More efficient and quicker glide path implementation (with the potential to dial down the size of the equity overlay when a trigger is met, as opposed to
a coordinated sale of equities and purchases of bonds across several managers in a short period of time)
StocksPLUS LDI: an illustration
As an example, let’s explore the framework for StocksPLUS LDI further by using a hypothetical corporate pension plan and an LDI equity overlay model. The
plan has the following characteristics:
- $1 billion in liabilities with $800 million in assets (80% funded)
- Closed to new entrants
- Approximately 14 years of duration
The plan is reviewing the options laid out in Figure 4:
Let’s assume that our plan sponsor seeks to maintain its current fixed income/equity mix. In this case, the introduction of the LDI equity overlay model
for half the equity exposure would enable the plan sponsor to almost double its duration hedge ratio (from 33% to 59%), leading to a reduction in surplus
risk of 17% (from 14.1% to 11.7%). This would all be accomplished while maintaining the same 60% allocation to return-seeking assets (equities in this
case). Note that the expected return also would likely go up as the collateral long bond portfolio has the potential to outperform the short-term financing
rate built into the pricing of the equity derivatives contract. Ultimately the plan sponsor would probably have a significantly higher hedge ratio,
meaningfully lower surplus risk and a higher return expectation.
Next, let’s look at a scenario where our hypothetical plan sponsor is contemplating re-risking the plan in the hope of offsetting the recent funding ratio
decline through more significant outperformance of assets relative to liabilities in the medium to long term. Under the traditional re-risking framework
the plan would increase its return-seeking allocation by 10 percentage points (and reduce its fixed income LDI portfolio exposure by 10 percentage points).
While this strategy would produce a slightly higher return expectation, it comes at a steep price: Incremental risk as surplus volatility increases by 15%
(from 14.1% to 16.2%). The return-to-risk ratio of 0.1 (+0.2% return/+2.1% risk) for such a strategy is unappealing at best.
However, combining re-risking and the LDI equity overlay model framework has the potential to achieve surprising results. In the example above, increasing
the return-seeking exposure by 10 percentage points while implementing half of the overall equity exposure through the LDI equity overlay model would enable our hypothetical plan sponsor to meaningfully increase return expectations
while keeping surplus risk in line with the initial allocation (and actually slightly lower).
Seeking returns, hedging risks
As plans consider re-risking in an attempt to bolster their funded status, they should be careful not to add more risk than they can tolerate. The
StocksPLUS LDI approach seeks to harmonize the return-seeking goal of equity investing with the goal of managing surplus risk.
If that is not having your (risk-frosted) cake and eating it too, then it is as close as one can get.
For a discussion on using the current low interest rates and potential tax benefits to fund plans by borrowing, please review December 2014’s
Featured Solution, “Rising Insurance Premiums: A New Impetus for Voluntary Funding of Corporate Defined Benefit Plans.”