Many pension plan sponsors have embraced the concept of reducing or eliminating mismatches between their pension assets and liabilities with the ultimate goal of lessening pension funded status volatility. A large number of plan sponsors, for example, are considering significant asset allocation shifts to better align the risk characteristics of their asset portfolios and their liabilities. This lower risk strategy is designed to help dampen cash flow contribution volatility as well as the balance sheet risks associated with the plan.
In practice, we have seen plans implement this approach by:
- Lengthening duration and/or increasing the credit exposure in the bond portfolio
- Utilizing overlays (Treasury futures, swaps, options) or other derivative strategies to synthetically extend the duration of the asset portfolio
- Increasing allocations to asset classes that provide a good match to liabilities such as long duration fixed income (often at the expense of equity or other risk-asset allocations)
- Achieving better risk diversification within the return-seeking portfolio (often through allocations to alternative asset classes)
Plan sponsors often combine these strategies in an effort to magnify the risk-reduction benefits and occasionally shift among the different strategies as dictated by an evolution in the plan’s strategic goals or a significant shift in market conditions. To systematically combine multiple facets of their pension risk management strategy and maximize its benefits, many plan sponsors have adopted a dynamic de-risking asset allocation strategy, or “glide path.”
Under the glide path approach, plans gradually shift out of return-seeking strategies that rely on equity exposure into liability-hedging long duration fixed income strategies. Typically, the plan’s funded-status improvement is linked to the glide path so that pre-determined funded-status levels act as triggers for the plan to shift toward a less risky asset allocation mix, until the desired risk position is achieved (additional market-related triggers may be overlaid on top of funding-ratio targets). These glide path strategies are customized based on the plan sponsor’s unique liability structure, initial asset allocation, contribution policy and the plan’s determination of its “end-state” tolerance for risk.
It ain’t what it looks like
Yogi Berra has been quoted as saying, “In theory, there is no difference between theory and practice. In practice, there is.” This phrase is quite applicable to the way LDI and glide path programs are structured.
While the concept of glide path strategies may seem relatively straightforward in theory, the practical considerations of implementing and monitoring a dynamic de-risking program can be quite challenging. Let’s consider an example where a plan sponsor pursuing a glide path strategy is close to meeting its next funding ratio1 trigger and is preparing for the upcoming changes in asset allocation. A number of steps will follow and need to be coordinated for successful implementation of the program:
- Confirmation that a funding ratio trigger has actually been met. This typically requires comprehensive liability present-value calculations, as well as a reconciliation of the market value of assets from the plan’s custodian. A quick turnaround is necessary to avoid a lag in the calculation and be able to execute in a timely manner.
- Coordinating money transfers between asset classes. The plan sponsor will need to be mindful of the tradeoff between executing quickly and the transaction costs associated with the trade.
- Adjustment of the fixed income portfolio composition or structure to achieve the targeted duration hedge ratio. As funded status improves, the glide path will typically require increases in the plan’s interest rate- and credit spread-targeted hedge ratios that may not be completely achieved by the asset allocation shifts. This will therefore require an adjustment to the LDI portfolio structure.
- For plans using overlays or other types of derivative strategies, possible adjustment to the notional exposure to those strategies that reflects the new asset allocation.
The coordination between the involved parties (plan sponsor, investment consultant, plan actuary, custodian and asset managers) is paramount when managing the glide path. Therefore, it is our opinion that a comprehensive game plan should be put in place before embarking on a de-risking strategy, and the best practices for glide path implementation should include:
- A limit on the number of parties involved in or affected by the transitions
- A detailed plan outlining the glide path and the associated transactions once a funded status trigger is met (including the timing and horizon over which asset transitions should occur). Plan sponsors could even consider having this plan written into the investment policy guidelines and have the asset allocation shifts required by the glide path preapproved to avoid a delay in the decision to shift along the glide path.
- A schematic outlining the functions and responsibilities of the various parties involved
- Clear conveyance of the overall liability-hedging program fixed income benchmark structure across multiple LDI managers
It is our belief that the appointment of a competent LDI completion manager can help achieve these objectives and is itself a best practice, especially when the size of the LDI program is (or is expected to become) a meaningful part of overall plan investments.
Combatting complexity with completion
For the sake of simplicity, it would be easiest for a plan sponsor and its LDI manager to execute an LDI program with a single fixed income manager. In reality, however, many plan sponsors employ multiple LDI managers to implement their overall strategy. While providing benefits (manager diversification, for example), a multi-manager LDI structure increases the potential for error in the implementation of the LDI program and makes coordination more difficult, especially in the context of a glide path, for many reasons:
- The plan sponsor has to deal with a number of parties when an LDI portfolio or benchmark structure change is deemed necessary.
- Complex calculations may be required to determine the specific changes within each mandate to achieve the desired overall fixed income target when the managers are running mandates against different benchmarks.
- Rebalancing across multiple managers may lead to unnecessary transactions, with one manager actually selling the type of securities that another manager within the structure is asked to purchase.
- Funding ratio and duration hedge ratio monitoring also becomes more cumbersome as more data from more parties need to be collected.
- Once a glide path trigger is met, the assets flowing into fixed income mandates are spread across a number of managers, which reduces the amount that each manager is asked to put to work, and at some point, may hamper the ability of the manager to put those assets to work efficiently. (Small purchases may reduce the ability to achieve both proper diversification and lower transaction costs, especially in the long-term credit markets.)
The LDI completion manager structure may help alleviate many of these drawbacks. Under this framework, one of the LDI managers is chosen to “quarterback” the program. The other fixed income managers are asked to run their portfolios against standard or plain vanilla fixed income benchmarks (long-term government/credit, long-term credit, etc.). The completion manager is the only one managing against a (highly) customized benchmark that is structured such that the overall fixed income target exposure is achieved given the mandates run by the other managers.
The scope of LDI completion manager assignments can vary considerably. In its simplest form, the completion manager role revolves around glide path monitoring support and regular fixed income portfolio adjustments in an effort to ensure that overall fixed income target exposures are achieved – especially when the plan hits a glide path trigger and assets flow from the return-seeking portfolio to the LDI portfolio. In more comprehensive assignments, LDI completion managers can also implement overlays to achieve synthetic exposures either to interest rate markets – to fine-tune the liability hedge – or to return-seeking markets like equities. The implementation of a synthetic equity overlay (equity futures or swaps) can significantly improve the efficiency of glide path transitions. Indeed, once a trigger is met, the reallocation from equities to bonds can be achieved by simply dialing down the size of the synthetic equity exposure instead of trading physical bonds and equities. In some cases, completion managers may even be asked to implement a portion of the return-seeking mandate (equities or alternatives, for example). This approach makes the transition from return-seeking assets to the LDI portfolio even more straightforward when funding ratio triggers are met.
LDI completion manager structure: an example
Let’s consider an example to explore the structure of an LDI program with a completion manager.
Figure 1 illustrates the potential differences between implementing a glide path using a traditional manager structure versus including an LDI completion manager in the process. The role of a completion manager is also pivotal when constructing an “end-state” portfolio, as shown in Figure 2.
As Figure 2 illustrates, a completion manager can significantly reduce the complexity involved in transitioning the glide path toward the “end-state” portfolio. This is mainly because as the portfolio changes, the adjustments and restructuring required throughout the glide path will occur within the completion manager’s portfolio; the other managers manage against a relatively static benchmark or target, thus reducing disruptions created by the glide path in their portfolios. The completion manager approach can also lead to a reduction in the number of managers given the completion manager’s ability to implement some of the return-seeking exposures − most often synthetically, through overlays, but sometimes through physical holdings (assuming that the completion manager has expertise outside of traditional LDI portfolios).
To avoid potential pitfalls, plan sponsors may want to consider a few guidelines when implementing a completion manager structure:
- Avoid heavy asymmetry in the completion portfolio benchmark. (Structure the satellite managers’ static benchmarks such that the completion manager’s benchmark maintains adequate diversification and exposure.)
- Minimize the scale and complexity of the transition by setting up the satellite managers’ benchmarks with the objective of facilitating future transitions in the completion portfolio benchmark.
- Allocate a larger share of assets to the completion manager in an effort to facilitate future transitions and rebalancing.
Given that many pension plans are considering de-risking strategies, such as a glide path, and intend to increase the size of their LDI programs across multiple fixed income managers, we believe it is important that they also recognize the complexities associated with implementing and managing a de-risking program.
An LDI program with a completion manager supported by satellite fixed income managers managing to static fixed income benchmarks has many benefits that may help address these complexities.
- It facilitates coordination for the LDI program given that the plan sponsor will only have to deal with the completion manager to “run” the LDI allocation.
- It provides a streamlined way to adjust overall fixed income exposure and duration hedge ratios while limiting portfolio disruptions for the other investment managers in the plan sponsor’s lineup.
- The completion manager may also manage synthetic overlays to enable the plan sponsor to achieve desired market exposures with limited disruptions in physical portfolios. This can be especially beneficial for sponsors that are following a glide path. In that case, the derivatives program can provide the benefit of easily rebalancing the plan’s equity exposure at each funded status trigger without selling/buying physical securities.
- The LDI completion manager develops a unique understanding of the plan sponsor’s objectives and circumstances that enables the completion manager to fulfill a number of strategic partner roles: providing support in designing and managing the glide path, monitoring glide path triggers, offering tactical advice to improve glide path implementation and assessing the plan’s need for liquidity to make benefit payments.
1Funding ratio is defined as the market value of assets divided by the present value of liabilities. In addition, plan sponsors should ensure that the funding ratio is measured based on a consistent methodology, i.e., if the market value of assets is used, then the present value of liabilities must be calculated on an unsmoothed basis as well (using a full yield curve approach under Pension Protection Act (PPA) funding or accounting rules).