- Current market conditions are encouraging sponsors of corporate pension plans to lock in improvements in funded ratios
- Completion portfolio managers can deliver plan sponsors the customization and risk management needed to reduce a plan’s funded status volatility over time
- Using a case study, we will demonstrate how the use of a completion manager can potentially help plan sponsors decrease interest-rate risk and reduce the tracking error of plan assets to liabilities
Phone a Friend: When Should Sponsors Seek a Completion Manager?
“Completion portfolio management” connotes a strategy of managing and reducing the financial risk associated with sponsoring a pension plan. For plan sponsors, the role of a completion portfolio manager will depend on the unique circumstances of each individual pension plan (Figure 1).
For example, plans with limited resources may rely on a completion manager to monitor the plan’s glide path and adjust the asset allocation as the plan’s characteristics evolve over the course of its de-risking journey. For plans early in the de-risking lifecycle, completion management may involve something as simple as an interest rate overlay to extend the duration of the plan assets without disrupting the existing asset allocation. For those plans farther along their de-risking glide paths, completion management may include a derivative program to fine-tune key rate duration (KRD) exposure in order to reduce the tracking error of plan assets to the projected liability cash flows.
Completion portfolio managers can also help plan sponsors manage the complexity of increasing a plan’s allocation to long duration fixed income assets that are more closely aligned with the liability cash flows. In the current environment, we believe this will be the most common (and useful) role of a completion manager.
Reducing Funded Status Volatility within a Multi- Manager Construct: It’s Complicated
Strong equity market returns, rising interest rates, and employer contributions have led to an improvement in funded ratios for many corporate pension plans. As a result, plan sponsors are looking for opportunities to lock in higher funded ratios.
Most plan sponsors have taken the initial step to extend the duration of their fixed income assets through allocations to mandates benchmarked to traditional market-based benchmarks, such as the Bloomberg Barclays Long Credit or Long Government/Credit indices.
However, as funded status improves, many plan sponsors are turning their focus to reducing surplus volatility. At this stage in a plan’s de-risking journey, more precision is needed. Traditional market-based benchmarks that were effective in the early stages of de-risking are unlikely to align closely with the risk factors of the liabilities.
Broadly speaking, for plans seeking to reduce tracking error to the liability, the greater the allocation to long duration bonds, the greater the value of using a completion manager to manage surplus volatility. This is especially true for plans that have implemented long-duration allocations using multiple asset managers hired at different points of the de-risking journey. In this multi-manager construct, maintaining or adjusting target hedge ratios or executing an asset allocation change becomes increasingly complex. Plan sponsors will also need to protect funded status against events like a non-parallel shift in the yield curve, as well as considering the implications of spread duration, credit risk, and potentially inflation risk.
Considering these challenges, plan sponsors may benefit from a single completion manager to coordinate across a plan’s roster of asset managers to streamline these changes and improve the efficiency and efficacy of the liability hedge.
However, successful completion managers need significant expertise and skills in all key areas of pension risk management:
- Actuarial resources
- Customizing benchmarks to the liability
- Quantitative tools to analyze risk relative to the liability
- Glide path management
- Portfolio management
- Derivatives and collateral management
- Deep understanding of the size, liquidity and duration limitations of the corporate bond markets
The completion manager coordinates across all asset managers, reducing the chance for an implementation error. A completion manager can also potentially reduce plan costs by eliminating unnecessary transactions due to rebalancing between asset managers. Instead of reallocating capital among the various asset managers, the completion manager can adjust the liability hedge by using derivatives.
The Role of Derivatives in Completion Portfolios
A completion portfolio manager can use a derivative overlay strategy in conjunction with cash bonds to develop a much more robust and customized liability-hedging portfolio. Although other instruments like U.S. Treasury STRIPS can also be used, these instruments can be rather blunt and require a change in the asset allocation—physical bonds need to be fully funded while derivatives only require margin to express the same exposure. An overlay strategy allows the asset manager to target specific risk factors to modify the liability hedge without disrupting the asset allocation. In our view, the greater the flexibility for derivatives usage, in term of maturities, notional amounts, and instrument types, the greater the potential reduction in the tracking error between assets and liabilities.
However, the use of derivatives introduces multiple considerations for plan sponsors to evaluate. The basis risk between derivative instruments, cash bonds, and the liability calculation, which is based on the Aa-rated corporate bond spread, can result in unintended consequences if these instruments do not behave as expected due to unforeseen shocks to the market. Derivatives also introduce increased operational complexity, making it imperative to utilize a completion manager with deep experience in the derivatives markets. If not managed effectively, the benefits of introducing a completion manager to a de-risking portfolio may be eroded.
Completion Management: Investment Process
Figure 2 outlines the investment process for implementing a completion portfolio. In step 1, it is important to note that the analysis is focused on the underlying market betas, which are defined by each asset manager’s benchmark. This ensures any active risk positions are not neutralized. The interest rate hedge ratio at each key rate maturity point and in aggregate is then calculated to identify any gaps. The tracking error between the assets and liabilities is also calculated and decomposed into its main components – interest rate, spread, and equity risk factorsb– to help us determine and rank the greatest sources of funded status volatility.
With input from the client, the next step is to define an acceptable range for funded status volatility. With that information in mind, the completion manager will determine the interest rate hedge ratio target in aggregate and at each key rate node and construct the completion overlay portfolio required to meet this objective.
Finally, the tracking error to the liability and interest rate hedge ratios require ongoing monitoring to ensure the completion portfolio accomplishes the overall objective and to rebalance the completion portfolio as needed based on previously defined ranges of tolerance.
Plan Analysis and Diagnostic
The initial analysis and diagnostic process provides a comprehensive analysis of the plan’s assets and liabilities. The liability was calculated using actuarial information provided by the plan and discounted using an Aa-rated corporate bond yield curve (FTSE Pension Discount Curve). The duration profile of the total plan assets was constructed by utilizing the benchmarks of each manager. The duration profiles of the assets and liabilities were then compared to identify any gaps with an emphasis at each key rate maturity node. Figure 3a illustrates the key rate durations of both the current portfolio and of the liabilities while Figure 3b displays the interest rate hedge ratios in aggregate and at each key rate duration node. The interest rate hedge ratio at the total plan level is 76% and the interest rate hedge ratios vary between 50% and 146% across the key rate maturity points.
What did we learn?
As you can see, the plan is over-hedged at the 25-year key rate and under-hedged at all other maturities.
Source: Voya Investment Management
Source: Voya Investment Management
Optimizing the Completion Portfolio
With the key rate gaps identified, the overlay portfolio is optimized to get an interest rate hedge ratio of 100% at the total plan level and at each maturity point without disrupting the current asset allocation. As shown in Figure 4a and 4b, this can be done through the use of derivatives, specifically interest rate swaps in this example. In practice, the completion manager may utilize a variety of derivative instruments including swaps, futures, and options to implement the most efficient hedge for the desired outcome.
The resulting portfolio adjustments
Interest rate exposure was extended at each key rate maturity point except the 25-year node. At the 25-year key rate, a short interest rate position was initiated to reduce the hedge ratio at that node. The completion overlay has neutralized the curve bringing the interest rate hedge ratio at each maturity point to 100%.
Source: Voya Investment Management
Source: Voya Investment Management
Given the objective of reducing the tracking error to the liability, it is important to evaluate if matching each KRD by utilizing a completion portfolio was an effective method to achieve this objective. Figure 5 displays the total tracking error to the liability for the original portfolio and the portfolio that utilizes a completion overlay. The tracking error is further decomposed into the three key components: interest rates, spreads, and equity risk factors.
The outcome, i.e. benefit for the client: Lower interest rate risk and lower overall volatility
As evidenced in the exhibits, with the completion portfolio, the interest rate risk dropped from 140 basis points (bps) of risk contribution to only six bps; i.e., virtually zero. This means total tracking error to the liability is coming almost entirely from the equity allocation. Finally, the total volatility was reduced by almost 30%, falling from 3.31% to 2.36%. To reduce the tracking error further, the plan sponsor would need to adjust the equity risk exposure. It is noteworthy that with the interest rate risk fully hedged, the contribution to volatility coming from the equity allocation increased slightly due to the correlation effect of hedging the interest rate risk.
Source: Voya Investment Management
Strong returns from risk-seeking assets and accelerated plan contributions as a result of the recent tax legislation has led to improved funded ratios for many plan sponsors. Coupled with the current regulatory environment, specifically the escalating variable rate PBGC premiums and the increasing cost associated with running an underfunded plan, sponsors are incentivized to lock in these improved funded ratios. As plans lock in these higher ratios and move closer to their target end-game, a completion manager can play an important role in the process to help plan sponsors meet their objectives through a higher level of customization and risk management needed to minimize funded status volatility. Having a trusted and experienced partner anchoring the portfolio and dynamically completing the existing assets around the plan’s liabilities will be extremely helpful from a plan governance perspective.
Given Voya’s multi-dimensional LDI team structure that integrates an experienced LDI strategy development team comprised of actuarial, quantitative, and macro resources with a team of skilled portfolio managers, we are highly experienced in conducting pension plan diagnostics and completion portfolio management. The LDI strategy team works closely with clients and their consultants to evaluate current plan conditions as well as end-state objectives to develop and recommend strategies appropriate to meet those objectives. These solutions can be off-the-shelf strategies benched to traditional market-based indices or serving the completion manager role through managing highly customized liability matching portfolios.
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