by Geri Westphal
LOW-RATE ENVIRONMENT CONTINUES TO ADD PRESSURE
After more than a decade of low interest rates, combined with a volatile equity market and fallout from the 2008 subprime and European crises, US corporate pension plans have faced continued deficits with today’s average funding ratio at 75.7% (Source: Milliman as of August 2016). At current levels, pension fund deficits can impact corporate valuations and can potentially handicap corporate development plans.
The temptation to wait and see is strong as investors are hoping that the problem can be resolved by a combination of rising interest rates, asset performance and additional contributions. As most funds are closed, and as populations age and retire, pension funds are running against time. This is amplified by the fact that, in some cases, pension payments exceed contributions and asset returns, thereby inexorably increasing the deficit.
THE CHALLENGES OF PENSION MANAGEMENT
Today, sponsors and pension schemes are faced with three types of challenges when tasked with managing pension plans:
- Defining a contribution schedule that takes into account the plan’s funding ratio and cash flows, as long-term returns may not be sufficient to cover future commitments notwithstanding an expectation that interest rates may normalize;
- Hedging drawdowns and reducing funding ratio volatility, since a severe drawdown could seriously jeopardize the ability to cover liabilities in the future; at the same time, sponsors need to recognize the need to manage their corporate balance sheets;
- Building optimal investment portfolios to achieve diversification and the expected returns.
The end goal for most sponsors is to minimize the cost of the pension commitments and, in some cases, potentially transfer the pension liabilities to an insurance company. Corporates who have done so have generally seen positive relative performance in their stock price as shareholders value the removal of the pension risks. This requires careful planning of contributions to balance short term corporate objectives (free cash flows, earnings, tax, cash flow) and long-term pension funds projections (asset and liability management to capture a window when the sponsor can implement such a step).
Rating agencies and equity analysts commonly consider any level of pension deficit as debt-like, creating almost full neutrality between running a pension deficit and paying the pension deficit financed by corporate debt. Other considerations may increase the importance of the pension deficit, for example, when the sponsor is engaging in a corporate event, and can include the following:
- Corporate debt creates a fixed schedule of cash outflows (interest rate and principal) while the pension deficit is a variable obligation for which cash flows are renegotiated on a regular basis.
- The pension deficit is typically a debt of the operating entity, effectively creating a structural subordination of the corporate debt relative to the pension deficit. Pension funds will in most cases have recourse to the operating entity, but potentially also to sister companies, and the holding company with respect to the deficit.
- In a liquidation scenario, the claim of the pension fund on the sponsor can exceed the pension accounting deficit.
- In several countries, the pension regulator has additional powers to intervene at the time of a corporate event, forcing the sponsor to consider funding as a condition of approvals. That can also restrict the ability of an operating entity to distribute dividends to the group.
WHAT IF I OVERFUND THE PLAN?
A pension fund surplus is generally not recognized as an asset of the sponsor since the contributions to a pension fund are unlikely to be recovered if the pension fund is in a surplus position in the future. In addition, a pension surplus can prompt proposals for increases in pension terms and statutory increases. Sponsors can generally tolerate small deficits and defined contribution schedules that provide a path to recovery, taking into account contributions, expected return on assets and annuity cash outflows.
A small deficit can be absorbed within reasonable expectations of asset performance and interest rate increases. In such a scenario additional contributions from the sponsor would only be required to cover unexpected adverse market events.
A large deficit will typically require very high expected returns on assets, combined with rising interest rates to facilitate a full recovery without additional contributions. The asset return expectations may prove to be unrealistic, since a positive impact of rising interest rates on liabilities can also coincide with a negative return on the fixed income assets, a significant part of most pension funds’ portfolios.
In addition, a “mature fund,” where most members are in retirement and receiving a pension, will be more sensitive to early additional contributions if pension payments exceed asset returns and ongoing contributions and thereby deplete the pool of assets in an underfunded plan.
IS IT TIME TO LOCK IN RATES?
When analyzing the risks of a pension fund, a typical break-down of the deficit-at-risk shows 50% to 65% of the risks concentrated on interest rates and inflation. The deficit-at-risk can be translated into a leverage ratio-at-risk for the sponsor. Organizations need to assess what deficit-at-risk (the “risk budget”) is acceptable for them.
Within this risk-budget constraint, the pension fund should consider allocating its risks in the most efficient manner to optimize long-term performance by trying to achieve a fully funded status without any delay (or trying to maximize the surplus at a given horizon). It is important to make the distinction between the strategic asset allocation that aims to define the long-term optimal outcome from the tactical positions that deviate from the strategic asset allocation to benefit from market opportunities.
Focusing on the strategic asset allocation, an interest rate gap between assets and liabilities has a negative risk premium as the yield curve is steep (in most market conditions). Hedging interest rates is the most efficient way to reduce the volatility of the pension deficit, capture the steepness of the curve to increase yield in a risk-neutral framework and manage the impact on the sponsor’s key financial metrics.
In today’s low-yield environment, hedging interest rates by extending the duration with interest rate swaps may not be the best strategy because tactically interest rates may have more potential to rise than fall and, as shown in Japan and Europe, yields can fall below 0%. Also, by locking in current rate levels, the pension plan would give up potential upside as yields rise.
After the implementation of Dodd-Frank clearing obligations, the use of swaps will require the posting of potentially large cash balances at CCP when interest rates rise. Pension funds have limited holdings of cash and would need to engage in a leveraging of their assets or liquidate as sets to have access to cash, most likely at a time when yields rise and the value of their fixed income portfolios falls.
The use of swaptions (the right to receive/pay fixed rate in the future) can help reconcile the objective of reducing risk, retaining upside potential and, at the same time, reducing potential cash collateralization requirements. For example, instead of entering into long-term receiving swaps, a plan can buy long-term receiver swaptions (6m10y receiver ATM) financed by selling short-term payer swaptions (1m20y payer OTM+25bps). This strategy can be refined by a systematic acquisition of “Best” receiver swaption financed by selling the “Worst” payer swaption.
MANAGING DRAWDOWN RISK
Diversifying asset portfolios is often much more challenging than initially expected. A series of typical concerns range from “How can I diversify a portfolio without unwinding multiple positions?” to “How should we measure diversification in the first place?” The first concern can easily be overcome using overlay strategies built to diversify an existing portfolio by hedging some of its market exposures while leaving others unchanged. Addressing how to measure diversification in a portfolio and maintaining that over time is a much more challenging task. That’s where risk premia quantitative modeling is useful.
The initial steps of this process focus on identifying the risk factors that will be monitored to achieve diversification and their associated building blocks – i.e., the risk premia indices that will be used to actually build the overlay strategy. Then comes the heavy lifting: How does one build an overlay strategy that ensures real diversification? One that diversifies the types of assets but also looks at correlations inside and across asset classes, making sure that the overlay will bring the expected diversification in normal market conditions as well as during bouts of market stress.
Société Générale Cross Asset Research has developed a range of proprietary techniques that allow the modeling of a portfolio and the building of a bespoke overlay to diversify it without changing its asset allocation. A set of 4 quantitative models are combined to analyze any portfolio:
| Rolling Correlation: how influential each risk factor is on the portfolio? |
| Drawdown Analysis: how to best hedge against market drawdowns? |
| Regression Analysis: which index brings the most diversification? |
| Cross Asset Analysis: bringing cross asset interactions |
Once the risk premia indices composing the overlay have been selected, their respective weightings are a function of their volatility: the more volatile each index, the lower its weighting in the allocation, to maintain a low volatility overall in the final allocation.
USING OUTSIDE FIDUCIARIES
The concepts described above also apply to funded investments. A severe drawdown in a plan portfolio could seriously jeopardize its ability to cover liabilities in the future. Reducing the magnitude of a potential drawdown can be key in achieving the necessary long-term appreciation of capital.
Within Société Générale in the US, the asset management business, Lyxor Asset Management Inc. (“Lyxor Inc.”) offers customized investment strategies that seek to mitigate the effects of a drawdown during prolonged equity market sell-offs, while seeking to provide some upside participation during up markets. This often can combine three types of alternative strategies to design liquid, scalable, and cost-efficient risk mitigating strategies:
- Managed Futures: Seeks to diversify under extreme market conditions.
- Global Macro: Seeks to diversify at inflection points in economic and market cycles.
- Alternative Risk Premia (“ARP”): Seeks to diversify during periods of low market volatility.
It is important to note that some of these strategies can be accessed at costs lower than those of typical hedge funds.
KEY TAKEAWAYS
Corporates are closing Defined Benefit (DB) schemes and offering their employees access to the Defined Contribution (DC) schemes. However the management of the legacy DB plans will continue for a long time before the plans run off. In the meantime, pension managers and sponsors need to define the best paths to manage the funded status of the plans.
Funding and derisking the interest rate (and inflation) sensitivity of a plan deficit should be essential components of any pension solution. High deficits and mature plans tend to require larger, earlier contributions. Corporates with high sensitivity to rating downgrades due to leverage should pay even more attention to the effect of the volatility of the pension deficit.
Reducing the deficit also relies on efficient portfolio allocation. This can be aided by using overlays to maximize access to risk premium and diversification. Without asset performance, the burden on the sponsor through contributions will be high.
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Eric Viet Global Head of Sovereign & Financial Institutions phone number: +44 20 7676 7633 |
Michael Clark Managing Director Head of Investor Solutions, SG Americas phone number: +1 212 278 5461 |
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