Article November 6, 2019

Pension investing – why equity derivatives now?

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Equity returns of 15% or higher would usually be cause for celebration among corporate pension plan investors. However, despite these strong returns, many plan sponsors have seen a decline in their funded ratios during 2019.  This is mainly attributable to falling interest rates, causing the value of liabilities to increase faster than assets for many. This is a continuation of a frustrating cycle that plan sponsors are all too familiar with: strong equity returns offset by rapidly rising liability values.

However, plan sponsors who have utilized derivatives to create a more efficient asset allocation may have seen their funding level hold up, or even improve, in this environment. Derivatives can allow plan assets to do “double duty”: interest rate risk can be managed without sacrificing exposure to growth assets such as equities. It is only through the use of derivatives that plan sponsors can “have their cake and eat it” by benefiting from rising equity markets while not being hit by falling long-term interest rates.

There are a number of ways to utilize derivatives to increase investment efficiency. We believe it is best for US corporate pension plans (especially those with greater than $50M in assets) to invest assets in Liability Driven Investment (LDI) bond mandates while capturing equity exposure synthetically, using options on major equity indices. Even in an era of low interest rates, investing physical assets in liability matching bonds is still an efficient and effective strategy, especially when complimented with a derivative strategy.

Constructing a portfolio in this way allows for a plan sponsor to:

  1. Limit potential equity upside that may not be needed;
  2. Use this forgone upside to pay for protection against equity market falls;
  3. Adjust the amount of equity upside/downside exposure over time as part of a de-risking glide path versus decreasing the amount of growth assets;
  4. Easily adjust the equity and interest rate exposures to reflect market views or other considerations.

An equity position created using derivatives might look like the picture depicted below.

Here, the plan benefits from the first 25% of equity market increases and is protected for the first 20% of market losses over a three year period. The level of potential upside vs. downside protected is fully customizable.

Plans that have utilized an LDI + synthetic equity strategy have posted strong returns in 2019 versus more conventional investment strategies. Below is a test of how this synthetic equity portfolio would have fared against more traditional asset allocations since the start of 2019.

Pension investing - why equity chart

*Returns shown are from 12/31/2018 - 8/31/2019

 

1The strategy invests in synthetic equity referencing the MSCI World Index with a notional of 50% of total asset value, protection down to 20% price falls, and total return capped over 3 years. The level of the cap is such that the overall premium is approximately equal to the cost of funding the structure over three years. All assets not used to pay the premiums on the options strategy are invested in the long credit portfolio used to calculate liability returns.                      

2Portfolio is invested in 50% MSCI World Total Return Index and 50% in the long credit portfolio used to calculate liability returns                                                                                                                

3Portfolio is invested in 50% MSCI World Total Return Index and 50% Barclays Global Aggregate Bond Index                  

4Liability return is estimated using a long credit portfolio consisting of 25% Barclays Bellweather 10 year, 25% Barclays Bellweather 30 year, and 50% Barclays Long Credit Index              

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