Pension plan glidepath: an investment opportunity
Many frozen pension plan sponsors have established “glidepaths” to manage the allocation of assets between growth assets (typically equity) and hedging assets (typically fixed income). These glidepaths are designed to systematically reduce the growth assets and increase the hedging assets as a plan’s funded status improves. This trade-off typically results in lower funded status risk but also lower expected returns. We believe there is an opportunity for plan sponsors to capture additional return for their plan in a low-risk manner, regardless of where they are on their glidepath.
Plan sponsors, especially those overseeing plans with high interest rate hedge ratios, can estimate equity market levels when growth assets would be sold. Knowing today the level of where future equity transactions will happen leads to an investment opportunity now for plan sponsors. The opportunity is to monetize the future decision to sell equities through the selling of a “call” option and collecting a premium. This is best explained through an example.
Let’s examine a pension plan that is 95% funded with $500M in assets (and a 100% interest rate hedge ratio) and on a glidepath where the next trigger happens at a funded status of 97%.
The glidepath allocations are as follows:
All else equal, in order to hit the next trigger point, equity markets would have to increase by just over 8% such that the equity portion of the portfolio increases by $10,600,000 as shown in the table below.
Once that trigger point is reached, the plan would sell 20% of the growth portfolio to get from a 25% overall portfolio allocation to a 20% allocation as required by the glidepath. This results in a sale of approximately ~$27M (20% * $135.6M) in equity.
So, let’s look at the opportunity. If we were to sell a 6 month call option with a notional value of $27M, and a strike price of 108% of the MSCI World index today, the plan would receive approximately $513K in premium, or 1.9% of the notional value. (1)
This trade will result in the plan being better off by $513K if markets don’t increase by more than 8% during that six month period. This risk of this trade would be if equity markets increased by more than 8% very soon after placing the trade. This would result in regret risk as the value of the call option would offset a portion of the equity gain.
To minimize this regret risk, we recommend call options with a shorter term to expiry – typically less than one year. Since these call options are liquid, plan sponsors can reverse a trade prior to expiry if necessary to minimize the impact of any regret risk.
Today, timing for a trade is beneficial for plan sponsors. The premium received for this call option is elevated compared to last year due to increased volatility, making the opportunity even more compelling. In fact, using the trade above as an example, current pricing generates nearly four times the premium compared to the same trade two years ago.
For plan sponsors with a high interest rate hedge ratio, this trade comes with little risk. For those with lower interest rate hedge ratios, one would have to consider the impact of a change in rates and equities on the funded status to avoid mistiming the selling of assets and the expiration of the option.
In conclusion, given the current increase in equity markets, the number of pension plans with glidepaths, and the current attractive pricing levels for selling call options, we recommend that plan sponsors assess if selling call options to monetize future decisions would be impactful.
(1) pricing as of 9/2/2020
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