Structured equity can increase funded status – a successful investment strategy for the past, present, and future
Challenging investment markets in 2020 have undone years of improvement in the funding levels of corporate defined benefit pension plans. The funding level of a typical plan, as noted in a recent study by Mercer, fell from 88% at the end of 2019 to 80% at the end of April (Chart 1). However, pension plan sponsors do not need to accept that significant funding level declines are the inevitable consequence of tough markets. It is possible to do much better. The investment strategy we discuss in this article would have kept a pension plan that was 88% funded at the end of 2019 at almost 84% funded as of April 30, versus 80% funded using a traditional investment strategy.
The investment strategy we discuss follows these investment principles:
- Hedge interest rate risk by investing in long-term corporate and government bonds designed to match pension plan liabilities (a Liability Matching portfolio);
- Simultaneously access a desired level of equity exposure synthetically;
- Shape this equity exposure to a desired risk/return profile.
Pension plans that invested using these principles, which we collectively refer to as “Structured Equity”, would have significantly improved their funding levels since 2010 and positioned themselves to close their deficits in future years, as shown below. A further description of this strategy can be found in our February 2020 article on the subject (Chart 2).
Chart 1 below shows the change in funded status of 3 different asset allocations on the same pension plan: a traditional 60% equity / 40% liability matching bond portfolio, a more conservative 40% equity / 60% liability matching bond portfolio, and a Structured Equity portfolio giving 60% equity exposure backed by 100% liability matching bonds. The Structured Equity plan shows clear and pronounced outperformance throughout the backtest period.
Next, we looked at performance year to date in 2020, as shown in Chart 2. We assumed that a pension plan sponsor was 88% funded in December 2019, and projected the impact of investing with our Structured Equity principles would be thus far in 2020 versus the two alternative strategies shown in Chart 1.
*Charts show funding levels for plans 80% and 88% funded at 1/1/2010 and 1/1/2020 in Chart 1 and Chart 2, respectively. Plans have 13 year duration as at 1/1/2020, service cost of 2.5% of liabilities per annum and contributions equal to service cost. Liability Matching portfolios are a combination of 67% Barclays Long Credit and US Treasuries to match the duration of liabilities. Equity portfolios are MSCI World Total Return. Structured equity strategies use put and call options to deliver participation to global equities with capital protection down to a 20% fall in markets over a period of 3 years, with downside participation thereafter. Equity upside above a certain level is forgone in the structured equity strategy. The strategy shown in Chart 1 incorporates 3-year equity option positions that are initiated 1/1/2010, 1/1/2013, 1/1/2016, and 1/1/2019, and 1/1/20 for the results shown in Chart 2.
As shown, the Structured Equity portfolio protected better than traditional portfolios.
Looking forward, we show how a Structured Equity portfolio can improve a funding deficit vs. traditional asset allocations. The result as shown in Chart 3 below is a higher median outcome with less risk.
*Projections assume starting funding levels of 88%, liability duration of 13, service cost of 2.5% of liabilities per annum, and contributions equal to service cost. Liability Matching portfolios match yield and duration characteristics of the liabilities. Expected returns for equity and fixed income allocations are 7% and 2.5% respectively. Structured equity strategies use put and call options to deliver participation to global equities with capital protection down to a 20% fall in markets over a period of 3 years, with downside participation thereafter. Equity upside above 26.8% total return is forgone in the structured equity strategy.
Structured Equity works because it removes investment risk from where there is no expectation of earning a return, e.g. hoping that long-term interest rates will rise, and adds it to where there is an expected return, i.e. holding more equities. This strategy has worked over the past decade and for all 5-year+ periods of the past 40 years. In a world where the Fed is likely to keep interest rates very low for a long time, it is likely to work in the future as well.
Aside from improving overall portfolio construction, Structured Equity enables plan sponsors to explicitly shape the outcome of equity returns. The most powerful use of this today is to sell potential future equity upside that may not be needed in order to add downside protection, thus adding more certainty to the portfolio. This allows a plan to hold a greater percentage in equities than a sponsor might otherwise be comfortable holding. In addition, the Structured Equity approach enables the plan sponsor to increase the amount of assets invested in a risk-controlled manner. With high certainty, the result is improved dollar returns. The key here is driving increased dollar returns and not focusing exclusively on percentage returns.
Structured Equity is also a great strategy for pension plans closer to full funding. Because of the focus on dollar returns versus percentage returns, Structured Equity can help plan sponsors reach their funding targets more quickly than a traditional approach or a plan on a glidepath as it reduces risk through the shape but allows a larger equity engine to drive home increased dollars.
- Liability Matching Bonds provide certainty and mitigate interest rate risk but investing solely in them means the funding level will not improve without contributions.
- Traditional equity investments can improve the funding level, but at the expense of taking both equity and interest rate risk (as the assets and liabilities do not match).
- Structured equity enables plans to control interest rate risk, take advantage of the credit risk premium by investing more in long-term corporate bonds than would otherwise be the case, and take equity risk in a controlled way at the same time.
Structured Equity has delivered better returns in the past, and there is a strong case that it will do so in the future. Plan sponsors can improve their odds by focusing on taking equity risk, which has an expectation of return, and mitigating interest rate risk, where there is no expectation of return.
We have developed an interactive modelling tool to show how different plans can benefit from Structured Equity. If you would like to see a more specific comparison based on your plan circumstances, contact Michael Clark below.
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