Asset Liability Management for Defined Benefit Plans. May 22, 2014

Transcription

1 Asset Liability Management for Defined Benefit Plans May 22, 2014

2 Introduction The most important strategic investment decision for a pension plan is asset allocation A research study by Brinson, Hood, and Beebower showed that more than 90% of the variability in a typical pension plan s performance over time can be explained by the asset allocation policy This study was completed in 1986, over two decades ago, but continues to remain true and relevant today 2

3 What is asset allocation? Asset allocation is an investment strategy that balances the risk and return of a portfolio by allocating the assets according to the goals and risk tolerance of a plan sponsor In general, one of the plan sponsor s primary goals is to be able to provide pension benefits to its members at retirement Therefore, it follows, that the growth of the assets of a pension plan should be the same or outpace the growth of the benefits or liabilities of the pension plan over time 3

4 Asset Only Studies In the past, plan sponsors would often only focus on the asset side of the equation to determine asset allocation and the pension plan s risk Today, most plan sponsors recognize that asset only studies do not incorporate the liability related risks As a result, Asset Liability Management ( ALM ) studies are the solutions that pension plan sponsors turn to in order to manage pension plan risks 4

5 Asset Only Analysis vs ALM Study Example : Fully funded Pension Plan with an asset allocation of 40% Bonds, 30% Canadian Equities, 30% Foreign Equities Asset-Only Analysis - Total Portfolio Risk of 8.8% ALM Analysis - Total Portfolio Risk of 14.1% 38% 17% 45% Bonds Canadian Equities Foreign Equities 47% 9% 20% 24% Bonds Canadian Equities Foreign Equities Interest Rate Risk Interest rate risk, which impacts the pension plan s liabilities, is the largest risk factor when performing an ALM analysis When the main driver of a pension plan s risk is the plan s liabilities, an ALM study is the solution to properly assess that risk 5

6 What are the steps to consider in conducting an ALM Study? Step 1: Setting the Objectives Step 2: Setting the Parameters Step 3: Setting the Baseline Step 4: Liability Driven Investment ( LDI ) Solutions Step 5: Dynamic Asset Allocation 6

7 Step 1: Setting the Objectives As stated earlier, the primary objective of most pension plans is to be able to provide pension benefits to its members at retirement Therefore, the strategy for choosing the asset allocation for a pension plan should not be focused on absolute return, but to produce positive excess return over liabilities at an appropriate risk level for the plan sponsor Excess return over liabilities is the difference between the asset return and the growth in liabilities, or the liability return 7% 6% 5% 4% 3% 2% 1% 0% Excess Return over Liabilities Cumulative Annualized Return of Liabilities Cumulative Annualized Return of Assets 7

8 Step 1: Setting the Objectives The secondary objective may be to minimize contributions and manage the volatility The ability to outperform the liability growth over time will consequently: Reduce and minimize future contributions Reduce the deficit and improve the funding ratio The ability to reduce the risk of underperforming the liability growth over time will consequently: Reduce the volatility of future contributions Reduce the volatility of the funding ratio 8

9 Step 2: Setting the Parameters Determine the objectives of the plan sponsor Provide benefit payments to members of the pension plan Minimize contributions Maximize funded ratio Manage the volatility of funding ratios and future contributions 9

10 Step 2: Setting the Parameters Ensure the plan sponsor and the consultant conducting the ALM study agree on the inputs of the study such as: 1) Asset classes What asset classes are currently used? What is the current asset allocation? Do you, the plan sponsor, want to consider additional asset classes that are not currently part of your line up? What are the maximum and minimum ranges to be included for each asset class? 10

11 Step 2: Setting the Parameters 2) Risk/Return profile of each asset class What are the long term assumptions that will be used? How were these assumptions developed? Can the plan sponsor make changes to the assumptions? 3) Liability projection What assumptions are to be included in calculating the liabilities? Indexation, closed or frozen plan, etc. Are there any upcoming changes to the plan provisions to be considered? How many different future potential scenarios should be analyzed? 11

12 Step 2: Setting the Parameters 4) Contributions What is the normal cost? What is the special payment schedule? 5) Time Horizon How far in the future is the plan sponsor interested in? What is the projected time horizon that will be used in the study? (5 years, 10 years, 15 years?) 12

13 Step 3: Setting the Baseline Run the ALM model and project assets and liabilities over the predetermined time horizon Use current asset allocation Use liabilities from most current valuation as the starting point with any adjustments agreed to Develop an efficient frontier Spectrum of optimal portfolios including the current asset classes and the additional asset classes Comparison of optimal portfolios to the current portfolio 13

14 Excess Return May 22, 2014 Step 3: Setting the Baseline Determine where you want to be on the efficient frontier Asset allocation decision How does this asset allocation impact the following metrics over the time horizon of the study: Contributions Funding Ratios Expenses 2.0% 1.8% 1.6% 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% Optimal Efficient Frontier Current 0.0% 5% 6% 7% 8% 9% 10% 11% Risk 14

15 Step 4: Liability Driven Investment ( LDI ) Solutions In determining the best asset allocation strategy, the plan sponsor needs to consider the sensitivity of the liabilities to interest rate changes Pension plans with a longer liability duration are much more vulnerable to interest rate movements These are typically plans with young demographics or a high proportion of active and deferred vested members 15

16 Jul 2009 Oct 2009 Jan 2010 Apr 2010 Jul 2010 Oct 2010 Jan 2011 Apr 2011 Jul 2011 Oct 2011 Jan 2012 Apr 2012 Jul 2012 Oct 2012 Jan 2013 Apr 2013 Jul 2013 Oct 2013 Jan 2014 Apr 2014 May 22, 2014 Step 4: Liability Driven Investment ( LDI ) Solutions If the asset allocation of the portfolio is not as sensitive to interest rate movements as the liabilities, then the portfolio is highly exposed to interest rate risk if rates move in the wrong direction (for example, if rates decrease) Depending on the risk tolerance of the plan sponsor, a pension plan 6% can be fully exposed, partially exposed, or fully hedged 5% against interest rate risk 4% 3% 2% Long Term Yields 16

17 Step 4: Liability Driven Investment ( LDI ) Solutions Example: Determine the Interest Rate Hedging Ratio of a frozen plan that invests 40% in the Universe Bond Index and 60% in equity markets. The liabilities are valued at $500 M and the plan is 90% funded from a solvency perspective. Interest Rate Hedging Ratio = = Dollar Duration of Assets Dollar Duration of Liabilities $ Assets x Average Duration of Assets / 100 $ Liabilities x Average Duration of Liabilities / 100 Low Interest Rate Hedging Ratio means high exposure to interest rate risk 17

18 Step 4: Liability Driven Investment ( LDI ) Solutions Interest Rate Risk Exposure Liabilities : $500 M Average duration of liabilities : 12.8 years Dollar Duration of Liabilities = $500 M x 12.8 years / 100 = $D 64 M Solvency Funded Ratio : 90% (solvency assets of $450 M) Fixed Income Weighting : 40% Duration of Fixed Income : 6.8 years Dollar Duration of Assets = ($500 M x 90% x 40%) x 6.8 yrs / 100 = $D 12 M Therefore, Interest Rate Hedging Ratio = 12 M / 64 M = 19% Only 19% of the interest rate risk is covered by the fixed income assets 18

19 Step 5: Dynamic Asset Allocation Strategies Dynamic Duration Schedule Another consideration in determining the best asset allocation strategy is the timing of implementing an LDI solution In a low interest rate environment, a plan sponsor may decide to stay exposed to interest rate risk in anticipation that interest rates will rise This is a tactical decision and can be either beneficial or detrimental to the funded status of the pension plan Once interest rates have increased, plan sponsors will want to gradually reduce their exposure to interest rate risk 19

20 Step 5: Dynamic Asset Allocation Strategies Example: How are the plan s assets and liabilities impacted by a change in interest rates? Tactical Decision: Impact on Different Asset Allocation Portfolios and Liabilities Interest Rate Movement Fully Exposed: 40% Bonds Asset Allocation Portfolios Partially Exposed: 20% Bonds and 20% LT Bonds Fully Hedged: 40% LT Bonds Liabilities Pension Plan With Fully Exposed Portfolio Mismatch With Fully Hedged Portfolio Decline by 1% 2.5% 3.7% 4.9% 12.8% -10.3% -7.9% Rise by 1% -2.5% -3.7% -4.9% -12.8% 10.3% 7.9% If the plan sponsor believes that interest rates are going to rise, they may want to be mismatched and improve their funded ratio by 10.3% 20

21 Step 5: Dynamic Asset Allocation Strategies This type of tactical decision is referred to as Dynamic Asset Allocation using a Dynamic Duration Schedule What this simply means is that the asset allocation strategy hedges a certain portion of the interest rate risk based on the level of interest rates It is important to understand the underlying risks of taking this tactical decision and its impact on funding ratio and the volatility of future contributions 21

22 Excess Return May 22, 2014 Step 5: Dynamic Asset Allocation Strategies The investment risk of a Dynamic Duration strategy falls between being fully exposed and being fully hedged to interest rate risk 2.0% 1.8% 1.6% 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% Efficient Frontier Fully Hedged Portfolio Dynamic Duration Portfolio Fully Exposed Portfolio Current 0.0% 5% 6% 7% 8% 9% 10% 11% Risk 22

23 Step 5: Dynamic Asset Allocation Strategies Dynamic De-Risking Schedule In a fast changing financial environment, having a dynamic asset allocation strategy may be a sound investment strategy for two reasons: 1) Pension plan liabilities change as the pension plan matures and as demographics evolve. This can reduce the sensitivity of the pension plan to interest rate movements as the duration of the liabilities decreases Liquidity becomes more important as the pension plan members age and benefit payments become more imminent Therefore, the proportion and the duration of the fixed income assets should be adjusted to reflect the changes in the duration of the liabilities and the additional liquidity needs 23

24 Step 5: Dynamic Asset Allocation Strategies 2) If a pension plan is well funded or fully funded, it is less advantageous for plans to be exposed to investment risk This is simply because there is no benefit to a plan sponsor to be excessively over-funded Therefore, the exposure to investment risk should be decreased as the funding ratios improve and the pension plan becomes fully funded and starts to accumulate surplus 24

25 Excess Return May 22, 2014 Step 5: Dynamic Asset Allocation Strategies A Dynamic De-Risking Schedule can be established to gradually reduce the investment risk of the pension plan based on the pension plan s funding ratio 2.0% 1.8% 1.6% 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% PTF 4 (100%) PTF 5 (105%) PTF 3 (95%) Efficient Frontier PTF 2 (90%) PTF 1 (85%) Current 0.0% 5% 6% 7% 8% 9% 10% 11% Risk 25

26 Summary The most important strategic investment decision for a pension plan is asset allocation ALM studies can assist plan sponsors in better understanding their liabilities, associated risks, and potential costs/contributions Interest rate risk is a major factor to consider while determining the optimal asset allocation for a pension plan An optimal asset allocation can minimize future contributions and manage the volatility of funding ratios 26

27 Summary Dynamic duration schedules allow sponsors to take advantage of current market environments and manage interest rate risk De-risking schedules allow sponsors to gradually reduce risk as the pension plan matures and/or funding ratio improves An ongoing monitoring process is important to determine if portfolio adjustments are required 27

28 Questions? 28

29 Contact Information Lucy Paglione, MBA National Investment Practice Leader (416) Howard Chao, CFA, F.C.I.A., F.S.A. Investment and CAP Consultant (416)