Streamlining Glide Path Implementation With an LDI Completion Manager

In Depth July 2013 Your Global Investment Authority Streamlining Glide Path Implementation With an LDI Completion Manager Rene Martel, FSA, CFA Executive Vice President Product Manager Pension plan sponsors are increasingly adopting a dynamic de-risking approach, or glide path, that gradually shifts a plan from return-seeking assets toward a liability-driven investment (LDI) strategy. Because of the complexities, we believe plan sponsors taking the glide path approach can benefit from choosing an LDI completion manager as a quarterback to coordinate the program. The LDI completion manager streamlines glide path implementation by consolidating the required portfolio adjustments and asset allocation shifts in one place, limiting disruptions in the other investment managers portfolios as they continue to manage against static benchmarks. Vijendra Nambiar Vice President Product Manager Many pension plan sponsors have embraced the concept of reducing or eliminating mismatches between their pension assets and liabilities with the ultimate goal of lessening pension funded status volatility. A large number of plan sponsors, for example, are considering significant asset allocation shifts to better align the risk characteristics of their asset portfolios and their liabilities. This lower risk strategy is designed to help dampen cash flow contribution volatility as well as the balance sheet risks associated with the plan. In practice, we have seen plans implement this approach by: Lengthening duration and/or increasing the credit exposure in the bond portfolio Utilizing overlays (Treasury futures, swaps, options) or other derivative strategies to synthetically extend the duration of the asset portfolio

Increasing allocations to asset classes that provide a good match to liabilities such as long duration fixed income (often at the expense of equity or other risk-asset allocations) Achieving better risk diversification within the returnseeking portfolio (often through allocations to alternative asset classes) Plan sponsors often combine these strategies in an effort to magnify the risk-reduction benefits and occasionally shift among the different strategies as dictated by an evolution in the plan s strategic goals or a significant shift in market conditions. To systematically combine multiple facets of their pension risk management strategy and maximize its benefits, many plan sponsors have adopted a dynamic derisking asset allocation strategy, or glide path. Under the glide path approach, plans gradually shift out of return-seeking strategies that rely on equity exposure into liability-hedging long duration fixed income strategies. Typically, the plan s funded-status improvement is linked to the glide path so that pre-determined funded-status levels act as triggers for the plan to shift toward a less risky asset allocation mix, until the desired risk position is achieved (additional market-related triggers may be overlaid on top of funding-ratio targets). These glide path strategies are customized based on the plan sponsor s unique liability structure, initial asset allocation, contribution policy and the plan s determination of its end-state tolerance for risk. It ain t what it looks like Yogi Berra has been quoted as saying, In theory, there is no difference between theory and practice. In practice, there is. This phrase is quite applicable to the way LDI and glide path programs are structured. While the concept of glide path strategies may seem relatively straightforward in theory, the practical considerations of implementing and monitoring a dynamic de-risking program can be quite challenging. Let s consider an example where a plan sponsor pursuing a glide path strategy is close to meeting its next funding ratio 1 trigger and is preparing for the upcoming changes in asset allocation. A number of steps will follow and need to be coordinated for successful implementation of the program: 1. Confirmation that a funding ratio trigger has actually been met. This typically requires comprehensive liability present-value calculations, as well as a reconciliation of the market value of assets from the plan s custodian. A quick turnaround is necessary to avoid a lag in the calculation and be able to execute in a timely manner. 2. Coordinating money transfers between asset classes. The plan sponsor will need to be mindful of the tradeoff between executing quickly and the transaction costs associated with the trade. 3. Adjustment of the fixed income portfolio composition or structure to achieve the targeted duration hedge ratio. As funded status improves, the glide path will typically require increases in the plan s interest rate- and credit spread-targeted hedge ratios that may not be completely achieved by the asset allocation shifts. This will therefore require an adjustment to the LDI portfolio structure. 4. For plans using overlays or other types of derivative strategies, possible adjustment to the notional exposure to those strategies that reflects the new asset allocation. The coordination between the involved parties (plan sponsor, investment consultant, plan actuary, custodian and asset managers) is paramount when managing the glide path. Therefore, it is our opinion that a comprehensive game plan should be put in place before 1 Funding ratio is defined as the market value of assets divided by the present value of liabilities. In addition, plan sponsors should ensure that the funding ratio is measured based on a consistent methodology, i.e., if the market value of assets is used, then the present value of liabilities must be calculated on an unsmoothed basis as well (using a full yield curve approach under Pension Protection Act (PPA) funding or accounting rules). JULY 2013 IN DEPTH 2

embarking on a de-risking strategy, and the best practices for glide path implementation should include: A limit on the number of parties involved in or affected by the transitions A detailed plan outlining the glide path and the associated transactions once a funded status trigger is met (including the timing and horizon over which asset transitions should occur). Plan sponsors could even consider having this plan written into the investment policy guidelines and have the asset allocation shifts required by the glide path preapproved to avoid a delay in the decision to shift along the glide path. A schematic outlining the functions and responsibilities of the various parties involved Clear conveyance of the overall liability-hedging program fixed income benchmark structure across multiple LDI managers It is our belief that the appointment of a competent LDI completion manager can help achieve these objectives and is itself a best practice, especially when the size of the LDI program is (or is expected to become) a meaningful part of overall plan investments. Combatting complexity with completion For the sake of simplicity, it would be easiest for a plan sponsor and its LDI manager to execute an LDI program with a single fixed income manager. In reality, however, many plan sponsors employ multiple LDI managers to implement their overall strategy. While providing benefits (manager diversification, for example), a multi-manager LDI structure increases the potential for error in the implementation of the LDI program and makes coordination more difficult, especially in the context of a glide path, for many reasons: 1. The plan sponsor has to deal with a number of parties when an LDI portfolio or benchmark structure change is deemed necessary. 2. Complex calculations may be required to determine the specific changes within each mandate to achieve the desired overall fixed income target when the managers are running mandates against different benchmarks. 3. Rebalancing across multiple managers may lead to unnecessary transactions, with one manager actually selling the type of securities that another manager within the structure is asked to purchase. 4. Funding ratio and duration hedge ratio monitoring also becomes more cumbersome as more data from more parties need to be collected. 5. Once a glide path trigger is met, the assets flowing into fixed income mandates are spread across a number of managers, which reduces the amount that each manager is asked to put to work, and at some point, may hamper the ability of the manager to put those assets to work efficiently. (Small purchases may reduce the ability to achieve both proper diversification and lower transaction costs, especially in the long-term credit markets.) The LDI completion manager structure may help alleviate many of these drawbacks. Under this framework, one of the LDI managers is chosen to quarterback the program. The other fixed income managers are asked to run their portfolios against standard or plain vanilla fixed income benchmarks (long-term government/credit, long-term credit, etc.). The completion manager is the only one managing against a (highly) customized benchmark that is structured such that the overall fixed income target exposure is achieved given the mandates run by the other managers. The scope of LDI completion manager assignments can vary considerably. In its simplest form, the completion manager role revolves around glide path monitoring support and regular fixed income portfolio adjustments in an effort to ensure that overall fixed income target exposures are achieved especially when the plan hits a glide path trigger and assets flow from the return-seeking portfolio to the LDI portfolio. In more comprehensive assignments, LDI completion managers can also implement JULY 2013 IN DEPTH 3

overlays to achieve synthetic exposures either to interest rate markets to fine-tune the liability hedge or to return-seeking markets like equities. The implementation of a synthetic equity overlay (equity futures or swaps) can significantly improve the efficiency of glide path transitions. Indeed, once a trigger is met, the reallocation from equities to bonds can be achieved by simply dialing down the size of the synthetic equity exposure instead of trading physical bonds and equities. In some cases, completion managers may even be asked to implement a portion of the returnseeking mandate (equities or alternatives, for example). This approach makes the transition from return-seeking assets to the LDI portfolio even more straightforward when funding ratio triggers are met. FIGURE 1: TRADITIONAL VERSUS LDI COMPLETION MANAGER STRUCTURES Traditional Structure Completion Manager Structure Fixed Income Structure Fixed Income Manager Structure Asset Allocation Overall (across multiple managers / mandates) 15% 12.5% 12.5% 60% Long Credit Long Gov't Int Credit 20+ STRIPS 12 15 60.5 Traditional Structure % Multiple managers with different mandates Manager A (10-20% of Assets) 25% Multiple mandates would need to be adjusted as the plan progresses along the glide path Requires coordination between many managers to make sure combination of mandates achieves desired targets (interest rate and credit spread exposures) 75% Manager B (10-20% of Assets) 25% 75% Completion Manager (20-60% of Assets) 25% 25% 5% 45% Completion Manager Structure Multiple managers with different mandates (although number of distinct underlying mandates is generally smaller) Only the completion manager mandate needs to be adjusted as the plan progresses through the glide path Reduces the amount of coordination required given that all portfolio adjustments are focused in the completion manager portfolio Return-Seeking Manager Structure Numerous managers within and across asset classes Coordination requirements can be cumbersome when glide path triggers are met (moving money from the return-seeking allocation to the liability hedging allocation) Lower number of managers as some return-seeking exposures can be implemented through overlays (equities for example) by the completion manager Reduces amount of coordination required given the fewer number of managers, and this can potentially help reduce implementation errors Source: PIMCO. Example for illustrative purposes only. JULY 2013 IN DEPTH 4

FIGURE 2: SAMPLE END-STATE PORTFOLIO WITH A COMPLETION MANAGER In the end-state portfolio, the completion manager implements a highly customized liability-hedging portfolio while the other managers continue managing against relatively static benchmarks Overall manager structure of the end-state portfolio remains the same as the completion manager portfolio, limiting portfolio disruptions Source: PIMCO. Example for illustrative purposes only. LDI completion manager structure: an example Let s consider an example to explore the structure of an LDI program with a completion manager. Figure 1 illustrates the potential differences between implementing a glide path using a traditional manager structure versus including an LDI completion manager in the process. The role of a completion manager is also pivotal when constructing an end-state portfolio, as shown in Figure 2. As Figure 2 illustrates, a completion manager can significantly reduce the complexity involved in transitioning the glide path toward the end-state portfolio. This is mainly because as the portfolio changes, the adjustments and restructuring required throughout the glide path will occur within the completion manager s portfolio; the other managers manage against a relatively static benchmark or target, thus reducing disruptions created by the glide path in their portfolios. The completion manager approach can also lead to a reduction in the number of managers given the completion manager s ability to implement some of the return-seeking exposures most often synthetically, through overlays, but sometimes through physical holdings (assuming that the completion manager has expertise outside of traditional LDI portfolios). To avoid potential pitfalls, plan sponsors may want to consider a few guidelines when implementing a completion manager structure: Avoid heavy asymmetry in the completion portfolio benchmark. (Structure the satellite managers static benchmarks such that the completion manager s benchmark maintains adequate diversification and exposure.) JULY 2013 IN DEPTH 5

Minimize the scale and complexity of the transition by setting up the satellite managers benchmarks with the objective of facilitating future transitions in the completion portfolio benchmark. Allocate a larger share of assets to the completion manager in an effort to facilitate future transitions and rebalancing. Conclusion Given that many pension plans are considering de-risking strategies, such as a glide path, and intend to increase the size of their LDI programs across multiple fixed income managers, we believe it is important that they also recognize the complexities associated with implementing and managing a de-risking program. An LDI program with a completion manager supported by satellite fixed income managers managing to static fixed income benchmarks has many benefits that may help address these complexities. 3. The completion manager may also manage synthetic overlays to enable the plan sponsor to achieve desired market exposures with limited disruptions in physical portfolios. This can be especially beneficial for sponsors that are following a glide path. In that case, the derivatives program can provide the benefit of easily rebalancing the plan s equity exposure at each funded status trigger without selling/buying physical securities. 4. The LDI completion manager develops a unique understanding of the plan sponsor s objectives and circumstances that enables the completion manager to fulfill a number of strategic partner roles: providing support in designing and managing the glide path, monitoring glide path triggers, offering tactical advice to improve glide path implementation and assessing the plan s need for liquidity to make benefit payments. 1. It facilitates coordination for the LDI program given that the plan sponsor will only have to deal with the completion manager to run the LDI allocation. 2. It provides a streamlined way to adjust overall fixed income exposure and duration hedge ratios while limiting portfolio disruptions for the other investment managers in the plan sponsor s lineup. JULY 2013 IN DEPTH 6

Biographies Mr. Martel is an executive vice president and product manager in the Newport Beach office. He focuses on liability-driven investments and is also a member of PIMCO's investment solutions team. Prior to joining PIMCO in 2006, he was responsible for conducting assetliability modeling and recommending risk management strategies for pension plan sponsors at Mercer Investment Consulting. He also advised institutional clients on asset allocation, investment policy and investment manager selection. Previously, Mr. Martel was in the actuarial practice of Mercer, advising pension plan sponsors on funding, accounting and plan design matters. He has 12 years of investment experience and holds an undergraduate degree in actuarial science from Laval University. Mr. Martel also holds the Fellow of the Society of Actuaries (FSA) designation. Mr. Nambiar is a vice president and product manager with the liability driven investments (LDI) team in the Newport Beach office. Prior to joining PIMCO in 2009, he was with Towers Perrin, where he was responsible for actuarial valuations, stochastic funding forecasts and asset-liability studies. He also analyzed and recommended risk-mitigation strategies for corporate pension plan sponsors. He has four years of investment experience and holds an undergraduate degree in actuarial science from the University of Illinois at Urbana-Champaign and a master s degree in financial engineering from the University of Michigan, Ann Arbor. Newport Beach Headquarters 840 Newport Center Drive Newport Beach, CA 92660 +1 949.720.6000 Amsterdam Hong Kong London Milan Munich New York Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Rio de Janeiro Singapore Sydney Tokyo Toronto Zurich pimco.com

PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Munich Branch (Company No. 157591), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam, Italy and Munich Branches are additionally regulated by the AFM, CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, and BaFin in accordance with Section 53b of the German Banking Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority's Handbook and are not available to individual investors, who should not rely on this communication. PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. PIMCO Asia Pte Ltd (501 Orchard Road #08-03, Wheelock Place, Singapore 238880, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. PIMCO Asia Pte Ltd services and products are available only to accredited investors, expert investors and institutional investors as defined in the Securities and Futures Act. PIMCO Asia Limited (24 th Floor, Units 2402, 2403 & 2405 Nine Queen s Road Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. PIMCO Australia Pty Ltd (Level 19, 363 George Street, Sydney, NSW 2000, Australia), AFSL 246862 and ABN 54084280508, offers services to wholesale clients as defined in the Corporations Act 2001. PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and Investment Trusts Association. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1 o andar, Rio de Janeiro RJ Brasil 22210-030. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. 2013, PIMCO. Newport Beach Headquarters 840 Newport Center Drive Newport Beach, CA 92660 +1 949.720.6000 Amsterdam Hong Kong London Milan Munich New York Rio de Janeiro Singapore Sydney Tokyo Toronto Zurich pimco.com