June 30, 2015
The last two months of the Third Quarter brought with it volatility that whipsawed pension asset versus liability returns, relative to just a quarter ago. As of June 30, 2015, the model asset allocation provided YTD returns over RL PPA liabilities of +5.43%. The Second Quarter finished with assets outperforming liabilities by 8.60%. The Third Quarter saw the model asset allocation underperform RL PPA liabilities by –7.05%, resulting in a YTD change of –6.93% from the quarter before, from +5.43% down to –1.50% in YTD asset vs. liability returns.
The past three months have seen funding ratios decline from 86% as of June 30, 2015 down to 80% as of September 30, 2015. With a potential debt ceiling showdown, continued equity volatility to start the Fourth Quarter, 30-year Treasury rates falling 21 bps in the last two weeks of September, the Fourth Quarter could potentially be filled with an unfavorable market environment for pension plans.
As playoff baseball makes its way through October, teams will find themselves adapting to a given situation. When losing, a team may shift its lineup to a more aggressive one. When winning, a manager may put in defensive specialists to preserve a lead while reducing the probability of increasing their lead. Similarly for pension plans, asset allocation may ebb and flow between risk management strategies and return oriented strategies.
For those plans that have already done any combination of implementing LDI strategies, making excess contributions, restructuring their plan design, and/or moved along their glide path, duration risk in a lower yield/ potentially rising interest rate environment is less of a concern. But what about those plans that want to reduce funding volatility but aren’t ready to extend duration with their physical bond portfolio, or those plans that want to have a more aggressive allocation (and have balance sheets to support that)? Overlay strategies can assist in reducing asset/liability volatility, yet still maintaining a return oriented asset allocation.
Implementing an overlay strategy allows for plan sponsors to use their fixed income portfolio as collateral to gain increased duration exposure, without extending the length of the physical bond portfolio. This provides risk management characteristics while being able to utilize a higher amount of assets to return seeking strategies. The flexibility of these strategies allow for variations in leverage that use either less bonds to match the liability duration with more leverage, or more bonds with less leverage to gain the desired dollar duration. The risks of an overlay strategy (collateral, counterparty, basis, liquidity risk, etc.) will need to be reviewed, but for some plan sponsors, the benefits may outweigh these risks in achieving their goals.