The final quarter of 2016 played out in a way that was indeed full of surprises. Donald Trump won the election, the Cubs did indeed win the World Series, and a rally ensued that saw equities finish the year with double digit positive returns while bond spreads widened. Assets resultantly outperformed liabilities for the quarter by a significant margin.
For the 12 months ending 12/31/16, the Ryan Labs Asset Allocation Model returned 8.14%. For the quarter ending 12/31/16, the asset allocation model returned +1.37%. However, RL PPA liabilities returned a –7.31% for the quarter, resulting in outperformance of +8.69%. For the year, however, liabilities returned +9.49%, with assets underperforming liabilities by –1.35%. This resulted in year over year funding ratios to decline from 83% to 82%. However, the quarter over quarter difference in funding ratios from September 30, 2016 through December 31, 2016 saw an increase in funding of +7%. Short term volatility can impact pension plans in different ways.
Volatility is a two-tailed coin. On one side, we have the right tail, which is what we’ve seen over the past quarter. Strong equity returns and yields rising provide for a potential glide path trigger event. But as quickly as a triggering event occurs, it could disappear before action is taken. Similarly, short term left tail events can significantly impact a pension plan’s ability to achieve their return objects and can cross a PPA threshold that will may result in higher premiums. How can a plan sponsor help reduce the impacts of short term left tail risk while capturing the opportunity that exists in short term right tail events?
Perhaps the most effective way of capturing right tail events is to take a page out the aforementioned World Series champion Chicago Cubs book. Play small ball. Rather than setting glide path triggers at levels that rarely occur, e.g., every 10% increase in funding ratios, set triggers at smaller triggers. Perhaps every 2% or 3% increase in funding should result in an increase of fixed income. This approach provides for a more active and dynamic method of capturing excess returns in the equity portfolio and porting them back to the liability side.
Similarly, taking a dynamic approach towards tail risk hedging can assist in reducing the probability that short term market dislocations significantly impacting the health and sustainability of a pension plan. Combining a long duration fixed income strategy and a dynamic tail hedge may help reduce surplus volatility tails. As we navigate through 2017, market uncertainty is prevalent. Regardless of whether markets continue to rally or if there is a drawdown, taking a dynamic approach towards capturing/hedging tail risk may benefit your plan.