The Global Investment Firm Unveils a Comprehensive Resource to Help Corporate Plan Sponsors Successfully Hedge Liabilities—And Avoid “Contribution Regret”
Boston (April 12, 2018) – US pension funds risk losing their improved funding status, unless they take action to effectively and thoughtfully hedge their liabilities, according to Cambridge Associates, the global investment firm.
Despite recent market volatility, factors such as strong equity returns, rising interest rates, and large plan sponsor contributions, driven in part by tax reform, have led to a significant improvement in funded status for many corporate pension plans. This means the once-yawning gap between assets and liabilities has been reduced or, in some cases, closed over the past few months. But this improved funding status—namely, the ratio of market value of assets to the present value of liabilities—brings new challenges.
The gains—amounting to billions of dollars—could be squandered unless plan sponsors protect them with strategic adjustments to their liability-hedging portfolio, which is designed to reduce the volatility of a plan’s assets relative to its liabilities as a result of changes in the liability discount rate.
Alex Pekker, senior investment director at Cambridge Associates and co-author of the firm’s newly released guide, Liability-Hedging Handbook: A Guide to Best Practices for US Pension Plans, says, “Plan sponsors need to find a new balance between generating returns to close the asset-liability gap and protecting any incremental improvements in funded status. Until recently, closing that gap has rightly been the primary focus and now since the funded status has improved for most plans, that balance should be shifting to the liability-hedging portfolio.”
He continues, “While nearing fully funded status is a momentous milestone for many plan sponsors, they should consider revisiting their investment strategy and developing a more sophisticated and nuanced approach to liability management so that they protect the huge gains.” Specifically, this means making sure they hedge not just interest rate risk but also curve risk and credit spread risk in a way that is customized to their pension plan.
If they don’t take this action, pension funds risk having what Cambridge Associates calls “contribution regret”.
Co-author Jeff Blazek, managing director and an outsourced chief investment officer (OCIO) in Cambridge Associates’ pension practice, says, “Institutions have been making the difficult decision to contribute to their pension plans, which curtails their ability to invest directly into their business or return profits to shareholders through dividends or share repurchases. While this allows chief executives to tell shareholders that the pension funding is being addressed, market action could directly – and adversely – impact the pension fund and hit the corporate balance sheet.”
Blazek continues, “This is a complex development that plan sponsors must keep in mind in managing the plan. If ignored, plan sponsors could end up in the uncomfortable position of having to make a further contribution or take a charge in pension expense.”
Three New Risks That Should be Hedged for A Fully-Funded Plan to Protect Its Investments
In its new guide, Cambridge Associates explains that the liability-hedging portfolio should not only get higher allocations as the funded status improves—it should also be restructured in order to tackle three additional kinds of risk:
- Curve Risk: With allocations to growth assets diminishing, well-funded plans can afford to hedge not only the overall interest rate risk of the liability but also its sensitivity to the full maturity spectrum of interest rates. This is important because short-term rates (e.g., 5-year maturity) often move differently than long-term rates (e.g., 30-year maturity). It is possible to mitigate these differing curve exposures through customized portfolio construction and the use of derivatives.
- Credit Spread Risk: Liabilities are valued using Aa corporate bond yields that incorporate the difference between the yield of a Aa corporate bond and the yield of a comparable Treasury. To hedge that difference in yields, also known as the credit spread, plan sponsors invest in credit. Yet, credit is correlated to equities, meaning that the allocation to credit should increase as the size of the growth portfolio decreases and the liability-hedging portfolio increases.
Pekker says, “Even a fully funded plan has an incentive to outperform the liabilities to offset ongoing administrative costs and any future mortality improvements, and there is certainly alpha to be found in credit when a plan has access to the best and most skilled managers.”
- Operational Complexity Risk: As plan sponsors hedge curve and credit spread risks in a more granular way, they tend to use more managers and more complex instruments, such as Treasury futures and interest rate swaps. This introduces more complexity, and so plan sponsors should be aware of the additional operational and reporting burdens and ensure that any associated risks are managed appropriately.
Cambridge Associates brings over 40 years’ experience as a global pension investment manager, partnering with owners of complex asset and liability pools across the full pension investing life cycle, including enterprise review, investment policy creation, asset allocation strategy, glide path design, manager research, de-risking, and risk transfer.
For a copy of Liability-Hedging Handbook: A Guide to Best Practices for US Pension Plans or to speak with Alex Pekker, please contact Katarina Wenk-Bodenmiller at email@example.com or (212) 255-8386.
About Cambridge Associates
Cambridge Associates is a leading global investment firm. We aim to help endowments & foundations, pension plans, and private clients implement and manage custom investment portfolios that generate outperformance so they can maximize their impact on the world. Working alongside its early clients, among them leading university endowments, the firm pioneered the strategy of high-equity orientation and broad diversification, which since the 1980s has been a primary driver of performance for institutional investors. Cambridge Associates delivers a range of services, including outsourced CIO, non-discretionary portfolio management, and investment consulting.
Cambridge Associates maintains offices in Boston; Arlington, VA; Beijing; Dallas; London; Menlo Park, CA; New York; San Francisco; Singapore; Sydney; and Toronto. Cambridge Associates consists of five global investment consulting affiliates that are all under common ownership and control. For more information, please visit www.cambridgeassociates.com.
The information presented is not intended to be investment advice. Any references to specific investments are for illustrative purposes only. The information herein does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. Some of the data contained herein or on which the research is based is current public information that CA considers reliable, but CA does not represent it as accurate or complete, and it should not be relied on as such. Nothing contained in this report should be construed as the provision of tax or legal advice. Past performance is not indicative of future performance. Broad-based securities indexes are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. Any information or opinions provided in this report are as of the date of the report, and CA is under no obligation to update the information or communicate that any updates have been made. Information contained herein may have been provided by third parties, including investment firms providing information on returns and assets under management, and may not have been independently verified.