Manager Insight

Rolling Cash Flow Immunization: A Solution for Managing Corporate DB Plan Benefit Payments

BY THE LDI SOLUTIONS TEAM | JANUARY 2019

We believe that plan sponsors’ demonstrated acceptance and adoption of the liability-driven investing (LDI) framework shows their focus on de-risking. An LDI framework enables plan sponsors to reduce a plan’s funding ratio volatility while seeking to improve its funding ratio in a systematic way. In practical terms, it entails identifying plan assets as either return seeking assets (RSA) or liability hedging assets (LHA) and focusing primarily on risk factors: interest hedge ratio (HR) and credit hedge ratio (CHR).

For a typical pension plan, adopting an LDI framework generally leads to increasing the HR by reducing the mismatch between the duration of assets and liabilities with an increased allocation to long-duration assets. However, this can lead to cash flow misalignment, particularly in the initial years of benefit payments. 

Given this limitation, we analyzed a modified asset allocation for pension plans that incorporates a rolling cash-flow-immunization allocation. In this paper, we show that such an allocation can potentially maintain a plan’s targeted HR while reducing the cash flow mismatch in initial years.

Focusing on Increasing Hedge Ratios Alone Can Contribute to Cash Flow Misalignments

To highlight the interplay between duration mismatch and the funding ratio volatility of a pension plan, we considered three hypothetical allocations (see illustration below). Each assumed 70% of the plan’s total assets were allocated to hedging assets and 30% to equities (risk assets). We maintained each allocation’s credit risk at 60% (CHR: 60%), while varying the interest hedge ratio from 100% to 60%. By keeping the credit risk and asset allocation between risk assets and hedging assets constant, our objective was to isolate the impact of duration mismatch on funding ratio volatility.

As shown in the illustration below and in line with our expectation, Allocation A (longer duration) with the highest HR has the lowest funding ratio volatility, while Allocation C (shorter duration) with the lowest HR has the highest funding ratio volatility.

 

Interestingly, the cash flow profiles resulting from these hypothetical allocations highlight another important potential outcome. While it is desirable for plans to have lower funding ratio volatility, allocation decisions based solely on increasing HRs can lead to cash flow misalignments. As shown in the illustration below, Allocation A, with the highest HR and lowest funding ratio volatility, has a significant cash flow mismatch from zero to five years.  In contrast, Allocation C, with the lower HR and higher funding ratio volatility, has better cash flow alignment for the same period.

 

Redesigning an Asset Allocation to Bridge a Cash Flow Gap

Historically, plans have used a combination of contributions and asset sales to make up for cash shortfalls to meet benefit payments. Neither action is optimal; the former is discretionary while the latter can lead to forced selling during market drawdowns (see previous page: Potential Benefit of Reducing Cash Flow Mismatch).

We believe pension plans should consider a cash flow immunization solution designed to pay off three to five years of annual benefit payments on a rolling basis. The average quality can be a function of the plan’s risk tolerance. An all-Treasury solution would have the lowest risk with highest cost, while a 100% high yield solution would have the highest risk with lowest cost.

In the illustration below, we show the modified asset allocation for hypothetical Allocation A, which includes a 10% allocation to an immunized portfolio of high yield credits (average credit quality: B1/B2) while maintaining a similar HR and CHR to the prior allocation. The modified asset allocation shows better cash flow alignment between assets and liabilities in initial years while maintaining funding ratio volatility and maximum drawdown similar to those of the liabilities—an interesting outcome worth consideration for DB plans.

Conclusion

As DB pensions age, we are seeing more and more plans being closed or frozen with risks transferred to insurance companies. In this era, LDI frameworks need to evolve to incorporate holistic asset allocations that lower funding ratio volatility—potentially improving the funding ratio and availability of cash for pension payments.

In this paper, we have highlighted a rolling cash flow immunization solution with three key potential benefits:

1. The described allocation can provide necessary cash flows in the initial years—a solution relatively easy to integrate within a DB plan asset allocation.
2. It can maintain a plan’s target HR and CHR by reallocating existing assets without changing the risk-return profile.
3. This approach seeks to improve operational efficiency by eliminating the need to rebalance to meet cash flow needs for benefit payments.
   

Disclosure

Drawdown is defined as the drop in the net asset value of an asset class from the peak. For the purpose of this paper, we have used three discreet cutoffs of 2.5%, 5.0% and 10.0% in addition to Maximum drawdown to highlight variation in return profile subsequent to a drawdown. The prevalence of positive values suggests that buying after a drop from peak has often been a successful strategy in the last two decades. We acknowledge that a similar analysis during a different time period may not materialize with similar conclusions.

This material is for informational purposes only and should not be construed as an investment advice. Any opinions or forecasts contained herein reflect subjective judgments and assumptions of the authors and do not necessarily reflect the views of Loomis, Sayles & Company, L. P. Investment recommendations may be inconsistent with these opinions. There can be no assurance that developments will transpire as forecasted. Proposed solutions and related analysis does not represent the actual or expected future performance of any Loomis Sayles products. Accuracy of data is not guaranteed but represents our best judgment and can be derived from a variety of sources. Opinions are subject to change at any time without notice.

Solutions are hypothetical only and do not represent the performance of any actual investment product or strategy. The use of hypotheticals has inherent limitations. They are heavily dependent on the assumptions and mathematical models used in construction, which may be incomplete or inaccurate. They are created after the periods shown and therefore could be deemed to have elements of “backtested” performance derived from retroactive application of factors with the benefit of hindsight. Hypotheticals do not reflect all material economic and market factors that may have affected investment decisions if these were actual accounts. Hypotheticals do not reflect the impact of actual trading which may affect the price and availability of securities, nor do they reflect the impact of management fees, brokerage fees or commissions and other expenses.

The ability of an actual portfolio to deliver required cash flows is not guaranteed and is subject to a variety of factors including, but not limited to, the availability of bonds, transaction costs, default risk, rebalancing risk, liquidity risk and management risk.

The analysis reflected in this presentation is limited to certain recent periods for which data is available. We make no representation that the experience of any other periods is comparable. It is not possible to invest directly in an index.

Key Risks

Credit Risk, Issuer Risk, Interest Rate Risk, Liquidity Risk, Non-US Securities Risk, Currency Risk, Prepayment Risk and Extension Risk. Investing involves risk including possible loss of principal.

Past experience is not a guarantee of future performance.

Definitions

Bloomberg Barclays US Intermediate Corporate: Unmanaged index that includes dollar-denominated debt from US and non-US industrial, utility, and financial institutions issuers with a duration less than 10 years.
Bloomberg Barclays Long US Corporate Index: Unmanaged index that includes dollar-denominated debt from US and non-US industrial, utility, and financial institutions issuers with a duration of 10+ years.
Bloomberg Barclays US Corporate Investment Grade Index: Unmanaged index composed of publicly issued US corporate and specified foreign debentures and secured notes.
Bloomberg Barclays US Corporate High Yield Index: Unmanaged index that includes fixed rate, non-investment grade debt.
Bloomberg Barclays US Intermediate Treasury: Unmanaged index includes all publicly issued, US Treasury securities that have a remaining maturity of greater than or equal to one year and less than 10 years, are rated investment grade, and have $250 million or more of outstanding face value.
Bloomberg Barclays US Long Treasury: Unmanaged index that includes all publicly issued US Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value.
Bloomberg Barclays Treasury STRIPS 25+ Index: Unmanaged index of zero-coupon bonds (coupons separated from the bond or note).
S&P 500: A market capitalization weighted index consisting of 500 US industrial, transportation, financial, and utility companies, calculated on a total return basis with dividends reinvested.
MSCI EM Index: Represents the performance of large- and mid-cap securities in 24 emerging markets. As of September 2018 it had more than 1100 constituents.

 

MALR024488

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