swap rates could normalize if regulation paves the way for a
centrally cleared repo market, providing an alternate avenue
to obtain this type of exposure.
In choosing one of these tools, plans may want to consider
the source of funds they intend to use to extend duration.
STRIPS may be a logical first step for a plan that is going to
sell return-seeking assets to fund the duration extension—
the STRIPS may provide a meaningful pickup in duration
compared with a return-seeking asset. On the other hand,
a plan that is just looking to get a little more duration out
of a modest existing fixed income portfolio may find that
STRIPS don’t significantly boost duration at the total plan
level and that synthetic options might be the best route.
How can a completion manager
contribute to an LDI strategy?
COLE: We think a completion manager can play a valuable
role within an LDI construct. As I noted, when it comes to
constructing a liability-hedging benchmark, we think a little
bit of customization can go a long way and that targeting a
few key risks—namely the overall level of interest-rate and
credit risk—may help substantially reduce funded-ratio volatility. One key role a completion manager can play is aggregating the risk exposures of the liability-hedging benchmark
and building a complementary portfolio that could help
align the levels of interest-rate and credit risk with the plan
liability and the target hedge ratio—what you might think
of as the final piece of the LDI puzzle.
TRAINOR: Completion managers can also partner with
plans on their derisking glidepath. They can assist with
designing the glidepath, measuring the funded ratio, monitoring progression along the glidepath, and actually implementing the derisking allocation.
Are there different considerations
when designing an LDI strategy for
a cash-balance plan?
LIU: Yes, a cash-balance plan is very different from a
traditional pension plan. In fact, it behaves a bit like a
bank deposit. At the beginning of the year, you know your
account balance. Over the course of the year, the plan gives
you a guaranteed crediting rate, and your cash balance
SPECIAL ADVERTISING SECTION
grows by that amount. The crediting rate is typically
something like the yield of the 30-year Treasury bond at
the beginning of the calendar year. This means that many
cash-balance plans pay interest at a long maturity yield, but
have almost no duration—i.e., there is no natural hedging
asset to meet such requirements, as there is with a traditional plan (where long corporate and government bonds
typically play the hedging role). In addition, cash-balance
plans are usually portable when participants change jobs, so
liquidity is important.
Pursuing the desired combination of liquidity, yield, and
duration may require a combination of assets, possibly
including short-duration Treasuries, mortgage-backed
securities, broad-market investment-grade credits, and
spread sectors such as high yield and bank loans. In our
research, we have found this to be a potentially effective
means to track to a cash-balance liability. Cash-balance
provisions vary from plan to plan, however, so it’s
important to conduct a detailed assessment of the best
strategy for each particular plan.
TRAINOR: It’s also important for a plan that has a cash-balance liability to think about how it should be hedged at the
total plan level. The answer typically depends on two factors.
First, what percentage of total plan liability risk is attributable to the cash-balance plan? And second, how much
is the plan currently holding in liability-hedging assets? If
the plan also has a legacy traditional formula, hedging that
traditional plan liability should generally be prioritized over
hedging the cash-balance liability. This is because the traditional plan liability will dominate the funded-ratio volatility
due to its higher volatility. But over time, cash-balance
liabilities may grow and make up a larger proportion of the
plan’s liability risk. At the same time, plans might increase
their liability-matching allocation as they derisk. As those
two variables converge, it may become important to have a
more refined cash-balance tracking strategy along the lines
that Louis described. n
7This material and/or its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to
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subject to change without notice. Individual portfolio management
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