Don’t blow your second chance: Managing risk when de-risking
Today, we find ourselves at an interesting point in the cycle of corporate defined-benefit (DB) plans. Just over a year ago in March, at the depths of the COVID-19 selloff, many plans experienced significant erosions in funded status—with those that retained a heavily return-oriented asset allocation likely down 10% or more. The pain at the time for plan sponsors was real—on multiple fronts. Emotionally, there was the discomfort of rebalancing back into a terrifying equity market that might fall even further amid the looming pandemic, while financially, there was the pain of knowing massive, unexpected employer contributions would be required if markets continued to sink.
All of this, of course, had been unimaginable just a few months earlier, with equity markets churning in record high after record high amid little in the way of market volatility at the start of 2020. Fortunately, due to massive fiscal stimulus and monetary policy actions, many pension funds saw a full recovery in their funded status ratios, with the average funded ratio among the largest U.S.-listed plan sponsors actually increasing slightly, from 84.9% at the end of 2019 to 86.2% at the end of last year. The ongoing combination of soaring equity markets and rising interest rates in 2021 has further boosted funded status ratios through the first quarter of the year. In short, the market has given DB plan sponsors a second chance. But with the memory of last year’s pain still top-of-mind, many plan sponsors are realizing that they might not be so lucky the next time around—in other words, they probably won’t be afforded a third chance when the next crisis hits. Accordingly, over the past several months, we've seen a strong de-risking trend among pension plans as they look to reduce funded status volatility and potential contributions.
What can be done in advance?
Not surprisingly, we are often in discussions with clients about the optimal approach to implement a de-risking strategy. In most cases, the best results can be achieved by first de-risking using a derivative overlay to effect the broad asset allocation shift and hedge ratio.
It’s important to understand that it can often take days, if not weeks, to implement a large-scale de-risking of physical portfolios. This is why having the proper tools in place—such as an overlay program—at the outset is so vital. This helps speed up the de-risking process and minimizes potential regret and Monday-morning quarterbacking of a delayed implementation in the event of market turmoil.
Notably, clients with a plan-level overlay often implement de-risking trades within days—and even hours—of their decision. This helps ensure that the plan is not overexposed to a market selloff that could occur between decision and action. In the latest wave of de-riskings this year, markets have been relatively calm and devoid of volatility, meaning that the slow movers haven’t been penalized just yet. But we all know markets can move very quickly, and that it’s only a matter of time before the next downward plunge occurs. A plan-level overlay can dramatically lessen this risk, to the extent that we’d argue it’s a must-have for many. After all, when your main objective is de-risking, why take on massive unintended risk?
The mechanics of de-risking
Having an overlay in place is a critical first step, but importantly, it’s only the beginning. Once the plan’s asset allocation is aligned to the strategic policy portfolio, the real work begins. The progression of moving the physical portfolios from equity assets to long duration fixed income, while concurrently adjusting the overlay hedges to maintain this asset allocation, is the riskiest and most operationally challenging component of making the asset allocation shift. With this in mind, we believe a great deal of planning should be applied to this process to ensure that portfolios maintain proper beta exposure and are not exposed to unwanted leverage or cash.
The sequencing of events should be planned out and executed with precision:
- Create a transition account with your implementation provider for the event.
- This account is for segregating the assets in transition from the rest of the plan
- Ensure the account has all the needed sub-custodial arrangements for trading foreign legacy and target securities
- Make sure the custodian has all the necessary documentation and the direction letter to take instructions from the implementation manager
- This can be done well in advance of initiating the de-risking process
- Identify target destination fixed income mandates that will be funded with proceeds from equity liquidations
- All destination managers should be contracted and ready to receive assets. This should also be done well in advance.
- Identify reduced/terminated equity managers that will provide the assets to be transitioned to fixed income mandates
- Know the details of the terminations and reductions (commingled funds, open dates, pre-notifications, etc.)
- Notify managers of upcoming activity for the asset reallocation
- Terminated managers should be notified as late in the process as possible
- Instruct reduced managers to work with your implementation provider to get lists for in-kind transfer or dates for cash redemptions out of commingled funds
- Instruct target managers to coordinate with your implementation provider to deliver preliminary and final target portfolios for trading
- Monitor the transition process.
- Your implementation partner should be managing all aspects of the event and reporting progress back to the plan daily, if not more frequently
- The implementation partner should lead regular calls with custody and accounting to ensure the process is going smoothly
- Always review the project after the event is complete.
- Evaluate both the process and results.
- The performance outcome of the event should be measured with T Standard implementation shortfall, and this result should be compared to the pre-transition estimate created prior to the event1
- Qualitative assessment should also be undertaken. Was the process operationally smooth and completed in the expected timeframes? This is key, as delays create risk, and risk is the enemy of good process and good outcomes.
- The quantitative and qualitative reviews are critical for creating a standard of success, as issues can be identified and addressed with corrective process for the next de-risking event.
Ultimately, the key is recognition of what’s going to create the biggest impact on performance—and the biggest factor in performance will always be asset allocation. Transaction costs do play a factor, but transaction costs will represent a small amount of total cost compared to the opportunity costs that could be incurred if portfolio exposure is mismanaged. This implementation risk should not be viewed through weekly or even daily volatility, but rather through the lens of hourly tracking error to capture the potential risk of poor implementation. In the matrix below you can see the hourly tracking error between the asset classes is 23-57 bps. In many cases, a single hour of risk can be more costly than the collective transaction costs of the event.
|Hourly tracking error||USD Cash||U.S. Large Cap Equity (SPY)||International Equity (EFA)||Emerging Markets (EEM)||Long Treasury Bonds||Long Credit (IGLB)|
|USD Cash||0 bps|
|U.S. Large Cap Equity (SPY)||33 bps||0 bps|
|International Equity (EFA)||34 bps||26 bps||0 bps|
|Emerging Markets (EEM)||45 bps||36 bps||31 bps||0 bps|
|Long Treasury Bonds (TLT)||32 bps||48 bps||50 bps||57 bps||0 bps|
|Long Credit (IGLB)||23 bps||39 bps||43 bps||49 bps||35 bps||0 bps|
Hourly tracking errors calculated based upon 60-day historical tracking errors between S&P 500 ETF (SPY), MSCI EAFE ETF (EFA), MSCI EM ETF (EEM), US Long Treasury ETF (TLT), and US Long Credit ETF (IGLB) through 02/25/2021. Standard & Poor’s Corporation is the owner of the trademarks, service marks, and copyrights related to its indexes. For illustrative purposes only. Data is historical and not a guarantee of future results. Indexes are unmanaged and cannot be invested in directly.
Pitfalls of using money managers to de-risk
When it comes to de-risking, using multiple managers to liquidate equity and then passing the cash on to bond managers may not sound all that problematic on the surface—after all, managers are pretty good at trading, right? However, this approach introduces significant market exposure risk, along with several other impactful shortcomings. Here are some of the key reasons why we believe using managers to de-risk is a hazardous approach.
- Performance holidays and a lack of accountability
It is good governance to measure the impact of the de-risking event. Having money managers trade rarely produces a meaningful performance number, and even when attained, it is nearly impossible to build a composite of all managers involved and measure the true cost of the event. When a cash raise or funding of a manager occurs, and it is greater than approximately 20% of the portfolio value, there is the potential for significant impact to the track record of that account. For example, if a manager raises 25% of the value in cash, and the market rallies 2% over the two days before settlement, the manager incurs a negative 50 basis point headwind to performance. This gets embedded in the longer history of the account. In most cases, the manager will ask for a performance holiday. To be clear, if the manager is on a performance holiday, then the plan sponsor, as the fiduciary, is still fully accountable for any performance outcomes during this time.
- Unnecessary round trips
Fixed income managers will often look to manage funding risk by putting on duration with Treasuries. This provides the best initial hedge to the target portfolio and allows them to take a more patient approach to buying less liquid securities. However, if an overlay is already in place to hedge the initial trade, those derivatives must now be unwound, and the manager will round-trip Treasuries to get to the ultimate portfolio. While it’s true that Treasuries are very cheap to trade—at about 4 to 6 basis points round trip—every basis point counts. So why incur this cost when a superior strategy is readily available?
- The concurrent trading of physicals and derivatives in real-time does not happen by chance.
Only a purpose-built implementation infrastructure can actively manage this market exposure risk while contemporarily minimizing transaction costs. Having multiple managers all involved can make this difficult task even messier, as shown in the herding cats example (#5) below.
- Multiple long credit managers experiencing a large funding at the same time can create heated competition for attractive bonds.
Take the example of three separate managers attempting to purchase the same bond. They will likely go to the same dealers, and these dealers could interpret three different managers buying the same bond as information that these bonds are in high demand. This, in turn, could create a detrimental price impact that pushes prices higher. A single implementation manager running the purchase program will minimize this competition factor and reduce market impact.
- Herding cats
A transition manager runs the coordination of all aspects of the de-risking trade, removing the substantial operational burden from the client. Simply put, when you don’t hire a transition manager, you are the transition manager. Taking on this responsibility can be like herding cats: arranging the trade timing of the managers providing funds, transferring assets, and—if an overlay is involved—coordinating the exposures with the funded managers. This can be incredibly complex, making it increasingly difficult to maintain the desired exposures. Every minute matters when exposures are off target.
In our experience the best risk-management and most cost-effective approach to implement a de-risking event is having an expert implementation partner manage the process with full accountability for the outcome.
The upside to better risk management
In addition to tighter performance outcomes, distinct measurement and accountability, there is one more notable benefit to de-risking in the manner described: temporary downside management. The nature of a de-risking overlay hedge provides downside risk management when implemented with Treasury futures. Should a left-tail risk event happen in the days or weeks between the decision to de-risk and implementation, the additional exposure to Treasuries—in addition to the change to a new lower risk asset allocation—will likely mitigate the impacts of an equity market drawdown.
While last year’s COVID-19 crisis is still fresh in all of our minds, we’ve also seen three other major risk off events this century: the tech-bubble crash of the early 2000s, the Global Financial Crisis in 2008 and the sovereign debt crisis of 2011. The chart below shows these stress events in three portfolios, all starting with a plan that is 100% funded:
- 60% Global Equity/40% BBG Long Gov/Credit
- 50% Global Equity/50% BBG Long Gov/Credit
- 60% Global Equity / 40% BBG Long Gov/Credit, with a -10% global equity/+10% long Treasury futures overlay.
The bottom line
The powerful market rebound from the early days of the pandemic has led to a swift recovery in funded status for defined benefit plans. Plan sponsors that missed the opportunity to de-risk before last spring’s selloff have been afforded a rare second chance at a do-over in less than one year’s time—yet there’s no telling how long the window of opportunity may be open. We believe that DB plans that are in a position to de-risk should strongly consider doing so—but only in a deliberate, precisely defined manner that does not create additional unintended risk. This where an overlay and a skilled transition management team can come into play. Let us know how we can help.