Most pension plans follow a carefully crafted strategic asset allocation (SAA), which is found to be the single largest contributor to pension fund returns. Periodically, exposures are reviewed and physical allocations are adjusted to help offset these deviations. However, instead of rebalancing the portfolio using physical securities (stocks, bonds, etc.), which can be costly and require more administrative work, an overlay program can normally achieve the desired result, often at a fraction of the cost, by minimizing the unintended exposures using derivatives. While the overlay program seeks to offset deviations to a pension plan’s SAA, the actual process is two-fold. Each month-end, the overlay seeks to match the SAA; however, on an intra-month basis, it determines the interim target weights through an adjustment process called incrementing.
In this paper, we seek to explain the reason for incrementing the SAA and the process behind it.