Approaches to Liability-Relative Asset Allocation: Hedging/Return-Seeking Portfolio Approach

As of 31 December 2015, WestRock, a global paper and packaging supply company, had a funding ratio of 105.9%. Basically, the company had a small surplus and could enjoy reduced future contributions if it could keep that surplus going while maintaining a certain rate of return. Suppose that the active lives portion of the pension fund's growth rate was similar to the average yield on the US Treasury yield curve. How would you position the majority of WestRock's pension fund?

Yes! You'd really want to invest the majority of the portfolio in the yield curve that matches the rate of growth in active lives. Plus, you can hedge that portfolio and basically ensure that WestRock won't have to make substantial future contributions. So it serves to achieve the client's goals. That's the focus of the liability-relative approach called hedging/return-seeking portfolio. As the name indicates, the asset allocation is broken down into two parts. The first part consists of developing an asset allocation strategy to hedge part of the portfolio, usually 100% of the liability. This is achieved through the use of cash flow matching, duration matching, or immunization.

Not quite. That's not going to meet the utility needs or client's expectations.

No, actually. That could grow the surplus or lose the surplus due to additional risk. That's not the client's goal.

Then, a second return-seeking asset allocation is developed for the surplus and managed independently. This return-seeking allocation can be done through mean–variance optimization or another asset allocation method. So for clients who desire a predictable cash flow path, the hedging/return-seeking portfolio is a natural option. What's another way to describe this type of client?

Nice try, but no. Moderate investors would want some additional risk exposure, not 100% hedging to the liability.

Not so. Aggressive investors want the full asset balance to maximize utility.

Exactly. A hedged portfolio really works best for a conservative investor because it isn't a risk-seeking portfolio, more of an insurance plan to avoid larger future contributions. So this strategy works best for insurance companies or those that have a surplus balance. But while this approach is best for conservative investors, it doesn't mean that a 100% hedge is the only way to implement this approach.

For example, a company may desire the ability to generate higher expected returns through a larger allocation to the risk-seeking portfolio, so the hedge percentage can vary. Or, the allocation to the hedging portfolio can increase as the funding ratio increases, so as more returns are generated, more assets flow into the safe portfolio. That strategy is known as the liability glide path. So when it comes down to it, there are multiple ways to hedge the portfolio but really one way to start the process. It begins with an identification of the correlation between the hedging assets and the actual liability. What should the correlation between the asset and the liability be?

No. Assets and liabilities can't move independently.

Definitely yes! You'd want those assets and liability to move in sync, so the correlation needs to be close to 1. That's the guiding principle when building a hedging portfolio.

That wouldn't be good. If the correlation is negative, the liability could increase, and the assets could decrease at the same time.

But while this may seem straightforward, building a hedging portfolio can be difficult due to various factors. Take the discount rate assumption as an example. It can be based off a government bond or common interest rate, but the liability could be influenced by economic growth. So the rates between the asset measurement tool and the liability are different. In this situation, what type of asset would help you develop a hedged portfolio?

That's right! You'd use inflation-indexed bonds so that the inflationary forces that are increasing the liability are also present in the asset portfolio. Other tools to help you manage the differences between the discount rate and liability growth factors include real assets and interest rate swaps. It's also important to note the natural driving factors behind the liabilities increase. For example, if a company has a growing number of young active lives, the liability will naturally be increasing. But suppose that the company's trustees determine that the discount rate is too low and decide to increase the discount rate. Naturally, this will alter the present value calculation. All else equal, what will happen to that company's liability if the discount rate increases?

No. Equities wouldn't be the best choice for this portfolio. That would increase risk.

No. That's not going to help you address inflationary concerns.

No. The discount rate is located in the denominator of the present value calculation.

Excellent! An increased discount rate means that the liability will be decreased, so it's important to know what the discount rate is and also how it compares to other companies. That's because higher discount rates will naturally lower contributions, so companies can hide a larger liability problem through the discount rate. So the more conservative approach is to use a lower discount rate and ensure that the contribution policy matches up with all applicable regulations.

That's not it. The discount rate definitely impacts the present value calculation.

But while these regulations may dictate the necessary contribution, regulatory bodies don't get into the business of specific asset allocation strategies. That's probably a good thing because not all institutional clients can effectively hedge their portfolios. Why would institutional clients not be able to hedge their portfolios?

No, actually. A declining surplus still indicates that the portfolio can be hedged.

That's not it. That could indicate a growing active working population.

Exactly! If there's no surplus, then the portfolio can't be hedged because that would mean that assets would be locked in below the value of the liability. So the hedging/return-seeking portfolio can't be used with a net liability unless the company makes a contribution to bring the pension up to fully funded status. There are also times when the hedging portfolio just can't be completed. This occurs when the risks to the portfolio can't be completely eliminated, like natural disasters. So there are times when this approach isn't applicable.

To sum it up: [[summary]]

Invested in a hedged portfolio of bonds

Invested in a hedged portfolio of equities

Invested in an asset mix that maximizes expected return per unit of risk

Moderate

Aggressive

Conservative

Close to 0

Close to 1

Close to -1

Equities

Nominal bonds

Inflation-indexed bonds

It increases

It decreases

There's no impact

There's no surplus

There's a declining surplus

There are growing future contributions

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