Is a risk-hedging overlay strategy right for your pension plan?

But that approach leaves some plans in a quandary, because it means fewer assets are available to take compensated market risks via equities and other return-seeking investments. Brett Dutton, head of pension strategy in Vanguard Institutional Advisory Services® (VIAS), points to risk-hedging overlay strategies as a potential solution.

"By facilitating independent control over the key drivers of funding status volatility—interest rate risk and market risk—an overlay strategy can improve liability-hedging outcomes while adding flexibility to the asset allocation process," says Mr. Dutton.

For the many plans that don't use overlay strategies, interest rate risk and market risk are inextricably linked. Both risks can be mitigated by increasing liability-hedging assets and reducing return-seeking investments. But this can be an unattractive trade-off for plans that rely on higher returns to close a funding gap or reduce future contribution requirements, or simply wish to maintain a higher allocation to risk assets.

To understand the potential benefits of risk-hedging overlay strategy, imagine a plan with a liability value of $100 million that's 80% funded. The plan's current portfolio holds 50% return-seeking assets and 50% liability-hedging assets. The portfolio doesn't use a risk-hedging overlay. The plan sponsor would like to reduce the plan's funding status volatility, so they consider reallocating to "Portfolio A," a more conservative 40%/60% that also has no risk-hedging overlay.

Since Portfolio A allocates more to liability-hedging assets than the current portfolio does, it exhibits a lower expected funding status risk and a greater ability to hedge interest rate risk, as indicated by a higher (although still not optimal) interest rate hedge ratio.² The downside: Portfolio A has less exposure to return-seeking assets, and therefore a lower expected average annualized 10-year return (4.7% versus 5.3% for the current portfolio, as shown in the graphic and table below).

Faced with that unappealing trade-off, the plan sponsor considers adopting a risk-hedging overlay strategy. The graphic and table compare the two portfolios with no overlay to two portfolios that use a risk-hedging overlay consisting of Treasury futures (Portfolios "B" and "C").³ Portfolio B holds 50% return-seeking assets and 50% liability-hedging assets. Portfolio C has a more growth-oriented 63%/37% mix. Both overlay portfolios target an interest rate hedge ratio of 80%—a much higher ratio than the portfolios with no overlay.⁴

The results: Portfolio B achieves the plan's target interest rate hedge ratio with less funding status risk and a similar expected return to the current portfolio; Portfolio C hits the target ratio with about the same funding status risk as the current portfolio, but with higher expected returns.

"Adding a Treasury futures overlay can produce a better trade-off between risk and return," says Mr. Dutton. "That's because it gives a plan sponsor the ability to improve interest rate hedging and reduce the plan's funding status volatility, while maintaining or even expanding the allocation to return-seeking assets."

Note that in the typical asset allocation process, in which a portfolio diversifies its physical assets between return-seeking and liability-hedging, the interest rate hedge ratio is effectively an output of the asset allocation decision. Without a futures overlay, the hedge ratio is dependent on the amount of assets that are available to hedge the liability. With a futures overlay, a plan can more easily set an explicit hedge ratio target as part of the asset allocation process.

To minimize the impact of interest rate risk and avoid an unintentional bet on the direction of interest rates, Mr. Dutton suggests plan sponsors consider setting the target hedge ratio between the plan's funding ratio and 100%. "So if the plan is 80% funded, the ideal hedge ratio could be 80% or higher."

Like all derivatives, Treasury futures use leverage, so a loss could exceed the amount invested if rates increase sharply beyond what the forward curve predicts. However, Mr. Dutton encourages plan sponsors to view the use of leverage in risk-hedging overlay strategies through an asset-liability lens.

Most pension liabilities contain a large implied short position on the Treasury market, since liabilities will decline if interest rates rise sharply. By not hedging this risk, plan sponsors implicitly elect to hold a leveraged interest rate position in the plan's surplus or deficit.

"If an allocation to Treasury futures loses value, the plan's liability value is likely also decreasing. Although the use of leverage increases potential volatility in the investment portfolio, it actually reduces or neutralizes the leveraged interest risk on the liability side," says Mr. Dutton.

Plan sponsors exploring a Treasury futures overlay strategy should also consider:

Complexity. Derivatives can add operational complexity to a plan, so consider working with an experienced outsourced chief investment officer (OCIO), consultant, or derivatives manager to shift some of that complexity.

Liquidity. Treasury futures have maintained liquidity through times of crisis, including the 2008–2009 global financial crisis and the COVID-19-related volatility of 2020. That's no guarantee of future liquidity, but it's unlikely that liquidity issues would affect a derivatives overlay program in an LDI portfolio.

Counterparty risk. Treasury futures are exchange-traded, so gains and losses are cleared daily through a central clearinghouse rather than a separate specific counterparty. This daily settlement process mitigates counterparty risk.

Margin calls. Treasury futures require initial margin, which is paid up front, and variation margin, which is cash reserved to settle potential losses. Establishing a conservative variation margin amount and monitoring the portfolio frequently can help ensure that a plan sponsor maintains sufficient liquidity for margin calls.

Vanguard has over a decade of experience building tailored LDI portfolios for pension clients. Our team of 30 dedicated pension experts is backed by the vast scale and resources of Vanguard. Our pension services include investment policy consulting, asset allocation and risk modeling, rebalancing, and comprehensive performance reporting.

We provide overlay strategies through our pension OCIO advisory services in partnership with Parametric Portfolio Associates LLC, a leader in custom solutions for institutions, advisors, and consultants. With more than 30 years of experience, Parametric manages over $300 billion in assets across an array of products and strategies including factors, equities, liquid alternatives, fixed income, and overlays (Source: Parametric, as of January 12, 2021).

"We combine our pension and portfolio construction expertise with the capabilities of an overlay specialist," says Mr. Dutton. "Parametric's investment philosophy aligns with ours. Like us, they emphasize transparency, efficiency, and attention to cost and risk. They also customize each portfolio to reflect the client's unique objectives and constraints."

Vanguard has a rich history of partnering with premier investment managers and service providers. We partner externally when it enables us to meet our clients' needs more effectively than if we were to build the capability in-house.

Overlay strategies are a powerful addition to the LDI toolkit. They offer plans an opportunity to improve liability hedging, mitigate funding status risk, and broaden options for asset allocation.

Overlays tend to work best for plans that have a long liability duration, are underfunded, or have significant capital deployed to return-seeking investments. Still, every plan is unique, and determining suitability requires a detailed understanding of your plan and its goals.

"Vanguard's OCIO service can help plan sponsors decide whether an overlay program is a good fit for them," says Mr. Dutton. "Our aim is to find the simplest possible solution that's effective. For some plans, that means no overlay strategy is needed. For others, an overlay is clearly the optimal approach for aligning the portfolio with the sponsor's objectives."

To learn more about the potential benefits of risk-hedging overlay strategies, read our research. For more on how Vanguard can help your plan reach its goals, visit our  pension plan solutions page.

Notes:

• All investing is subject to risk, including the possible loss of the money you invest.  There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss. The information contained herein may not be relied on in any manner as investment advice or as an offer to sell or a solicitation of any investment product or service sponsored by Parametric Portfolio Associates LLC.
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