Liquidity Management and Arbitrage: an Opportunity for Defined Benefit Plans

FEATURED SOLUTION May 2016 Liquidity Management and Arbitrage: An Opportunity for Defined Benefit Plans

AUTHOR A number of plan sponsors have explored pension risk transfer strategies over the last few years. Among these, lump sum programs aimed at terminated vested participants (or retirees to a lesser extent) have been the most popular. The main catalyst has been the ability to

Rene Martel transfer the liability and its associated risk at a lower cost Executive Vice President than the plan sponsor would have to recognize had it kept it on its balance sheet.

The arbitrage opportunity resulted primarily from the use of an outdated mortality assumption as well as lagged discount rates used to calculate participants’ lump sums. Yet a number of factors may significantly reduce the ability of plan sponsors to take advantage of this arbitrage opportunity in the future:

1) Lump sum calculation rules may soon start to reflect updated mortality assumptions;

2) A large portion of the liability suitable for lump sums has already been paid out over the last few years;

3) The advantage arising from the use of lagged discount rates would vanish if interest rates rise.

Nonetheless, investment markets now offer a similar opportunity for plan sponsors to defease a portion of their near-term liabilities. Indeed, given prevailing spread and yield levels in credit markets, investors can build cash flow matching portfolios for near-term liabilities that considerably outyield the discount rate applied to these upcoming benefit payouts. As a result, plan sponsors can immunize their short-term benefit payments at a lower cost than their accounting or economic value. 2 May 2016 Featured Solution

SHORT-TERM LIABILITIES: Consider a plan seeking to As shown in Figure 1, the cash A DIFFERENT KIND OF RISK “quasi-immunize” the liability cash flow matching portfolio would Historically, most LDI strategies flows projected to be paid over a dramatically outyield the have focused on matching the plan three-year period from mid-2017 discount rate on those near-term liability duration and other risk to mid-2020. Figure 1 shows a liability benefit payments factors. Implicitly, this means LDI potential structure for the cash (4.4% versus 1.6%). This would portfolios are more heavily tilted flow matching portfolio, while ultimately enable the plan sponsor toward matching longer-dated cash Figure 2 shows how its expected to “quasi-defease” $500 million flows – and for good reason, given coupon and maturing principal worth of liabilities with a $448 that these carry considerably more income would compare with the million investment, representing a risk than those projected to be paid liability benefit payments. 10% discount. in the short term.

However, the liquidity risk associated with the payment of Figure 1: Defeasing short-term liabilities at a discount near-term cash flows should not be ignored. These benefit payments are Near-term cash flow matching portfolio structure typically met by maintaining a small Index Weight Yield cash allocation within the plan and/or liquidating assets perceived US Credit BBB 1.5-3 Yr Index 45% 2.3% as more liquid (equities or bonds, US Credit BBB 3-5 Yr Index 15% 2.8% for example). In this case, though, the plan sponsor faces either the US High Yield BB/B 1.5-5 Yr Index 40% 7.3% risk of having to raise liquidity at an Blended benchmark 100% 4.4% inopportune time (e.g., after equity or bond market declines) or must accept minimal compensation on Market value / Present value Yield its cash allocation. Liability present value $500 million 1.6% (Citi AA as of 3/31/2016) IS THERE A BETTER WAY? Cash flow matching portfolio $448.5 million 4.4% Plan sponsors have a better Net benefit for the plan $51.5 million 2.8% alternative: They should consider cash flow matching the first few Source: Barclays and Bloomberg as of 31 March 2016 Sample for illustrative purposes only. years of upcoming benefit Sample liability stream is based on a representative account and is provided for illustrative payments, thus significantly purposes only. The liability stream has been modified for the purposes of this illustration. The present value of the liability was calculated by discounting projected liability cash flows with the reducing (or nearly eliminating) Citi Pension discount curve as of 31 March 2016. Figure is provided for illustrative purposes and the liquidity risk associated with is not indicative of the past or future performance of any PIMCO product. those cash flows. May 2016 Featured Solution 3

In addition, the immunization Figure 2: Cash flow match versus liabilities strategy should significantly reduce the operational burden of raising $ in millions and managing liquidity to cover those benefit payments. $300 $250 Figure 2 shows the portfolio cash $181 $200 $176 $170 (+) flows extending slightly longer than $157 $160 the liability benefit payments. This $150 $93 is intentional and recognizes that $100 $77 high yield bonds (which make up $33 $50 $25 40% of the cash flow matching portfolio) often get called before $0 maturity; some portfolio cash flows 4/2016 – 7/2017 – 7/2018 – 7/2019 – 7/2020 – Post 6/2017 6/2018 6/2019 6/2020 2/2021 2/2021 would therefore be received earlier, Liability US High Yield BB/B 1.5-5Yr Index filling some gaps between the US Credit BBB 1.5-3 Yr Index US Credit BBB 3-5 Yr Index orange and blue bars in prior years.

Given its meaningful exposure to Total cash flows high yield securities, the defeasance $ in millions strategy must factor in potential defaults and implementation costs. $800

Portfolios such as these have $546 $600 $527 experienced annual default-related losses of less than 0.4% since 2000, $400 according to our analysis of Moody’s data; transaction costs $200 under current market conditions would amount to roughly 0.25%. $0 Liability Crossover portfolio Therefore, the yield buffer (the 2.8% Source: Barclays and Bloomberg as of 31 March 2016 excess yield of the portfolio over the Sample for illustrative purposes only. Sample liability stream is based on a representative account and is provided for illustrative liability discount rate) provides a purposes only. The liability stream has been modified for the purposes of this illustration. meaningful margin of safety See Figure 1 for benchmark weightings detail. Figure is provided for illustrative purposes and is not indicative of the past or future performance of any PIMCO product. compared to the anticipated combined impact of defaults and come to pay more attention to short-term liabilities. In the current transaction costs (of 0.65%). That market, investors have a unique opportunity. They can: said, investing in lower-quality securities requires careful risk 1) Defease near-term liabilities at a significant discount relative management and therefore skill in to their accounting or economic valuation; credit selection is essential. 2) Reduce considerably the liquidity and market timing DON’T COME UP SHORT risk associated with meeting near-term benefit payments;

As plan sponsors face increasing 3) Lessen the operational burden and resource commitment associated liquidity challenges in several with raising and managing liquidity to cover benefit payments. markets, we believe the time has Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose Newport Beach Headquarters value. Investors should consult their investment professional prior to making an investment decision. 650 Newport Center Drive This material contains a hypothetical simulation. No representation is being made that any account, product, or strategy will or is Newport Beach, CA 92660 likely to achieve profits, losses, or results similar to those shown. Hypothetical and forecasted performance results have several +1 949.720.6000 inherent limitations. Unlike an actual performance record, these results do not do not reflect actual trading, liquidity constraints, fees, and/or other costs. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated or forecasted results and all of which can adversely affect actual results. In addition, references to future results should not be construed as an estimate or promise of results Amsterdam that a client portfolio may achieve. Barclays U.S. Credit Index is an unmanaged index comprised of publicly issued U.S. corporate and specified non-U.S. debentures Hong Kong and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. The Barclays High Yield Index is an unmanaged market-weighted index including only SEC registered and 144(a) securities with fixed London (non-variable) coupons. All bonds must have an outstanding principal of $100 million or greater, a remaining maturity of at least one year, a rating of below investment grade and a U.S. Dollar denomination. It is not possible to invest directly in an unmanaged index. Milan This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice Munich or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in New York any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2016, PIMCO. Rio de Janeiro

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