Special Report

March 2011

Capital Efficiency Matters

by Matthew Nili, BlackRock Multi-Asset Client Solutions

Dual-beta strategies can help solve the lower risk, high return challenge faced by many defined benefit plan sponsors

Introduction
Many pension plan sponsors struggle with conflicting objectives. These sponsors wish to invest in return-seeking assets (e.g. equities) to improve their plans funded position. They also wish to invest in liability-matching assets (e.g. long duration fixed income) to reduce surplus risk. A finite capital pool, often exacerbated by a low funded position, makes it challenging to achieve these dual objectives. Synthetic instruments, however, provide an opportunity to gain capital efficiency, allowing plan sponsors to alleviate the conflict and achieve both of the desired exposures. In this paper we discuss plan objectives and the importance of considering exposures and capital separately. In addition, we illustrate how a dual-beta strategy provides the necessary capital efficiency to help achieve these objectives and discuss certain investment considerations for practical implementation.

Often, unhedged discount rate risk associated with the liabilities market value is a major source of this surplus volatility. The unhedged risk can lead to low correlations of returns between assets and liabilities. This was the case for the representative pension plan shown in Figure 1, where assets and liabilities had a correlation of only 34% over the period shown.2 Figure 2 illustrates net surplus exposures for a typical pension plan. The net exposure to long corporate yields (liability exposure less long fixed income assets) is pronounced. The overall investment portfolio can be summarized as a combination of long equities and a substantial short position to long bonds.
Pension plan funded ratios have rebounded from the depths of the financial crisis, yet most plans remain considerably underfunded.

Figure 2: Typical pension plan asset & liability exposures for a plan that is 82% funded
Bonds - aggregate

The issue: unmet dual objectives

Pension plan funded ratios have rebounded from the depths of the financial crisis, yet most plans remain considerably underfunded. Regulatory, reporting, investors, and market pressures have left plan sponsors in a difficult situation. Many sponsors would like to maintain return-seeking assets that they expect should provide incremental return over their plans liabilities. They also strive to manage high surplus volatilitythey are all too aware that plan funded ratios fluctuated dramatically over the past decade.1

Bonds long duration Real estate & alternatives Public equity Private equity

Liability

Figure 1: Estimated funding ratio changes for a US corporate pension plan

150% 140% Funded ratio (A/L) 130% 120% 110% 100% 90% 80% 70% 60% Dec 1996 Dec 1998 Dec 2000 Dec 2002 Dec 2004 Dec 2006 Dec 2008 Dec 2010 -60% -90% -120% 60% 30% 42.5%

122%

Corresponding net surplus exposures: Typical net surplus exposures (illustrative)

7.5% 0% -30%

10%

20%

-102% Public equity Private equity Bonds aggregate Long rates

-112% Credit spreads

Source: BlackRock, Estimated Funding Ratio Changes for a US Corporate Pension Plan 2 Using monthly estimates for sample plan asset and liability returns

Real estate alternatives Source: Pension & Investments, BlackRock

For use with Institutional and Professional Investors Only - Proprietary and Confidential The opinions expressed are as of 24 March 2011 and may change as subsequent conditions vary.

Root causes for the asset-liability mismatch?

In shortrunning the risk of over simplificationpension plan funding and accounting standards of the past essentially encouraged pension plans to consider themselves as asset-only investors. As a result, the natural and somewhat justifiable response from plan sponsors was to build what they considered well diversified total return portfolios, (i.e. the classic 60/40 stock/bond portfolios). While investment theory has evolved, with a growing realization that capital efficiency and alternative assets contribute to diversification of growth portfolios (often referred to as optimal beta or similar), the traditional asset-only approach was both easy to adopt and used broadly by plan sponsors. Overtime, however, there have been changes to the accounting and pension funding rules governing corporate pension plans. Investors are now focusing much more on the risks and consequences to plan sponsors of changes in pension plan surpluses. The result is that investment risks and risk budgets need to be reappraised. This process will naturally take some time as it requires unlearning past practices and adopting new ones. One of such practices is using leverage to help manage asset-liability portfolios effectively. Leverage is a very useful tool for many plans and can be vital for certain plans.

The low interest rate and credit spread hedge ratio implies that there is likely to be a negligible sympathetic asset return when a plans liability value changes due to market forces. This dynamic represents a key contributor to surplus risk.

Building more efficient asset-liability portfoliosGaining investment efficiency through capital efficiency
Investment efficiency (i.e. expected return per unit of surplus risk) can be achieved by improving the liability matching characteristics of the assets. There are many ways in which this can potentially be done, all of which seek to extract more out of the same finite pool of assets. We would like to focus on two straightforward portfolio choices that can increase capital efficiency and reduce surplus volatility. These are: i) an interest rate duration extension using a treasury futures overlay (or using a similar substitute), and ii) a hybrid equity and bond investment, which we refer to as dual-beta.

i) Extending interest rate duration

Our model pension plan could implement an interest rate duration extension via a Treasury futures (or interest rate swap) overlay. This strategy better matches asset and liability exposure to interest rates as shown on the x-axis of Figure 4. As an example, we will assume the interest rate hedge ratio is increased to 70% via a sufficient quantity of Treasury futures. Figure : Interest rate and credit spread hedge ratios
100% Credit spread hedge ratio 80% 60% 40% 20% 0% Client liability

Hedging the liability discount rate

We have established that a significant source of risk, in many cases, can be attributed to very low levels of liability discount rate hedging seen in plans. In the United States, corporate bonds tend to drive liability discount rates. This means that there are two components of the liability discount rate to hedge: i) long Treasury interest rates and ii) long credit spreads3. Figure 3 shows the liability hedge ratios for our typical pension plan, as depicted in Figure 2.4 Figure 3: Interest rate and credit spread hedge ratios
100% Credit spread hedge ratio 80% 60% 40% 20% 0% Client liability

Current portfolio

Current portfolio + Treasury futures overlay

0%

20%

40%

60%

80%

100%

Interest rate hedge ratio Source: BlackRock Current portfolio 0% 20% 40% 60% 80% 100%

Interest rate hedge ratio

Source: BlackRock

In this suggested strategy, the credit spread hedge is not increased because Treasury-based instruments are used to gain additional duration. This overlay, which represents more capital efficient interest rate exposure, is therefore a major improvement in managing asset-liability risk. However, more can be done to enhance capital efficiency.

We note that the interest rates of importance here are not short term rates, but instead long term rates, particularly 10 year and over rates. This is because of the very long term nature of pension plan liabilities. This comment also applies to credit spreads. Any reference to credit spreads implicitly refers to high quality corporate credit spreads of terms equal to the liabilities 4 Assumes no credit spread duration from investments other than fixed income spread assets. In reality this is a simplification as there is a reasonable link between equities and credit spreads

ii) Using the dual-beta approach

For a more complete hedge of the liability, greater credit exposure is required to cover both interest rate and credit spread movements (move further north and east in our hedge ratio illustration, Figure 4). Purchasing physical credit securities is the natural choice to accomplish this, but requires additional capital to be secured from elsewhere in the portfolio.5 A dual-beta approach seeks the additional capital for bond investing from equities within the plans asset allocation. Equity exposure can be readily attained synthetically, with little give up versus passive physical equities. As such, equity securities provide an effective alternative for capital release to fund harderto-replicate credit exposure.

Figure 6: Interest rate and credit spread hedge ratios

100% Credit spread hedge ratio 80% 60% 40% 20% 0% Current portfolio Current portfolio + Dual Beta Client liability

Current portfolio + Treasury futures overlay 40% 60% 80% 100%

0%

20%

Interest rate hedge ratio Source: BlackRock

Understanding the dual-beta structure

To illustrate how this works, consider an initial $100 capital allocation to a passive equity strategy. Under the dual-beta approach, the $100 could instead be redeployed with $50 invested in physical long credit securities and the remaining $50 used as collateral to fund $100 equity and $50 Treasury futures. The structure of the portfolio exposures is outlined below. The end result is exposures to $100 in passive equity and $100 in a combination of long treasury and long credit bonds. Figure 5: Outline of dual-beta structure
Existing capital Dual beta capital

Figure 6 shows the hedge ratios for the example plan if the plan implemented this dual-beta strategy to achieve the same overall duration as the previously examined simple Treasury futures strategy.
The dual-beta allocation provides the desired capital efficiency that improves the pension plans exposures to liability hedging assets, without reducing exposure to return-seeking assets

The dual-beta allocation provides the desired capital efficiency that improves the pension plans exposures to liability hedging assets, without reducing exposure to return-seeking assets (equities). It also scores an improvement over the interest rate overlay strategy in that it achieves exposure to long physical credit which offers favorable liability matching characteristics.

Dual beta exposures

Benefits of dual-beta strategies

To illustrate the benefits of capital efficiency contained in this dual-beta approach more broadly, Figure 7 shows two example efficient frontiers. The Long FI/Equity frontier (in blue) simply allocates between physical long duration fixed income and equities while the other frontier (in orange) adds a dual-beta fund into the eligible investment universe.

$100 of equity futures

$50 cash $100 of equities $50 cash

$50 of long treasury futures

Figure 7: Efficient frontiers: with and without dual beta

7.4% Expected return on assets $50 of long credit bonds 7.0% 6.6% 6.2% 5.8% 5.4% 5.0% 4.6% 8% 10% 12% 14% 16% 18% 20% 40% Long FI/ 60% Equity 40% Core FI/ 60% Equity 40% Long FI/ 30% Equity/ 30% Dual beta

$100 equity exposure

Source: BlackRock

$100 long gov/ credit exposure

Figure 5 provides a graphic representation of the example above, consisting of a $100 capital pool
5 6

Surplus volatility (% of assets) Source: BlackRock Long FI / Equity Long FI / Equity + dual beta

An alternative is to get credit spread exposure synthetically via credit default swaps (CDS), but a basis exists whereby these spreads can be significantly lower than physical bond spreads which are used to inform many liability discount curves. CDS portfolios also tend to be less diversified than physical credit portfolios Assumes 82% funded status and Liability duration of 13.5 years. Volatility and correlations based on historical returns for representative indices. Expected returns are based on BlackRock long-term forecasts

As shown, the addition of the capital efficient dual-beta exposure shifts the frontier to the upper left portion of the graph. With greater ability to hedge liability interest rate risk, this change has increased efficiency by reducing surplus risk per unit of expected return6. For example, the above addition of the dual-beta investment in place of 30% of the equity assets reduces surplus volatility by approximately 15% (over 2% absolute), while benefitting expected return. Referring back to the funded ratio chart we examined earlier (Figure 1), including a 30% capital allocation to a dual-beta investment would benefit from similar reductions in surplus volatility. In the chart below, we show how this sample plans funded ratio might have changed by year, if it started each year fully funded (i.e. assets equal liabilities). Figure 8: Change from fully funded by year
35% Change in funded ratio 25% 15% 5% -5% -15% -25% -35% 2009 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2010

Although funded status continues to be sensitive to equity markets, as intended, there is a greater degree of control of the plans funded ratio. This is due to the increased match between asset and liability exposures to long corporate yields. It is also interesting to note that in years where equity markets performed very poorly, and in turn funded ratios were negatively impacted, the dual beta investment helped mitigate some of decline in funded ratio by hedging simultaneously falling interest rates.

Conclusion
Pension plan sponsors face difficult challenges. The dual objectives of maintaining expected return and simultaneously reducing surplus risk, while common among defined benefit plans, are hard to achieve via traditional allocations. Many plan sponsors have started to embrace liability-driven investing (LDI) as a way to reduce surplus risk. In the absence of capital efficient strategies, however, the sponsors often find that they are not able to achieve both the return-seeking and liabilityhedging exposures they desire. Fortunately, simple structures exist that can increase capital efficiency (i.e., strategies that make the same plan assets work harder). In addition, there are collective funds that provide operationally simple execution. For many pension plans, the dual-beta strategies outlined in this paper can help them move closer toward achieving their objectives.

With dual-beta

Without dual-beta

Source: BlackRock

Appendix
A) Implementation considerations in capital efficient dual-beta strategies As with all investment decisions, there are certain considerations to bear in mind. i. Collateral adequacy Collateral is required in all overlays to support the synthetic exposures. In the dual-beta strategy, the initial value of cash set aside for collateral needs to support two sets of futures treasury futures and equity futures. The amount of collateral and hence the amount of leverage used needs to be considered and judged appropriately. A key determinant is the level of market shock that can be tolerated, and the mechanism through which the leverage in the portfolio is managed and reset over time. In the context of dual-beta there are diversification benefits for the collateral pool. The combination of long Treasury and equity exposures into a single collateral pool significantly stabilizes the structure against adverse market movements. This can be seen in the data below which shows few historical observations where poor treasury and equity returns occur together.7 Figure 9: Negative index return observations (rolling 21 business days)
400 Observations 300 200 100 0 1 -30% 4 -25% 8 4 -20% Returns SPX Long Treasury 24 17 -15% 74 1 -10% -5% 156 389 Observations

Combined Equity & Long Treasury (2:1 ratio) negative return observations (rolling 21 business days)
400 300 Occurred in October 2008 200 100 1 0 -30% -25% -20% Returns SPX -15% -10% -5% 8 27 195

Source: BlackRock, Bloomberg, Barclays Capital

In Figure 9, the chart to the left shows historical downside observances for the standalone components of the collateral pool, with 17 total occurrences of returns below -20%. On the chart to the right, the equity and Long Treasury components are combined in a 2:1 ratio, as would be for the dual-beta investment collateral pool. There is only one occurrence of returns below -20%. To be sure, a scenario where equities were stressed and interest rates rose would be painful from an asset-only perspective. The dualbeta approach would suffer sharp capital losses. In the context of the pension plan, however, one could expect that liability values would also decrease significantly due to a rise in liability discount rates, and so the overall surplus position would not be as problematic. This less-than-ideal occurrence also needs to be considered in the context of the much improved surplus risk performance that the pension plan would enjoy in many other more likely scenarios. ii. Transaction costs Applying a dual-beta strategy would incur transaction costs due to the sale of the physical equity assets, purchase of Treasury and equity futures, and purchase of the physical credit bonds. These costs could be on the order of 0.5% on the capital used8, but it is important to note the relationship of cost to potential benefit. A relatively small move in rates or spreads could translate into significant surplus changes as liability durations are very long. iii. Active management Given that the equity allocation for the dual-beta investment is achieved through futures, this exposure does not provide a direct substitute for actively managed equities. However, the strategy is a more or less direct replacement for existing passive equity exposure, and generally speaking alpha can often be maintained on existing assets through the removal of constraints, such as long-only constraints.

7 8

Returns source: Bloomberg, Barclays Capital. Based on 4706 observations rolling 21 days between June 30, 1991 and October 31, 2010 A slight cost reduction might be afforded by entering into a reverse EFP, where one gives a broker S&P physicals in exchange for futures and cash

Appendix (cont.)
B) Change in Net Surplus Exposures Figure 10 shows changes in net surplus exposures for the typical plan examined earlier when 30% of equity capital is used to fund a dual-beta investment9: Figure 10: Net surplus exposures: Typical net surplus exposures Pre dual beta
60.0% 42.5% 30.0% 7.5% 0.0% -30.0% -60.0% -90.0% -1 20.0% -1 02% -1 2% 1 1 0% 20%

Net surplus exposures: "Typical" net surplus exposures Post 30% allocation to dual Beta
60.0% 42.5% 30.0% 7.5% 0.0% -30.0% -60.0% -90.0% -1 20.0% -72% -97% 1 0% 20%

Public equity

Private equity

Real estate alternatives

Bonds aggregate

Long rates

Credit spreads

Public equity

Private equity

Real estate alternatives

Bonds aggregate

Long rates

Credit spreads

Source: BlackRock, Bloomberg, Barclays Capital

With negative credit spread exposure as sizable as rates, if not larger, the dual-beta investment is particularly useful in helping to reduce both surplus risks.
9

Charts are illustrative

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