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Session 180 IF, New Developments in Pension Fund Investments
Moderator:
Jeffrey G. Passmore, FSA, EA
Presenters: Tamara Burden, FSA, MAAA Scott E. Gaul, FSA, MAAA
Jeffrey G. Passmore, FSA, EA Alexander Pekker, ASA, CFFA, Ph.D.
SOA 180 - Recent Developments In Corporate Pension LDI - Panelists
Short Maturity
$1.0 Billion
Long Duration
Credit
$5.3 Billion
Core/Core Plus
$3.4 Billion
Credit/Other
Benchmarks
$2.4 Billion
Short Maturity$0.8 Billion
Long Duration
$6.5 Billion
Core/Core Plus
$3.2 Billion
Credit/Other
Benchmarks
$2.9 Billion
Tamara Burden, CFA, FSA a principal and managing director of Milliman Financial Risk Management. The company was formed in
1998 as a practice of the actuarial consulting firm Milliman and is now organized as a wholly owned subsidiary. The mission of
Milliman Financial Risk Management is to create transformational improvement in the retirement security system and it carries that out
using 140 consultants over three continents to hedge market risk around the globe. Milliman FRM is the leading provider of hedging
services to variable annuity writers and offers advisory and subadvisory services to over 70 funds with a total AUM in excess of $70
billion. Tamara is based in Dallas and can be reached at [email protected].
Scott Gaul is Senior Vice President and Head of Distribution, Pension Risk Transfer at Prudential Retirement. Prudential Retirement
delivers retirement plan solutions for public, private, and nonprofit organizations. Our services include state-of-the-art record keeping,
administrative services, investment and risk management, comprehensive employee communications, and trustee services. Prudential
Retirement is part of Prudential Financial. For nearly 140 years, Prudential Financial, Inc., has helped individual and institutional
customers grow and protect their wealth. Today, we are one of the world's largest financial services institutions with operations in the
United States, Asia, Europe, and Latin America. We also have one of the most recognized and trusted brand symbols: The Rock ®, an
icon of strength, stability, expertise, and innovation. Scott is based in Hartford, CT and can be reached at [email protected].
Jeff Passmore, FSA, CFA is Director and Client Portfolio Manager and LDI Strategist at Barrow Hanley. Barrow Hanley was founded
in 1979 and is the largest manager of active US value equities. Barrow Hanley has managed bonds since 1983 and has managed long
duration bond portfolios for corporate pension plans for more than 25 years. Barrow Hanley is a subsidiary of Old Mutual, an
international financial services group based in London. Old Mutual Asset Management, the US based asset management arm of Old
Mutual, is comprised of 7 independent asset management firms representing a broad spectrum of investment strategies, capabilities, and
styles. Barrow Hanley remains an independently managed company and continues to operate autonomously from its Dallas, Texas
headquarters. Jeff is located in Dallas and can be reached at [email protected]
Alexander Pekker, PhD, CFA, ASA, Director of Quantitative Strategies at Sage Advisory Services. Founded in 1996 and based in
Austin, TX, Sage is a registered investment advisory firm that is 100% employee owned. Sage specializes in taxable and tax-exempt
fixed income asset management, global tactical exchange traded fund (ETF) strategies, and asset/liability services for institutional
clients. Alex’s responsibilities include ALM analytics and customized investment strategy design for defined benefit plans, cash balance
plans, insurance companies, and other liability-sensitive clients as well as quantitative analysis and research. Alex is located at the Sage
headquarters in Austin and can be reached at [email protected].
BARROW, HANLEY, MEWHINNEY & STRAUSS, LLC
October 14, 2015
Jeff Passmore, CFA, FSA – Client Portfolio Manager, LDI Strategist
Recent Developments In Corporate Pension LDI
BARROW, HANLEY, MEWHINNEY & STRAUSS, LLC
QUESTIONS
Short Maturity
$1.0 Billion
Long Duration
Credit
$5.3 Billion
Core/Core Plus
$3.4 Billion
Credit/Other
Benchmarks
$2.4 Billion
Short Maturity$0.8 Billion
Long Duration
$6.5 Billion
Core/Core Plus
$3.2 Billion
Credit/Other
Benchmarks
$2.9 Billion
1
By a show of hands:
• What types of pension plans do you work with:
• Single Employer,
• Multi Employer,
• Public, and/or
• Other?
• What type of actuarial work do you do”
• Traditional pension actuarial (liability) work,
• Investment consulting,
• Investment management,
• Other?
BARROW, HANLEY, MEWHINNEY & STRAUSS, LLC
LIABILITY DRIVEN MEANS KNOWING VOLATILITY SOURCES
Projected Benefit Cash Flows; Source: Barrow Hanley
Pension Liabilities Generally Have Three
Sources of Hedgeable Volatility: Rates,
Spreads and Curve
Rates-based Volatility Can Be Measured and
Managed Mostly With Duration Matching
Techniques
Spread Volatility Is Also Important When
Hedging Pension Liabilities (Pension Cash
Flows Are Discounted Using Corporate
Bond Yields)
Curve Volatility Not Hedged Through
Duration Matching Is Small And Can Be
Managed Through Key-rate Duration
Matching
Different Benefit Cash Flows Have Different
Sensitivities To Each Source
BARROW, HANLEY, MEWHINNEY & STRAUSS, LLC
LIABILITY DRIVEN MEANS KNOWING VOLATILITY SOURCES
Projected Benefit Cash Flows; Source: Barrow Hanley
Pension Liabilities Generally Have Three
Sources of Hedgeable Volatility: Rates,
Spreads and Curve
Rates-based Volatility Can Be Measured and
Managed Mostly With Duration Matching
Techniques
Spread Volatility Is Also Important When
Hedging Pension Liabilities (Pension Cash
Flows Are Discounted Using Corporate
Bond Yields)
Curve Volatility Not Hedged Through
Duration Matching Is Small And Can Be
Managed Through Key-rate Duration
Matching
Different Benefit Cash Flows Have Different
Sensitivities To Each Source
56% Vol
37% Vol
6% Vol
Gotcha: Spread volatility is a
big part of total volatility
BARROW, HANLEY, MEWHINNEY & STRAUSS, LLC
CUSTOM LDI BENCHMARKS
Traditional Pension PBO liability using Citigroup Pension Discount Curve, S&P 500, Long G/C for the period
2005-2014. Assets assumed equal to liability. Monthly volatility relative to PBO. Source: Barrow, Hanley
Observations
Traditional Pension asset allocation has
significant volatility.
Much of the liability volatility can be
hedged using LDI.
Even full hedging with custom
benchmarks has some volatility.
Benchmark can be designed using risk
metrics or historical results.
BARROW, HANLEY, MEWHINNEY & STRAUSS, LLC
CUSTOM LDI BENCHMARKS
Traditional Pension PBO liability using Citigroup Pension Discount Curve, S&P 500, Long G/C for the period
2005-2014. Assets assumed equal to liability. Monthly volatility relative to PBO. Source: Barrow, Hanley
Observations
Traditional Pension asset allocation has
significant volatility.
Much of the liability volatility can be
hedged using LDI.
Even full hedging with custom
benchmarks has some volatility.
Benchmark can be designed using risk
metrics or historical results.
Gotcha: Duration of
Cashflows and Liabilities can
be Different
BARROW, HANLEY, MEWHINNEY & STRAUSS, LLC
ASSET-LIABILITY REPORTING
Plan Sponsor Sample Report Pension Asset-Liability Report
Retirement Plan of Plan Sponsor As of March 31, 2015
Page 1
Funded Status (GAAP, $) 3/31/2015 EOY (12/31/14) FYE (10/31/14)
Liabilities 318,138,808 310,886,382 302,686,612
Assets 341,713,765 340,109,303 336,443,139
Funded Position 23,574,957 29,222,921 33,756,527
Funded Ratio 107% 109% 111%
Estimated Estimated
Funded Position (GAAP, $M) Funded Status (GAAP)
Required Contribution (ERISA/PPA) Asset Loss ($M)
Projected Asset Loss During the Next Twelve Months
Assuming One in Twenty Bad Year (5th Percentile)
($35.2)
LTM Ending 3/31/2016
Required Contributions for Next Plan Year Assuming One
in Twenty Bad Year (5th Percentile)
$0.0
2016
Dashboard
3/31/2015 12/31/2014
Annual Risk1
Asset Allocation
($20.0)
As of 3/31/2016
$23.6
As of 3/31/2015
Funded Position of the Plan Projected 12 Months Assuming
One in Twenty Bad Year (5th Percentile)
107% 100%
As of 3/31/2015 As of 3/31/2016
Funded Status of the Plan Projected 12 Months Assuming One
in Twenty Bad Year (5th Percentile)
Stocks, 46%
Long Duration Bonds,
42%
High Yield5%
Private Equity
4%
REITS4%
Values are estimated using the most recent historical information available and projecting forward using changes in interest rates, credit spreads, benchmark returns and expected cash flows. See additional detail in the appendix regarding projection methodology.
1 Annual risk is the value at risk at the fifth percentile. This represents a bad outcome that would be expected five times ev ery 100 years.
Stocks, 46%
Long Duration Bonds,
41%
High Yield5%
Private Equity
4%
REITS4%
Assets-Liabilities: Projected and
with Historical Context
Some Detail on Assets
High Level Risk Measures
Detail Should Follow
Desirable Characteristics of
Asset-Liability Dashboard
BARROW, HANLEY, MEWHINNEY & STRAUSS, LLC
Plan Sponsor Sample Report Pension Asset-Liability Report
Retirement Plan of Plan Sponsor As of March 31, 2015
Page 4
Hedge Ratios
Interest Rate Hedge 45% Asset vs. Liability Duration
Spread (Quality) Hedge 50% Asset vs. Liability Spread Duration
Convexity Hedge 41% Asset vs. Liability Convexity
Sources of Risk ($)
Stocks (21.8)$ 43% Stocks about half of risk
Interest rates (Liability net of bonds) (28.1) 56% Rates about half of risk
Alternatives (0.6) 1% Alts contribute little to risk
Total (50.5)$ 16% Funded Status Loss
By Source of RiskBy Asset Class
Pension Plan Risk
Diversification
Values are estimated using the most recent historical information available and projecting forward using changes in interest rates,credit spreads, benchmark returns and expected cash flows. See additional detail in the appendix regarding projectionmethodology.
1 Annual risk is the value at risk at the fifth percentile. This represents a bad outcome that would be expected five times every 100
Stocks, 46%
Long Duration Bonds,
42%
High Yield5%
Private Equity
4%
REITS4%
Stocks43%Rates,
53%
Alts1%
61.1
50.4
(29.3)
43.6 5.6 3.2 2.9 (36.7)
0
45
90
135
Liabilities Total Risk
Funded Status Risk Attribution1 ($M)
ASSET-LIABILITY REPORTING
Risk Metrics that Match Sources of
Liability Risk
Expressing Risk In Ways Plan
Sponsors Understand
Illustrating Impact of
Diversification on Risk
Desirable Characteristics of
Risk Report
BARROW, HANLEY, MEWHINNEY & STRAUSS, LLC 8
Scott Gaul, FSA, MAAA
SVP and Head of Distribution
Pension Risk Transfer
Prudential Retirement
For financial professional or institutional plan sponsor use only. Not for further distribution. 1
RISK RETENTION vs. RISK TRANSFER
• 60% equity, 40% fixed income
• Take advantage of MAP-21
• Current PPA corporate bond basis allows for favorable pricing
• Plan asset that perfectly matches liability
• Convertible to buy-out
• Complete settlement of plan liability for transacted group
• Assets transfer to insurer
Lump Sum Buy-in Buy-out
• Lump sum
• Buy-in
• Buy-out
Transfer Asset Plan Design Status Quo
RETAINING RISK TRANSFERRING RISK
• Benefit curtailment
• Freeze benefits
• Cash balance
• Glide path
• Liability-Driven Investing (LDI)
For financial professional or institutional plan sponsor use only. Not for further distribution. 2
• Insurer makes guaranteed payments to participants
• Insurer covers investment and longevity risk
• May trigger settlement accounting and reduce funded status
• Irrevocable
• Eliminate all costs
• Insurer makes guaranteed payments to plan
• Insurer covers investment and longevity risk
• Does not trigger settlement accounting or reduce funded status
• Convertible to buy-out at any time
• Retain administrative and PBGC costs
BUY-OUT Plan investment matches liability. Complete settlement of plan liability.
BUY-IN
For financial professional or institutional plan sponsor use only. Not for further distribution. 3
EVALUATING A RETIREE PENSION BUY-OUT New Mortality Basis
1 GAAP liability reflects RP-2014 mortality table with MP-2014. 2 Costs not included in the GAAP retiree obligation include per person administrative expenses of $40 per year and PBGC expenses per person of $57 in 2015, $64 in 2016, and indexed after 2016. 3 GAAP obligations are discounted using rates unadjusted for investment management fees and the risk of credit defaults and migrations. These are estimated at 30 and 24 basis points per annum, respectively.
Pricing is indicative and provided for discussion purposes only. Percentages represent present value of estimated future costs. Pricing is subject to change per market conditions and specific client demographic information.
100% 1% 3% 2%
106% (2%) 104%
$112M $110M $106M
GAAP Retiree
Liability1
Buy-out Valuation
Difference Economic Value
Credit Defaults and Downgrades3
Investment Management
Fees3
Administrative and PBGC Expenses2
Perc
enta
ge o
f GAA
P Ob
ligat
ion
Reflects increase in GAAP liability due to change in mortality basis Insurer bears
all risk
Plan sponsor bears investment, regulatory, and longevity risk
Costs borne by plan sponsors if a buy-out is not executed
For financial professional or institutional plan sponsor use only. Not for further distribution. 4
A FLEXIBLE APPROACH TO IN-KIND ASSET TRANSFER Illustrative Reference Portfolio Characteristics
Credit Quality Acceptable Range
A- or Better Up to 80%
BBB+, BBB, BBB- 20-25%
BB+, BB, BB- Up to 6%
Issuer Limits Per Issuer
AAA through A- 1%
BBB+ through BBB- 0.75%
BB+ and Below 0.5%
Sector Acceptable Range
Industrials 50-80%
Finance 15-18%
Utilities 5-15%
Non-corporate 5-15%
Non-US: Investment-Grade Acceptable Range
Overall Up to 16%
Country Up to 6%
Non-US: Below Investment-Grade Acceptable Range
Overall Up to 4%
Country Up to 2%
In order to provide some flexibility, Prudential may also provide ranges around characteristics for credit quality, issuer exposure, sector exposure, country exposure and other characteristics as necessary.
5900 Southwest Parkway | Building 1 | Austin, Texas | 78735 | t: 512.327.5530 | w: www.sageadvisory.com
LIABILITY DRIVEN INVESTING FOR SMALL DB PLANS
Alexander Pekker, PhD, CFA, ASA Director of Quantitative Strategies Sage Advisory Services, Ltd. Co.
October 14, 2015
2
ABOUT SAGE
Overview • Registered Investment Advisor based in Austin, Texas • Founded in 1996 by Robert G. Smith III and Mark MacQueen • 100% employee owned • 46 employees, 21 Investment Professionals • $10.9 Billion AUM/AUA as of 6/30/2015
Strategies and Services • Taxable Fixed Income Strategies • Tax-Exempt Fixed Income Strategies • Global Tactical ETF Strategies • Asset/Liability Services
TOTAL FIRM ASSETS BY CLIENT TYPE (6/30/2015)
Public Funds5.28%
Corporate31.57%
Subadvisory0.32%
Insurance18.82%
Health Care6.46%
Taft-Hartley12.18%
High Net Worth20.96%
Endowment & Foundations
4.41%
Asset/Liability Management and Liability Driven Investing Solutions • Dedicated to the analysis of complex client situations and development of customized investment solutions for defined
benefit plans (and other post-retirement benefit plans) • $1.3 billion in LDI mandates, $300 million in cash balance plan mandates, and $900 million in other liability-focused
mandates • Built over 200 client relationships and completed over 600 ALM studies since 1999 • Publications, client education and commentary on ALM, LDI, pension plan derisking, cash balance plans, and the
defined benefit space in general
3
Source: 2012 Private Pension Plan Bulletin, Abstract of 2012 Form 5500 Annual Reports, Department of Labor; numbers shown include hybrid plans such as cash balance plans as well as plans not insured by PBGC.
Many, Many, Many Small Plans… • The vast majority of DB plans with over $1 million in assets are small plans
• 72%, or over 15,000, have $1 million to $10 million in assets • 9%, or almost 2,000, have $10 million to $25 million in assets
• These plans are underserved, despite being subject to the same regulations and having many of the same needs as larger plans
17,254
9,708
3,811
1,947 1,954 2,107 1,327 641 0
5,000
10,000
15,000
20,000
Under $1m $1-2.5m $2.5-5m $5-10m $10-25m $25m-$100m $100m-$500m Over $500m
Num
ber o
f Pla
ns
Assets
Number of Single Employer Plans (2012)
17,420 Plans 4,075 Plans
LIABILITY DRIVEN INVESTING FOR SMALL DEFINED BENEFIT PLANS
4
… Many, Many, Many Challenges • Asset/liability analytics are (perceived to be) costly to produce and interpret • Current strategies, i.e., mutual funds and separately managed bond portfolios, are inefficient and ineffective
• Liability-based customization is not feasible at small plan size
LIABILITY DRIVEN INVESTING FOR SMALL DEFINED BENEFIT PLANS
Cash Flow Projection
ASSET/LIABILITY ANALYTICS CHALLENGES
Cost
Liability Duration, Etc.
Cost Often, unsophisticated actuary and investment advisor
Mutual Funds
INVESTMENT STRATEGY IMPLEMENTATION CHALLENGES
Not designed for pension liability hedging
Separately Managed Bond Portfolios
Diversification Liquidity Transaction cost Minimum account size
Customization
Few (if any) solutions for under $10-25 million Often, unsophisticated investment advisor
No Easy Solution
This Can Be
Solved!
5
Mutual Funds Are Not a Viable Solution • Investment objective is not liability-related • Cashflows, duration, and key rate durations do not resemble liability characteristics • Sector and quality allocations do not match liability discount rate
LIABILITY DRIVEN INVESTING FOR SMALL DEFINED BENEFIT PLANS
Sample Market Index Cashflows Look Nothing Like Pension Liabilities
BC Aggregate BC Capital Long Credit
Aaa 9%
Aa 11%
A 38%
Baa 42%
US Investment Grade Credit Universe
Source: Benchmark cash flows are cash flows for the iShares BC Aggregate ETF (AGG) and the iShares Long Credit ETF (CLY) provided by CMS BondEdge, as of September 28, 2015. Market value of the benchmark is set equal to the present value of liabilities, and benchmark cash flows are adjusted proportionately.
Source: Barclays Capital US Investment Grade Credit Index, as of September 29, 2015.
6
Exchange Traded Funds (ETFs) Are A New and Growing Technology • An ETF is a fund (collection) of stocks and/or bonds (like a mutual fund) that trades on an exchange throughout the
day (like a stock); exchange-traded products (ETPs) include exchange-traded notes • There are almost 1,800 exchange-traded products with over $2 trillion in AUM, covering all asset classes • There are 300 fixed income exchange-traded products with over $350 billion in AUM
LIABILITY DRIVEN INVESTING FOR SMALL DEFINED BENEFIT PLANS
0
100
200
300
400
0
100
200
300
400
Growth of Fixed Income ETFs
Number (Left) AUM ($ Billion, Right)
Source: The Guide To Fixed Income ETFs, BlackRock, June 2015 for data through 2Q 2015; ETF.com and Sage for 3Q 2015 (as of September 29, 2015). As of 3Q 2015, fixed income exchanged traded products include 17 exchange-traded notes with $0.3 billion in AUM.
7
Fixed Income ETF Space is Broad and Liquid • Numerous ETFs in a broad array of market segments, from US Government to High Yield to Emerging Market Debt • Each market segment has at least 2 ETFs with over $500 million in AUM
• Fixed income ETF AUM grew at 38% annualized over the last 10 years; ETF trading volume grew at 34% annualized over the last ten years
LIABILITY DRIVEN INVESTING FOR SMALL DEFINED BENEFIT PLANS
Source: ETF.com and Sage, as of September 29, 2015 for market segment distribution and The Guide To Fixed Income ETFs, BlackRock, June 2015 for ETF AUM and trading volume growth.
Market Segment AUM
($ Billions) Number of
ETPs
Number of ETPs with
AUM > $100m
Number of ETPs with
AUM > $500m
Broad Domestic 95.8 28 18 11
Government 70.0 36 29 18
Inv. Grade Credit 68.8 56 23 13
Securitized 9.5 7 4 2
Preferred/Convertible 21.5 9 8 4
High Yield 37.5 28 15 10
Municipal 17.4 35 18 8
International 26.1 61 31 11
Leveraged/Inverse 5.3 40 5 3
Total 351.9 300 151 80
Most Useful for LDI Portfolios
8
Portfolios of ETFs Solve Many Challenges • Diversified, transparent, low-cost, liquid, and available at virtually any account size • Portfolios of ETFs can be customized to match liability characteristics
• Some limitations persist, such as sector and security selection, plan sponsor investment policy restrictions (e.g., minimum quality or ESG), and ETF tracking error (actual price to NAV and NAV to index)
LIABILITY DRIVEN INVESTING FOR SMALL DEFINED BENEFIT PLANS
High Diversification
BENEFITS OF ETFS (WITH SOME LIMITATIONS)
Exposure to hundreds of issuers E.g., iShares Long Credit ETF (CLY) has nearly 1,400 bonds and 487 issuers
Low Transaction Cost
Traditional bond ETF expense ratios are generally under 25 bp Premiums/discounts may create transaction costs beyond expense ratio
High Liquidity
Exchange provides liquidity ETFs are traded intra-day
Low Minimum Account Size
Can be implemented at virtually any account size
Customization
Create a portfolio of ETFs to match liability (duration, discount rate, etc.) Cannot choose credit sectors (e.g., energy) or issuers, implement restrictions
9
Creating Liability-Matching Portfolios Requires Expertise • Actuarial expertise • ETF expertise
• LDI and investment management expertise
LIABILITY DRIVEN INVESTING FOR SMALL DEFINED BENEFIT PLANS
ETF Due Diligence
INVESTMENT STRATEGY IMPLEMENTATION
Index methodology (e.g., credit vs. corporate) Structural analysis (sponsor, portfolio management) Security traits (expense ratio, premium/discount, tracking error)
Blend ETFs to Match Liabilities
Match key liability characteristics (duration, yield to maturity, etc.) Ensure proper sector exposure to approximate liability discount rate Add active management (if desired)
Monitoring and Rebalancing
Regularly review ETF universe (e.g., fixed-maturity ETFs) Evaluate quality of matching (not only duration but also sector allocation, e.g., mass upgrades/downgrades and spread volatility) Adjust with annual liability updates
10
SAMPLE ETF PORTFOLIO 12/31/2014
BARCLAYS- RUSSELL LDI 12 INDEX 12/31/2014
Duration 12.13 12.13 Yield to Maturity 3.87% 3.84% Average Quality A1 A1 Expense Ratio 0.12% N/A
Source: Barclays Live, Vanguard. iShares, Sage.
Sage Small Plan LDI Solution – Sample Plan • Compute key liability characteristics and evaluate plan sponsor risk tolerance • Create optimal portfolio of ETFs from a broad universe of approved fixed income ETFs
• Match key liability characteristics • Express active management view when appropriate
• Re-evaluate and rebalance regularly
LIABILITY DRIVEN INVESTING FOR SMALL DEFINED BENEFIT PLANS
Long Credit ETFs 58%
Interm. Credit ETFs
27%
Long Gov't ETFs 15%
Sample Liability-Hedging All-ETF Portfolio 12/31/2014
11
Sage Small Plan LDI Solution – Sample Plan (Continued) • Strategy shows good tracking error • There are periods of price-NAV tracking error during market stress (particularly downgrades, large spread-widening)
• Key challenge is match credit spread of the liabilities appropriately
LIABILITY DRIVEN INVESTING FOR SMALL DEFINED BENEFIT PLANS
0%
10%
20%
30%
40%
50%
60%
12-2009 12-2010 12-2011 12-2012 12-2013 12-2014
Sample ETF Portfolio Backtest (Cumulative Return)
Portfolio Barclays-Russell LDI 12 Index
Tracking Error Monthly: 1.69% Tracking Error Quarterly: 1.39%
Source: Barclays Live, Vanguard. iShares, Sage.
12
Summary • Small plans are a large and underserved segment of the corporate DB space • Small plans face huge challenges in implementing customized, liability-driven investing strategies via traditional vehicles • Fixed income ETFs enable the creation of customized, liability-matching all-ETF portfolios that are more effective than
traditional vehicles for small plans • Coupled with streamlined analytics, Sage provides a complete, cost-effective all-ETF pension risk management solution
for small plans • Basic liability analytics • Derisking strategy (including, glidepath) • All-ETF liability-hedging portfolio and all-ETF return-seeking portfolio
LIABILITY DRIVEN INVESTING FOR SMALL DEFINED BENEFIT PLANS
13
Sage Advisory Services, Ltd. Co. (Sage, we, our and us) is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should be relied upon as such. This study contains hypothetical examples for illustrative purposes based on modeled returns. Modeled (projected) returns are an estimate of hypothetical average historical returns of asset security classes, derived from the application of model asset allocations. Actual returns are likely to vary from modeled returns. Past performance is not indicative of future returns. As with any vehicle, there is always the potential for gains as well as the possibility of losses Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, derivatives risk, income risk, and other investment company risk. As interest rates rise, bond prices fall. Credit risk refers to an issuer’s ability to make interest payments when due. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. Foreign investments involve additional risks as noted above. Investing involves substantial risk and high volatility, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise. Our Tactical ETF strategy invests in exchange traded funds (ETFs). Investors should consider funds’ investment objectives, risks, charges, and expenses carefully before investing. The investment return and principal value of an investment will fluctuate, so that an investor’s shares, when redeemed, may be worth more or less than their original cost. ETFs trade like stocks and may trade for less than their net asset value. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. 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 results and all of which can adversely affect actual results. This study contains historical asset allocations and portfolio changes (“Portfolio Changes”) which are based on model portfolios and actual changes made to client portfolios or model portfolios may vary based on investment guidelines requested by each such client. There is no assurance, as of the date of publication, that the securities purchased, as a result of the Portfolio Changes, remain in the model portfolios or that securities sold have not been repurchased. Additionally, it is noted that the securities purchased as a result of the Portfolio Changes may not represent the entire model portfolio. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the model portfolios or the strategies discussed herein. With respect to the model portfolios, a complete list of all recommendations made by Sage over the previous twelve (12) month period will be made available upon request. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. No part of this Material may be produced in any form, or referred to in any other publication, without our express written permission. For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.
DISCLOSURES
PROPRIETARY & CONFIDENTIAL
SIMPLIFY, GROW, PROTECT…YOUR ROUTE TO A SUSTAINABLE PENSION PLANMILLIMAN FINANCIAL RISK MANAGEMENT LLC
PROPRIETARY & CONFIDENTIAL2
LIMITATIONS AND DISCLOSURES• For investment professionals use only. Not for public use or distribution.
• Past performance is not indicative of future results. Recipients must make their own independent decisions regarding any strategies or securities or financial instruments mentioned herein.
• Milliman Financial Risk Management LLC does not make any representations that products or services described or referenced herein are suitable or appropriate for the recipient. Many of the products and services described or referenced herein involve significant risks, and the recipient should not make any decision or enter into any transaction unless the recipient has fully understood all such risks and has independently determined that such decisions or transactions are appropriate for the recipient.
• Any discussion of risks contained herein with respect to any product or service should not be considered to be a disclosure of all risks or a complete discussion of the risks involved.
• The recipient should not construe any of the material contained herein as investment, hedging, trading, legal, regulatory, tax, accounting or other advice. The recipient should not act on any information in this document without consulting its investment, hedging, trading, legal, regulatory, tax, accounting and other advisors.
• Milliman Financial Risk Management LLC does not ensure a profit or guarantee against loss.The materials in this document represent the opinion of the authors and are not representative of the views of Milliman Financial Risk Management. Milliman Financial Risk Management does not certify the information, nor doe sit guarantee the accuracy and completeness of such information. Use of such information is voluntary and should not be relied upon unless an independent review of its accuracy and completeness has been performed.
PROPRIETARY & CONFIDENTIAL3
Diversification fails during crises when
all asset classes decline together
THE FAILURE OF DIVERSIFICATION
Source: Milliman, Inc. 2010
Source: Milliman Financial Risk Management LLC as of 1/1/08 – 12/31/08
For illustrative purposes only. Past performance is not indicative of future results. The S&P 500, Russell 2000,
NASDAQ, Investment Grade Corporate Bonds, Emerging Markets, Commodities, EAFE, REITs, High Yield Bonds,
Private Equity and Hedge Funds are represented by the S&P 500 Index, Russell 2000 Index, NASDAQ Composite
Index, Barclays Capital U.S. Aggregate Total Return Index, MSCI Emerging Markets Index, S&P GSCI Index, MSCI
EAFE Index, Dow Jones Equity REIT Total Return Index, Merrill Lynch High Yield Master II Index, S&P Listed
Private Equity Index (TR) and HFRX Global Hedge Fund Index, respectively.
Diversification losing effectiveness as
global markets become more correlated
Putnam Investments
(2011)
“Twenty years ago, the
average correlation of
asset classes in the
typical pension plan was
25%. Now, the average
correlation of those same
asset classes is 70%.”
PROPRIETARY & CONFIDENTIAL4
Asset
Class
Volatility:
2000-2010
Volatility:
Q4 2006
Volatility:
Q4 2008
US Large cap 21% 7% 67%
US Small cap 26% 14% 77%
Developed
International 19% 8% 60%
Emerging
Markets 21% 11% 67%
or, why NOT to use a static allocation
THE PROBLEM WITH 60/40
PROPRIETARY & CONFIDENTIAL5
or, why NOT to use a static allocation
THE PROBLEM WITH 60/40
The performance shown is historical, for informational purposes only, not reflective of any investment, and does not guarantee future results. Any reference
to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles
that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products,
which otherwise have the effect of reducing the performance of an actual investment portfolio.
PROPRIETARY & CONFIDENTIAL6
S&P 500 Index from 1990 to 2014
RELATIONSHIP OF RETURN TO VOLATILITY
The performance shown is historical, for informational purposes only, not reflective of any investment, and does not guarantee future results. Any reference to a
market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as
market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have
the effect of reducing the performance of an actual investment portfolio.
PROPRIETARY & CONFIDENTIAL7
S&P 500 Index from 1928 to 2014
RELATIONSHIP OF RETURN TO VOLATILITY
The performance shown is historical, for informational purposes only, not reflective of any investment, and does not guarantee future results. Any reference to a
market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as
market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have
the effect of reducing the performance of an actual investment portfolio.
PROPRIETARY & CONFIDENTIAL8
• Volatility shows “stickiness” with prolonged periods of low and high vol:
• You don’t know if the market will go up or down next week, but you can be pretty accurate in assessing whether it will be calm or volatile
• This lends itself to a short-term volatility prediction model
VOLATILITY MANAGEMENT
The performance shown is historical, for informational purposes only, not reflective of any investment, and does not guarantee future results. Any reference to a
market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as
market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have
the effect of reducing the performance of an actual investment portfolio.
PROPRIETARY & CONFIDENTIAL9
You CAN do it!
VOLATILITY MANAGEMENT
Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results.
There is no assurance that the investment process will consistently lead to successful investing.
PROPRIETARY & CONFIDENTIAL10
RESHAPE THE DISTRIBUTION OF RETURNS
THESE RESULTS ARE BASED ON SIMULATED OR HYPOTHETICAL PERFORMANCE RESULTS THAT HAVE CERTAIN INHERENT
LIMITATIONS. UNLIKE THE RESULTS SHOWN IN AN ACTUAL PERFORMANCE RECORD, THESE RESULTS DO NOT REPRESENT
ACTUAL TRADING. ALSO, BECAUSE THESE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THESE RESULTS MAY HAVE UNDER-
OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED
OR HYPOTHETICAL TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE
BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR
LOSSES SIMILAR TO THESE BEING SHOWN.
PROPRIETARY & CONFIDENTIAL11
UPSIDE PARTICIPATION, DOWNSIDE PROTECTION
Using a futures overlay can capture, on average, 75-80% of the upside potential of equities with 25-30% of the downside exposure in a crisis
THESE RESULTS ARE BASED ON SIMULATED OR HYPOTHETICAL PERFORMANCE RESULTS THAT HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE THE RESULTS SHOWN IN AN ACTUAL
PERFORMANCE RECORD, THESE RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, BECAUSE THESE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THESE RESULTS MAY
HAVE UNDER-OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED OR HYPOTHETICAL TRADING PROGRAMS
IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS
LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THESE BEING SHOWN.
PROPRIETARY & CONFIDENTIAL12
SIMPLIFY…
For illustrative purposes only. Past performance is not
indicative of future results. The S&P 500, Russell 2000,
NASDAQ, Investment Grade Corporate Bonds,
Emerging Markets, Commodities, EAFE, REITs, High
Yield Bonds, Private Equity and Hedge Funds are
represented by the S&P 500 Index, Russell 2000 Index,
NASDAQ Composite Index, Barclays Capital U.S.
Aggregate Total Return Index, MSCI Emerging Markets
Index, S&P GSCI Index, MSCI EAFE Index, Dow Jones
Equity REIT Total Return Index, Merrill Lynch High
Yield Master II Index, S&P Listed Private Equity Index
(TR) and HFRX Global Hedge Fund Index,
respectively.
• If they don’t help
in a crisis
• If they are
expensive
• If they are illiquid
Why use them?
PROPRIETARY & CONFIDENTIAL13
GROW…
THESE RESULTS ARE BASED ON SIMULATED OR HYPOTHETICAL PERFORMANCE RESULTS THAT HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE THE
RESULTS SHOWN IN AN ACTUAL PERFORMANCE RECORD, THESE RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, BECAUSE THESE TRADES
HAVE NOT ACTUALLY BEEN EXECUTED, THESE RESULTS MAY HAVE UNDER-OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET
FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED OR HYPOTHETICAL TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT
THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE
PROFITS OR LOSSES SIMILAR TO THESE BEING SHOWN.
PROPRIETARY & CONFIDENTIAL14
PROTECT!
THESE RESULTS ARE BASED ON SIMULATED OR HYPOTHETICAL PERFORMANCE RESULTS THAT HAVE CERTAIN INHERENT LIMITATIONS.
UNLIKE THE RESULTS SHOWN IN AN ACTUAL PERFORMANCE RECORD, THESE RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO,
BECAUSE THESE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THESE RESULTS MAY HAVE UNDER-OR OVER-COMPENSATED FOR THE
IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED OR HYPOTHETICAL TRADING PROGRAMS IN
GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING
MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THESE BEING SHOWN.
PROPRIETARY & CONFIDENTIAL15
YOUR ROUTE TO
A SUSTAINABLE
PENSION PLAN
PROPRIETARY & CONFIDENTIAL
Milliman, Inc.
Financial Risk Management LLC
71 S. Wacker Dr. - 31st Floor
Chicago, IL 60606
Ph: +1 312 726. 0677
Fx: +1 312 499 5700
www.milliman.com
Questions?
Thank You!