Disclaimer: Views in this blog do not promote, and are not directly connected to any Legal & General Investment Management (LGIM) product or service. Views are from a range of LGIM investment professionals and do not necessarily reflect the views of LGIM. For investment professionals only.

When entering bear territory…

Hindsight is 20:20, so pension schemes may wish to consider protection in 2020.

Equity is often the main engine driving growth for a pension scheme’s investment strategy to achieve the returns necessary to meet its funding-level objectives on the journey to end-game.

Equities are held in the hope or expectation of greater returns in the future, but this comes with a risk of a downturn: as we all know and as recent weeks have made abundantly clear, what goes up can come down. If asset values remain low at an actuarial valuation, this can leave the sponsor with a bigger deficit to plug, often requiring bigger contributions.

How to survive a bear encounter – prepare, don’t predict

Bears are among the world’s most deadly predators, with a bite strong enough to crush a bowling ball. A ‘bear’ market is one where prices are falling, and the bite out of the funding position can be painful for a pension scheme!

Contrary to popular belief, and perhaps the odd Hollywood movie, even if you are Usain Bolt, trying to outrun a bear is likely to be futile (for you, not the bear!). A bear can run 35 miles per hour in short bursts, so there is little chance for a human being of outrunning it (Bolt’s top speed is 27 miles per hour).

For a pension scheme, this is analogous to waiting until the equity market is just about to fall, then trying to reduce your equity allocation faster than the market drops.

There are two alternative suggestions for surviving bear encounters, according to an internet search: a) stand your ground and stay ‘fixed on the floor’, or b) ‘roll’ into a ball position.

Similarly, a pension scheme has two ways of preparing to survive a bear market. The first approach is a ‘fixed floor’ partnership approach and the second is a ‘rolling delegated’ approach.

We discuss each of these in turn, with a few more bear references along the way.

The more suitable approach of the two will depend on a particular scheme’s requirements, including both the timeframe of protection and the level of delegation desired.

1. Stay ‘fixed on the floor’ – partnership

The first approach is buying insurance up to a specific date via ‘fixed floor’ protection to protect the funding level from one valuation date to the next. Often, some upside participation is sold away, i.e. the returns on the upside are limited in order to pay for the cost of the protection.

This type of strategy can improve the scheme’s overall risk-adjusted returns and narrow the range of outcomes at a specific important date, e.g. a triennial actuarial valuation or target disinvestment or de-risking date. In order to maintain the protection beyond this date, it would need to be rolled periodically. We have developed a framework which enables us to partner with pension schemes to identify opportunities to roll protection if desired as expiry approaches.

Many clients have successfully protected their portfolios using this type of ‘fixed floor’ protection. Our previous post looks in more detail at the merits of this type of equity protection.

2. A roll a day keeps the bear away: delegation with ‘dynamic rolling’ protection

In equity protection, ‘dynamic rolling protection’ can be preferable for clients who favour more delegation and on-going protection. This can be an efficient way to implement protection, with potential improvements from both a governance and an investment risk perspective. It can also be a highly liquid way of diversifying a growth portfolio. Essentially, ‘daily rolling’ can keep that bear at bay and soften the blow.

Now, let’s leave the bear tips behind (for now) and explore the five key features of dynamic rolling protection.

a) Potential to improve risk-adjusted returns over the longer term

A well implemented dynamic equity protection strategy could improve the risk and return characteristics of your equities, protecting scheme funding levels not just from one valuation to the next but on a continuous basis. This could significantly reduce volatility and potentially increase returns.

b) Increase market participation

Protection is often paid for by selling some upside participation beyond a certain level. Dynamic protection can offer greater upside participation because the upside moves up in line with market movements, instead of being set at a static level. If we think of the upside as a ceiling or a cap on returns, then with dynamic protection, as equity markets rise over time, that upside ceiling will also rise, meaning that it is less likely to be hit.

c) Lighten the governance load

Dynamic protection can be more effective from a governance perspective as the continuous rolling removes the need for restructuring. For a fixed floor, decisions are required each time the protection approaches expiry, for example, deciding whether protection is still warranted and if so, when to roll it on. Indicative pricing may need to be considered and documentation put in place.

The automated nature of the roll of a dynamic hedge can be useful if trustees have already decided that they would like to maintain the protection, as it can free up their time for other strategic decisions.

d) Easy and efficient to implement

Rather than having multiple individual contracts to protect the portfolio, we use an innovative approach to codify the protection into one easy-to-implement contract. This distils the benefits of the strategy into a single package. The resulting harmonisation ensures the protection can be priced by a number of counterparty banks. This provides transparency, healthy competition and also price tension, which helps to ensure the best pricing and outcome for schemes. As a result, these strategies can often be implemented cost effectively.

e) Do a bit every day; it smooths the bumps away

For fixed floor protection, the performance of the strategy may vary, depending on the exact date it is implemented. In addition, the periodic restructuring also exposes the scheme to the equity market level when the structure is implemented or rolled.

Dynamic protection, on the other hand, uses daily implementation, which removes this range of outcomes and timing risk. With small increments each day, you effectively end up in the middle of the range, the ‘average’ outcome, and timing risk is reduced.

The bottom line

For a while now, we have seen many pension schemes benefit from Goldilocks economic conditions – ‘not too hot, not too cold’. Perhaps now the market is showing signs of a malicious bear lurking around the corner.

Three key tips can help:

  1. Be alert and aware of the potential attack. It can be difficult to foresee and they can happen relatively suddenly.
  2. Prepare, don’t predict. Plan now which strategy you will employ to help soften the impact of an unexpected attack.
  3. Do not run. Understand the best ‘form’ to adopt.

Bear attacks can be softened with equity protection, which can be implemented in two different ways: the stand ‘fixed on the floor’ partnership position, or the ‘dynamic rolling’ delegation approach. Either can be an efficient way to protect a portfolio, especially at a specific point in time, but the most suitable approach will depend on scheme-specific requirements.

 

Please take our advice with a pinch of salt and use professional sites for your bear safety tips. Similarly, please speak to your client representative for further information on equity protection strategies.

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