The Markets March 19, 2014

Overlay Strategy Keeps DB Investments on Target

Even the best laid plans can go off track, and this is true for defined benefit plan portfolios.
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Plan sponsors and their consultants may spend considerable time designing strategic asset-allocation strategies, but “through the course of time, due to market movements and cash flows in or out due to contributions and distributions, target allocations may get out of balance,” explains Brian Roberts, senior consultant at NEPC, LLC in Boston.

An NEPC paper written by Roberts says derivative overlay strategies offer an array of benefits, which can include securitizing idle cash, maintaining policy target exposures and managing transitions within the portfolio. An overlay solution can also help manage risk related to currency exposure, equity beta or, particularly for corporate pension plans, interest rates. In addition to maximizing the efficiency of an investment portfolio, overlay strategies also aim to keep costs low through the use of liquid and transparent derivatives that are a cheaper alternative to trading physical securities.

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Roberts explains to PLANADVISER that an overlay strategy is one for which a plan sponsor has a manager in place that oversees the overall asset allocation and makes adjustments using derivatives to keep the asset allocation at its target. For example, if the asset allocation is out of balance due to a run up of equities, an overlay manager, based on very specific, pre-determined rules agreed with the plan sponsor, using derivatives, will obtain the market exposure that is missing.

Roberts says “derivatives” is a broad term, but the primary focus of the paper is the use of exchange-traded futures. “This is the type we would anticipate most plan sponsors would employ,” he says. A futures contract is an agreement between two parties to exchange a security at a future date at an agreed upon price. But, you get that asset class exposure for only a fraction of the capital required to purchase a security.

How Does a Derivative Overlay Strategy Work?

Roberts uses the example of a long-term target allocation of 60% in the S&P 500 and 40% in the Barclays Aggregate Index that gets off balance because cash is needed on hand in preparation for paying a distribution. The asset allocation may be only 55% S&P 500/35% Barclays, with 10% in cash. An overlay manager can allocate 5% to equity and 5% to fixed income without using all the cash to get the exposure.

The paper explains that if the portfolio has $100 in cash, it may require only $5 in initial margin to get the equity exposure—leaving $95 in cash available. “Once benefits are paid to plan participants, the overlay manager can adjust the derivatives exposure to the most up-to-date cash position,” Roberts adds. “Whatever cash is there is effectively invested, not more or less. That’s an example of how an overlay manager can move quickly in and out of positions.”

Just with any investment, there is no guarantee with the derivative overlay that the portfolio will always gain. The gain or loss gets credited every day, Roberts says. Every day there is a mark to market where the buyer or seller will pay a variation margin to maintain the value of the contract. It is really about measuring over the long term how keeping cash invested will benefit the portfolio. Cash is a drag on return over time. According to the paper, based solely on the estimated historical value provided by equitizing cash and rebalancing, an overlay provider’s net benefit-to-cost ratio can be as much as 7:1.

One of the benefits of an overlay strategy specific to pension plans is interest rate hedging. This is beneficial to corporate pension plans that have adopted a liability-driven investing (LDI) framework, Roberts notes. The overlay strategy gives plan sponsors the ability to manage assets to liabilities in such a way that when interest rates move, assets in the plan move to match liabilities. There are two ways an overlay strategy can help, he says.

First, an overlay manager can monitor and maintain the interest rate hedge ratio more closely. “If you want to hedge 50% of interest rate exposure, you can do that fairly well with other investments, but market moves, etcetera, can put it off balance,” Roberts says. “An overlay manager can look at it daily to maintain the hedge ratio.” He adds that for plans that have a glide path in place, and want to increase the hedge at a certain trigger, an overlay manager can act on that intra-month at any given day. “Doing that intra-month captures spikes in the market instead of waiting until you get the month-end report and risking that the market is off again; you can capitalize on shorter-term market movements.”

The second way overlay strategies can be helpful with interest rate hedging is they help manage the hedge ratio across the yield curve. According to the paper, for LDI implementation done with fixed income strategies benchmarked to a common index, such as the Barclays Long Credit Index, there may be a mismatch in duration between assets and liabilities along the yield curve. An overlay manager can improve the effectiveness of the hedge by filling in the gaps that may exist between liabilities and assets at various points in the yield curve, that is, key rate durations, and move a plan’s target hedge ratio along a pre-determined “glide path” on any given day, thereby taking greater advantage of intra-month moves in rates and return-seeking assets.

There are things to keep in mind when selecting an overlay provider and when implementing the overlay strategy—all discussed in the paper—but, the bottom line is incorporating an overlay strategy helps maintain target allocations with greater liquidity, and for plans using LDI, the strategy helps the portfolio move along the glide path more efficiently, Roberts concludes.

The NEPC paper, “Overlay Strategies: Increasing Portfolio Efficiency Through Derivatives” is here.

Data & Research March 18, 2014

Health Care Costs Top Retiree Fear List

A vast majority of Americans report they are worried about health care costs in retirement, but many still substantially underestimate what the expense may be.
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Fidelity Investments’ recent “Retirement Savings Assessment” survey finds Americans are increasingly concerned about health care costs in retirement, with 84% of respondents saying they are unsure whether they will be able to cover medical expenses through retirement.

Fidelity warns the problem may be even greater than such figures suggest, as almost three-fourths (71%) of respondents expect to have better-than-average health in retirement—an overly optimistic assumption for many, since the Centers for Disease Control and Prevention (CDC) reports that 35% of U.S. adults are considered obese, and only 20% meet the centers’ overall physical activity recommendations.

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Another troubling result from the survey shows nearly half of pre-retirees ages 55 to 64 believe they will need about $50,000 to pay for their individual health care costs in retirement, while Fidelity’s annual Retiree Health Care Cost Estimate, which benchmarks the projected cost of health care in retirement, found that the average couple can expect to spend more than $220,000 in health care expenses over the course of their retirement. In contrast, Fidelity finds the average participant balance in 401(k) plans for which it serves as recordkeeper is about $89,300.

In addition to underestimating health care costs, many workers are unaware of the long-term financial impact that making positive health decisions can have. When asked which type of resolution is more important to keep—financial or physical—a little more than half (53%) of respondents said they would prefer to keep financial fitness resolutions, compared with 43% who opted for physical fitness. However, many do not realize the significant connection between the two, Fidelity says, and the importance of focusing on both health and finances when it comes to managing health care costs in retirement.

“Making smarter decisions about your health means you’re making smarter financial decisions, particularly when it comes to retirement,” explains John Sweeney, executive vice president of retirement and investing strategies at Fidelity.

Sweeney says those who are in good health tend to be more active in retirement and are able to spend more of their accumulated assets on discretionary expenses, such as travel. He says the survey also makes it clear that staying healthy is one of the most powerful ways to reduce essential costs in retirement, as retirees will not have to spend money on persisting medical expenses or long-term care.

“Simply put, not only can an apple a day keep the doctor away, it can very well help protect your retirement nest egg, too,” Sweeney says.  

Fidelity gives a fairly bleak assessment of what these results mean for workers’ chances of achieving a comfortable and secure retirement. With longer life spans, medical costs rising faster than general inflation, declining retiree medical coverage by private employers and funding challenges for Medicare and Medicaid, managing health care costs is expected to remain a critical challenge for retirees for some time to come. That is why the importance of maintaining a healthy lifestyle cannot be understated, Fidelity says.

The firm estimates an unhealthy individual with a pre-retirement income of approximately $80,000 may need an income replacement ratio as high as 96%, or approximately $76,800 per year, to meet his health care expenses. Conversely, if that same person were in excellent health, he might need just 77% of pre-retirement income to maintain the same standard of living. In other words, good health can cut nearly 20% from income needs during retirement.

To help plan for retirement health care costs, Fidelity suggests the following:

  • If possible, increase your savings level. Set an annual total savings goal of 10% to 15% or more of income, including both individual and employer contributions. Also, workers should consider investing a portion of any raises, bonuses or tax refunds into retirement savings.
  • Make saving automatic. Workers who cannot reach the 10% to 15% threshold immediately should consider increasing their contributions to savings plans by 1% every year to reach this goal, either manually or through automatic escalation features included in many plans.
  • Contribute to a health savings account (HSA). Individuals who are offered a qualifying high-deductible health plan (HDHP) through their employer should also consider saving in a health savings account. HSAs offer a “triple tax advantage,” Fidelity says, meaning contributions and investment earnings accumulate tax-free and continue to roll over from year to year if not spent. Distributions from HSAs for qualified medical expenses are not subject to federal taxes.

More information is available at www.fidelity.com.

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