Pavonia LDI Consultants offers asset management and advisory services to small firms with defined benefit plans and to individuals planning for retirement.
At the beginning of 2019, Whitney Adams, senior adviser, meets with her new client, Donald Berendsen, in order to review the fixed-income portion of his retirement portfolio. Berendsen, who plans to retire in four years, intends to use this part of the portfolio to supplement income he will be receiving from Social Security, a US government retirement income program.
Berendsen explains to Adams, “I plan to continue saving for retirement, regularly adding funds to the portfolio until I retire, and I would like a low-risk solution to provide additional retirement income.”
Adams replies to Berendsen, “We focus on the ability of the portfolio to meet future cash flow needs and seek to immunize the liabilities as an objective in the management of the portfolio. If the fixed-income portfolio achieves an average annual investment return of at least 4% for the next four years, the proceeds of its liquidation will be enough to purchase an annuity sufficient to provide the funds needed to supplement your Social Security benefits. Until then, we will observe the following principles for managing the portfolio:
Principle I | Our investment strategy is structured to address a Type I liability. |
Principle II | The strategy should begin by analyzing the size and timing of liabilities. |
Principle III | The solution will require an asset-driven liability framework as opposed to a liability-driven investing one. |
I have summarized your fixed-income portfolio consisting of three government bonds in Exhibit 1. The yield curve has steepened since the bonds were purchased, which can be seen by comparing their respective yield to maturities (YTMs) of the purchase price yield to today’s yield.”
Exhibit 1
Berendsen Fixed-Income Portfolio Characteristics
Bond A | Bond B | Bond C | |
Coupon rate | 0.50% | 9.00% | 4.45% |
Maturity date | 15-Feb-2021 | 15-Aug-2023 | 15-Feb-2027 |
YTM at time of purchase | 2.95% | 4.72% | 4.97% |
YTM at current price | 1.85% | 4.70% | 5.07% |
Market value | USD732,412 | USD930,720 | USD986,100 |
Allocation | 28% | 35% | 37% |
Macaulay duration | 1.49 | 3.48 | 6.43 |
Note 1: Interest earned on cash: 1.00%
Note 2: Portfolio cash flow yield: 4.15%
Adams states, “Generally when we evaluate similar situations, we will use a passive, as opposed to an active, management strategy for the fixed-income portfolio, which means the risk of measurement error will be greater than asset liquidity risk.”
Later, Adams and junior portfolio manager Frank Neeson review the fixed-income portfolios of two new defined benefit plan clients, Lawson Doors & Cabinets, Inc., and Wharton Farms. Lawson’s plan has 30 participants, who are mostly experienced craftsmen and machinists, whereas Wharton has over 100 participants in its plan. The average participant age is 15 years younger for the Wharton plan compared with the Lawson plan. In both plans, participants receive a monthly benefit upon retirement based on average final pay and have no option for a lump sum distribution. The two plans’ portfolio characteristics are shown in Exhibit 2.
Exhibit 2
Selected Plan Portfolio Statistics
Lawson | Wharton | |
Market value of assets | USD15,498,000 | USD8,351,000 |
Duration of assets | 7.79 | 7.82 |
Duration of liabilities | 7.78 | 10.01 |
Semiannual portfolio dispersion | 46.07 | 147.22 |
Accumulated benefit obligation | USD14,389,000 | USD7,470,000 |
Portfolio cash flow yield | 4.47% | 4.51% |
Adams states to Neeson, “For the Lawson and Wharton plans, we can consider one of three alternative strategies to manage the multiple liabilities associated with these plans. Whenever a plan’s surplus is less than 5%, we favor passive management strategies. We could also use a derivatives strategy, and I prefer derivatives strategies that protect the portfolio against an increase in interest rates but will not produce large losses if rates decrease.”
Neeson comments, “The durations for almost half of the bonds in the Wharton portfolio are clustered around 4 years, and the durations of the remainder around 12 years, while the durations of the Lawson portfolio bonds are clustered between 6 years and 8 years. In general, a laddered bond portfolio approach would improve liquidity management for both, although the Lawson portfolio would experience an increase in cash flow reinvestment risk and the Wharton portfolio would experience a decrease in convexity.”
Question
Which of the following three strategies is least likely appropriate for the plans in Exhibit 2?
- Duration matching
- Cash flow matching
- Contingent immunization
Solution
Solution
B is correct. Cash flow matching is least appropriate for both plans. In both the Lawson and Wharton plans, participants are entitled to receive a monthly benefit. Cash flow matching entails building a dedicated portfolio of zero-coupon or fixed-income bonds to ensure there are sufficient cash inflows to pay the scheduled cash outflows. However, such a strategy is impractical and can lead to large cash flow holdings between payment dates, resulting in reinvestment risk and forgone returns on cash holdings.
C is incorrect. Contingent immunization is an appropriate strategy for both plans. Contingent immunization allows for active bond portfolio management until a minimum threshold in the surplus is reached. The threshold of 5% (of assets greater than liabilities) is exceeded in both plans; the Lawson portfolio has a surplus of 7.7%, and the Wharton portfolio has a surplus of 11.8%.
A is incorrect. Duration management is also appropriate for both the Lawson and Wharton plans. In this case, however, because they enjoy a surplus of assets to liabilities, the contingent immunization strategy is most appropriate. Since the plans are in the process of being advised by Pavonia, Wharton would likely be advised to eliminate the duration gap in similar form to Lawson.
Doubt: I didn’t understand the explanation for why ‘B’ is the answer, and why ‘A’ is not the answer.
For ‘B’ being the answer, they say that CF matching is inappropriate because it matches inflows with scheduled outflows – isn’t that the case here with monthly retirement benefits for employees?
And there is barely an explanation given for why duration matching is appropriate despite the duration mismatch currently in the Wharton portfolio
genuine question. I am also unable to understand the logic.