Tail Hedging Leaves DC Plans Poor, Not Protected, Study Finds

Even DC investors approaching retirement in 2008 would have been better to ride out that market than blunt decades of returns by paying to hedge tail risk, according to researchers.

(March 5, 2013) – It is an appealing notion, in a post-2008 world: tail risk hedging for defined contribution (DC) plans.

But plan sponsors looking to insure against the catastrophic personal retirement losses all-too-common in the financial crisis could do more harm than good pursuing that strategy, a study has found.

Two finance researchers working in Australia used historical data to simulate the impact of both active and passive tail risk hedging on DC investor cohorts stretching from 1928 to 2010. Anup Basu of the Queensland University of Technology and Griffith University Professor Michael Drew found that for two-thirds of the investor cohorts, the strategy would have done more harm than good for their bottom line.

“Overall, our findings indicate that historically holding hedged positions would have proved very costly for most DC plan investors,” the authors wrote. “Whilst buying tail hedges would have proved beneficial in some cases, the misgivings about these strategies among long horizon investors are not unfounded. Extreme or tail risk events, by very definition, are events with low probability of occurrence … Since the timing of these events is unpredictable, the investors are required to remain hedged all the time.” Even when groups in the model encountered these extreme events, the authors found that in many cases the protections were not worth their long-term cost.

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This was particularly true of passive hedging strategies, except for the DC cohort covering the Great Depression years. On average, Drew and Basu found that active hedging would have resulted in nearly 10% greater wealth at retirement for equity investors as opposed to passive hedging.

(The study modeled passive hedging by allocating 1% of the portfolio to buying tail hedge every year regardless of price. The active approach spent the same portion [1%] on out-of-money put options, but purchased at certain price levels based on market conditions.)

Annual returns averaged 14.49% for the study’s sample groups of unhedged DC investors. Applying active hedging to the simulation brought that figure to 14.10%, and the passive approach pulled it down further to 13.6%.

Even for the cohort of DC plan members approaching retirement during the financial crisis—which Drew and Basu call “a ferocious tail event”—hedging still would not have been worth the decades of drag on returns, according to the study: “Undoubtedly, both active and passive hedging produced higher returns than the unhedged strategy during this crisis event. However, the investors with unhedged strategy still retire with a higher wealth than those adhering to hedged strategies. This shows that the pay-offs from hedging during the crisis in 2008 (and earlier crash between 2000 and 2002) were not large enough to recover the cost of hedging over twenty years.”

Read Anup Basu and Michael Drew’s paper, “The Value of Tail Risk Hedging in Defined Contribution Plans: What Does History Tell Us,” here.

A bill to close Florida's massive defined benefit pension plan to new members will soon go before state lawmakers--some of whom have put 'Pension Reform' high on their 2013 to-do lists.

(March 4, 2013) – The 2013 legislative session commences tomorrow in Florida, when lawmakers will take up, among other proposals, a bill to close the state’s $131.9 billion defined benefit (DB) pension plan.

House Bill 7011, if passed in its current form, would close the DB plan to new members effective January 1, 2014, and prohibit current members of the state’s defined contribution (DC) plan from switching into the pension system.

Legislators will soon receive copies of an auctorial study comparing cost projections of continuing the DB plan versus switching to DC, according to a staff member from the Florida Retirement System. The study was commissioned by House Speaker Will Weatherford—who lists pension reform as one of his five goals for the 2013 session—and prepared by actuarial firm Milliman.

The Florida Retirement System’s unfunded pension liabilities sit at $19.3 billion as of July 1, 2012—a figure which Milliman foresees rising over time due to longevity increases if the DB plan remains open. However, the study also found that closing the DB plan alone would not be an effective way to deal with that shortfall. “If the plan is closed,” Milliman’s researchers stated, the unfunded liability “is not expected to be lower than the current amount until 25 years later. If the plan is kept open, it is not expected to be lower during the projection period. The growth in the unfunded liability is a function of the funding policy,” which, the study asserts, would lead to a rise in unfunded liabilities over the medium-term.

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Over the long term, Milliman concluded that closing the DB plan would in fact cut Florida’s unfunded pension obligations. The study estimated the figure would fall to $16.1 billion by 2041, whereas the state would face a $74.5 billion shortfall that year with an open DB plan.

A closed plan, or “soft freeze” in Milliman’s terms, would likely force the fund’s CIO (currently Ash Williams) and investment team to change their tact: “Over time, the State Board of Administration may lose the ability to invest with a long-term perspective as annual cash flow becomes more and more negative … This will possibly necessitate future changes in asset allocation in order to provide sufficient sources of cash for benefit payments, which in turn could impact the rates of return earned by the fund’s assets.”

In a pre-session meeting on February 7, the Government Operations Subcommittee approved the bill by a vote of nine to three, with one abstainer. The bill has been sent on to the Appropriations and State Affairs committees for review, which can commence when the legislative session opens tomorrow.