Rhode Island Turns to Options and Emerging Markets Debt to Improve Funding

Currently 54% funded but with high hopes for a greener tomorrow, the Rhode Island State Investment Commission (SIC) is entertaining portfolio allocation proposals from its consultant NEPC that would add equity options and emerging markets debt to the $8.5 billion portfolio.

The commission is ultimately trying to establish a portfolio that would limit the probability of the state retirement system’s funding level falling below 50% during the next five years to around 15%. It’s also looking to maintain at least three times the annual benefit payment amount in assets in a recessionary scenario.

To help with this, NEPC is suggesting the SIC exploit the flexibility of stock options to provide an additional layer of insulation from market swings. An average options portfolio beta of between 0.4-0.7 indicates a slight drag during an equity market uplift, but carries some attractive risk-mitigating characteristics in the event of a stock sell-off.

Capturing volatility risk premia through the sale of options would provide an additional diversifier to the SIC, which the consultant noted “has proven to be fairly consistent over time and in some ways is similar to earning a coupon.”

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The proposed allocation presented in the NEPC report sees a new segment for options that makes up approximately 5% of the portfolio, and is anticipated to generate a 4.8% five- to seven-year return.

For emerging markets debt, NEPC proposed the asset class for its ability to offer attractive yields relative to the rest of the world. It would provide a nice diversifier to the SIC’s current liquid credit exposure that’s heavily concentrated in the US, NEPC said.

NEPC said the asset class would “produce a high and stable income return stream to help mitigate the system’s negative cash flow and reduce the need to sell portfolio assets to meet required benefits.” The NEPC’s report proposed a 2% allocation to the asset class.

CIO recently held a discussion with Air Canada Pension Plan executives Vince Morin and Tarik Serri, who explained how they are taking advantage of newly enacted legislation in India that has opened up the doors for lucrative private credit strategies in the country.

The SIC and NEPC will review an additional analysis during their October 30 meeting and plan to seek approval of an optimal mix.