Best Ideas for the Hibernation Portfolio — Mercer

Mercer Insights

Liability Driven Investing



As the wave of Liability Driven Investing (LDI) has continued to gather steam, the discussion has moved beyond what LDI is to how to implement efficient LDI portfolios and best manage pension risk, factoring the idiosyncratic characteristics of the liabilities and the yield-curve construction rules, as well as the time horizon of the plan sponsor. Pension plan sponsors typically fall into two groups: those looking to terminate the pension plan and those looking to maintain the plan as a going concern. For plans on a termination path, there is likely to be a period where they are maintaining a “holding pattern” before embarking on the final approach to landing. For ongoing concern plans, there is typically an objective to maintain a target-funded state with minimal funded status volatility. Consequently, both groups have an interest in maintaining a low risk portfolio despite their different end-state objectives. We define a hibernation portfolio as a portfolio that seeks to minimize the funded status volatility.

In this paper, we set out our recommended construction of a hibernation portfolio and discuss potential variations depending on plan sponsor objectives. We first examine portfolio construction in a risk-return framework using forward-looking market assumptions and then test our portfolios with historical data. We pay particular scrutiny to the failings of credit bonds in creating a hibernation portfolio and discuss potential remedies, and we further examine the return requirements of a hibernation portfolio. Finally, we briefly discuss a number of topics: whether it makes sense to over-fund a hibernation portfolio, portfolio construction aspects, and cashflow versus valuation hedging.

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Gordon Fletcher

Ricky Kimalat

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