Rime of the Dynamic Asset Allocation Mariner

My favorite poem in high school was The Rime of the Ancient Mariner by Samuel Taylor Coleridge.

OK…I actually didn’t read much poetry in high school. But I do remember head-banging to the Iron Maiden song of the same name (all 13 minutes of it) so I think I’m sufficiently qualified to continue.

If you’re not familiar, Rime is a seven part epic with dozens of stanzas that tells the tale of the eponymous Ancient Mariner’s agonizing journey to his ultimate destination.  (The Maiden version also features a crushing guitar solo.)  Blown off course by a storm, the Mariner spends the rest of the poem battling through unfavorable conditions to return to the comfort of port.

Many sponsors of underfunded defined benefit (DB) plans can probably relate to the Mariner’s plight. Burdened with an albatross of unfunded liability about their necks, and mired in the doldrums of low corporate bond rates, funding ratios are often “as idle as a painted ship upon a painted ocean.”

Charting the Course

Exhibit 1

Here we see the S.S. Underfunded far from it’s destination of “Full Funding”.  She has been out on open water for many years, exposed to the buffeting gales of the equity markets and the violent riptides of interest rates.  And although the captain is an able sailor, he hasn’t made much progress toward port.  The funding ratio remains significantly low.

Maneuvering Toward the Goal

There are only three ways that the captain can work toward the comfort of full funding:

  • Return Seeking Assets (Wind): Letting out sail by investing in return seeking assets like equities can quickly improve funding ratios , pushing the ship toward full funding. This comes with significant risk, however, as equity winds have been known to blow suddenly in either direction! (Like the great nor’easter of 2008.)
  • Interest Rate Leveraging (Tides): The captain also has a drift anchor that he can use to stabilize the ship. (A drift anchor acts as a brake by increasing drag rather than tethering to the seabed.) The longer the drift anchor is let out, the greater the drag and the more stability it provides. Coincidentally, the degree to which the drift anchor is let out is analogous to the duration of the plan’s fixed income holdings. Letting the drift anchor out only a short way (like short duration bonds) allows the ship’s funding ratio to drift more with the tides of interest rate movement. When interest rates rise, short duration bonds outperform liabilities and the funding ratio improves. Conversely, letting the drift anchor out longer (so duration matches liabilities) reduces funding ratio drift. So the funding ratio doesn’t benefit as much from rising rates, but is protected more should the tide go out again and rates drop.
  • Cash Funding (Rowing): Expensive and tiring, but the only method that guarantees positive progress.

Like most skippers, our captain suspects the crew doesn’t have the stamina to pull the boat all the way to shore (and the admiral has other plans for that cash elsewhere in the organization.) So some combination of the first two elements is going to be required.  The problem is that both also introduce risk that the funding ratio could decline, and the ship drift further from its goal.

Waiting for Fair Conditions

Being so far from home, the captain has decided that potential investment upside reward outweighs downside risk. He opts to let the sails out full in the hopes of catching a positive updraft in the markets.  The drift anchor of fixed income duration is set short to take full advantage of expected rising rates.  So the call is put out for a “traditional” investment allocation (such as 60 percent equities and 40 percent short duration bonds.)  A sustainable funding policy is also employed to help row toward full funding.

For this example, we’ll assume a year of fair conditions. Equity markets generate positive returns and interest rates rise about 1 percent.  (This would push liabilities of a typical DB plan down 10 to 15 percent, while core bonds would only lose about 4 percent, for a net return of 6 to 11 percent vs. liabilities.)  Lo and behold, the funding ratio has improved significantly.  The ship is much closer to its goal!

Now what?

Calibrating Risk with the Need to Take It

In years past, our captain “doubled down”, hoping for another positive year. Risk was not reduced in the portfolio.  Sails were kept full and the drift anchor kept short.  Unfortunately, the winds of equity markets and tides of dropping interest rates quickly reversed the progress that was made.  (One needs look no further back than 2013 and 2014 for an example of this.)

This time however, “a sadder and wiser man” chooses to calibrate the risk of the portfolio with the need to take it. With the funding ratio closer to full, the need to maintain such a high exposure to equities is diminished.  With interest rates higher, the duration of fixed income holdings is extended to match the behavior of liabilities better (a “liability driven investment” or “LDI” strategy), so a subsequent reversal of rates (or tides) doesn’t drag the ship back out to sea.

Our captain cuts sails and lets out the drift anchor further. Volatility risk to the funding ratio is decreased significantly, while still maintaining some upside potential.  (He gives the order to the crew to cut equity exposure to 30 percent and extend the duration of fixed income closer to that of plan liabilities.)

Exhibit 2

Adjusting to Wind, Tides and Distance

As the winds of equity markets and the tides of interest rates push our ship, and the crew continues its annual funding/rowing, the captain will continue to trim sales and set the drift anchor length according to the funding ratio of the plan. (Of course, he will rely on his actuarial mate to provide regular readings to help him make informed decisions.)

The closer the plan gets to full funding, the more a duration matched bond strategy under LDI makes sense. Ultimately, when the ship reaches its goal, the captain may set the allocation to 100 percent fixed income with duration matching that of the liabilities.  Sails are furled and the anchor finally allowed to touch bottom.  Back in port, the captain is now indifferent to fickle equity markets and corporate bond rates.  And the weary crew can finally stop rowing.

Dynamic Asset Allocation

Home finally, the captain reviews the charts. Not too long ago, his ship was adrift in unfunded liabilities everwhere (“nor any drop to drink”).  But through his disciplined, logical reallocations — reducing equity risk and extending fixed income duration as his funding ratio improved — he has reached his long sought objective.

Unbeknownst to him, he accomplished this by using a process known as “2-Dimensional Dynamic Asset Allocation”– the two dimensions being fixed income weighting and duration.

Exhibit 3

Argh! Compliance note:  Of course, many other captains in many other ships may take slightly different routes based on guidance of their financial advisor and funding ratio reporting from their actuary!  Blogs are not financial advice!

As he reflects on the long journey, the captain suddenly realizes that the ship will need to be rechristened under a new name. “S.S. Underfunded” no longer seems appropriate.

Mike Clark is a fellow of the Society of Actuaries (SOA) a member of the American Academy of Actuaries (AAA) and a card-carrying land lubber who begs the forgiveness of any real sailors (or English teachers) offended by any errors or oversimplifications in his metaphor.

Affiliation Disclosure

Examples are for illustrative purposes only.

The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.

No investment strategy, such as diversification or asset allocation, can guarantee a profit or protect against loss in periods of declining value. Use of Dynamic Asset Allocation does not guarantee improvement in plan funding status nor the timing of any improvement.

Equity investment options involve greater risk, including heightened volatility, than fixed-income investment options. Fixed-income investment options are subject to interest rate risk, and their value will decline as interest rates rise.

Insurance products and plan administrative services are provided by Principal Life Insurance Company, a member of the Principal Financial Group® (Principal®), Des Moines, IA 50392.