For corporate defined benefit (DB) plans, there was a time when liability-driven investing (LDI) wasn’t part of everyday jargon. Today, however, more and more pension plan sponsors focus not only on the asset side of the equation, but also on how assets perform in concert with the underlying pension liability. As part of this increased liability awareness, the completion mandate was born. Completion portfolios are custom LDI solutions that, when combined with other fixed income mandates, seek to mitigate specific liability risk characteristics such as duration while customizing exposure along the yield curve.
Completion mandates are clearly a positive development. In this piece, however, we will seek to demonstrate that the value of a completion portfolio – although arguably positive at all points in our view – may not be constant along the de-risking journey. Said differently, there may be a point along the de-risking glide path where the completion mandate no longer punches above its weight. This doesn’t necessarily mean the completion mandate should be abandoned. It’s simply a time to assess the benefits and costs (both explicit and opportunity costs) of such an allocation.
What is a completion portfolio?
Consider a plan whose physical assets hedge 80% of the liability’s sensitivity to interest rates, but a 100% hedge is desired. The task of the completion mandate in this case is to hedge the remaining 20%. In addition to total duration, completion mandates can seek to hedge yield curve mismatches. The goal is to ensure that changes in the shape of the yield curve do not meaningfully affect a plan’s funded status. Some completion mandates go a step further and address the spread exposure embedded within the liability. When it comes to the allocation of assets to a completion mandate, two schools of thought dominate. In one, plan sponsors adopt a bundled approach to completion. In this case, the completion exposure is embedded within the active mandate of one of the plan’s LDI managers. Combined with the rest of the fixed income allocation, the mandate seeks to achieve the target hedge set by the plan sponsor. This type of completion mandate generally reduces operational burdens for plan sponsors (especially as it relates to rebalancing), lowers transaction costs, adds flexibility to target additional factors like spread duration, and, importantly, improves the ability to seek to generate alpha relative to custom benchmarks (to better match the high hurdle imposed by liability discount rate methodologies).
In the second approach, the completion mandate is set up as a separate, standalone beta-seeking portfolio (i.e., typically a Treasury- only allocation that seeks to hedge the liability’s return due to changes in Treasury rates). This typically results in assets being unbundled from the active fixed income portfolio in pursuit of beta-like returns, at the opportunity cost of forgone alpha potential and potentially cumbersome operational considerations.
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Measuring the benefits of completion
Conventional wisdom, and we largely agree with it, suggests that the further a plan progresses along its glide path, the more important it is to have a custom solution to best match risk characteristics of the liability. This is simply because as plans de-risk (e.g., reduce their return seeking allocation), yield curve and spread exposure mismatches compose a larger share of the total surplus volatility. Therefore, custom solutions designed to address these risks have a larger overall risk-mitigating impact. That said, the value is not a singular measure.