Tailor Your Risk by Buttoning-up with an Equity Collar
Pension plans have experienced strong funded status improvements driven by the steep rise in interest rates and strong equity returns over the past several years. At this stage, maintaining that status becomes more important than the incremental benefit of achieving higher returns. Now, with equity valuations stretched to alarming levels and with the Federal Reserve signaling no further interest rate hikes, plans may no longer be able to rely on greater discounting to offset potential equity risk. As an alternative, a collar structure can be utilized to reduce the volatility of the return-seeking asset portfolio, thereby mitigating the risk of a significant drawdown while still allowing the plan the opportunity to meet its funding objectives.
In this context, we believe it is particularly crucial for pension plans to limit the range of potential funded status outcomes. Using a collar strategy defines the range of equity outcomes, giving sponsors greater control over the actions required to finish fulfilling pension obligations. Further, most long-term capital market assumptions are based on a negative correlation between equity and Treasury returns, but as recent returns have demonstrated, this is not always the case. In certain instances, this can improve the funded status of a pension. However, the use of a collar likely improves funded status outcomes relative to unhedged equity across more potential market environments.
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