Most corporate pensions have advanced beyond the standard 60-40 portfolio mix and invest with an eye to the relationship between assets and liabilities. Risk and reward are more clearly defined in that context than ever before. Those metrics are expressed in terms of surplus or funded ratio return and volatility. They’re both the correct type of measures for evaluating pension investments, but—as always—the details are crucial.
It’s not uncommon to see the terms funded ratio volatility and surplus volatility used interchangeably. However, there are subtle differences between the two that institutional investors should understand. Let’s take a look at what those differences are and why they matter.
Which metric makes more sense in LDI?
The distinction between surplus volatility and funded ratio volatility can have an impact on how a liability-driven investing (LDI) hedging program is managed. The surplus is calculated by subtracting liabilities from assets, while the funded ratio is calculated by dividing assets by liabilities. Managers measure the volatility of both surplus and funded ratio in terms of their standard deviation, typically representing funded ratio volatility as a percentage and surplus volatility as a dollar amount, although the latter can also be represented as a percentage by dividing it by either beginning assets or beginning liability.
There’s another common term we need to address: funded status volatility. It’s even more common for funded status (the plan’s benefit obligations minus the fair value of its assets) to be used interchangeably with the other terms. For a pension plan, the projected benefit obligation (PBO) is a measure of accrued liability following accounting standards, which means funded status is a more specific representation of our surplus equation. In an LDI context, the liability is usually based on PBO, potentially with some variation in the discount yield curve. That means funded status volatility is essentially the same as surplus volatility. Be sure to double-check with your LDI manager exactly how they’re using these terms.
In an LDI environment, whether the risk around one is better than the risk around the other depends on the plan’s unique circumstances. Corporate plan sponsors are probably tuned in to the dollar value of underfunding; this is an amount they’ll need to make up one way or another. Depending on the investment strategy, most sponsors are likely in a position where the surplus decreases at the same time the company faces heightened market stress. Some may be more comfortable thinking in terms of funded ratio, perhaps because of events triggered by regulations for funding. It’s good to remember, however, that LDI and investment strategy are usually focused more on fair-value accounting than smoothed funding rules.
Funded ratio volatility vs. surplus volatility by the numbers
Let’s consider the following example to illustrate the differences between the measures. The two cases start in the same place with a 90% funded ratio with a surplus of -$100. Case 1 illustrates a path where there’s positive surplus volatility but no funded ratio volatility. Case 2 illustrates the opposite, which is a path with funded ratio volatility but no surplus volatility.
Scenarios are for illustrative purposes only. They do not reflect the experience of any client or the performance of any strategy offered by Parametric.
Given the difference between subtraction and division, it’s not surprising that the two measures move slightly differently. It’s safe to say they typically move together, since they’re both based on measures between assets and liabilities. But it’s a good idea to know that this is far from always the case. In fact, they can actually move in different directions, which you can see in the following example: Funded ratio has increased while surplus has decreased.