For a while during the last decade, Hewlett-Packard had a fully funded pension plan that was invested almost entirely in fixed income and had hedged 100% of its interest-rate risk. Then in 2008, $125 billion HP acquired EDS. The EDS defined-benefit plan was heavily invested in equities and the financial crisis left it severely underfunded. In 2009, the company merged the HP and EDS U.S. plans, which had a combined funded status of just 82%, increased the plan’s allocation to risky assets and unwound its interest-rate hedge.
In 2010, HP’s benefit fund investment team was asked to get the combined pension plan back to fully funded status within five years, and the team began to work on a strategy to reduce risk as the plan’s funded status improved. They built a Monte Carlo simulation model to analyze how different strategies would affect the plan’s funded status and the volatility of funded status. Then the team designed a dynamic asset allocation strategy in which the funded status of the plan can trigger changes to its asset allocation, and the funded status together with the level of interest rates can trigger changes in the plan’s interest-rate hedge ratio.
“The general idea is to take away risk when we can,” says senior portfolio manager David Cheng. “If our funding ratio improves, we want to lower our risk profile.”
The benefit fund investment team implemented a framework that includes a dashboard that monitors the plan’s funded status on a daily basis, trigger levels that are pre-approved by the investment committee so that changes can occur in real time, and three derivatives overlay programs in fixed income, equities and currencies to facilitate investment changes.
“Our framework is really designed so that we can be nimble and flexible,” Cheng says. “We don’t have to go back to the investment board and wait for weeks or months until they approve our strategy. The entire strategy has been approved and when we’re at a trigger point, we can go ahead and execute our strategy in real time.”