While more closely aligned to the needs of matched portfolios than equities, these assets frequently lack the cash flow timing characteristics needed by plan sponsors. In addition, they often contain imbedded interest related options, such as prepayment or call privileges. These options make matched funding techniques, such as those that aim to match the average duration of assets to the average duration of liabilities, difficult to implement. If call or pre-payment options are exercised, the payment stream will change, leaving the portfolio open to a cash flow mismatch. But there are alternative investment options for these types of portfolios, mortgages being another investment option that should be considered.
COMMERCIAL MORTGAGES
For life insurers, the solution to this cash flow mismatch often comes through the use of term commercial mortgages. Commercial mortgages are used extensively to offset term liabilities, as they offer an excellent match for products that have similar cash flow characteristics, such as annuity and pension payments.
Commercial mortgages offer predictable monthly cash flows with terms of one to 25 years, attractive spreads over government bonds and limited or no prepayment options. They allow a plan sponsor to match fixed cash outflow obligations, month to month, over a pre-established time period.
Life insurers typically employ a variety of matched funding strategies, depending on the characteristics of the insurance products they back. Commercial mortgages, ranging from short-term construction and inventory loans to long-term multi-family housing loans, are frequently a large portion of the matched assets in ‘Immediate and Deferred Annuity’ lines which require both short-term and long-term payment streams. Combined with bonds, these assets provide the flexibility to match long-term liability duration to within a tenth of a year.
Because mortgage payments are comprised of a principal and an interest component, their duration characteristics are somewhat different from those of bonds. With a maximum duration of approximately 10 years, a mortgage duration curve is typically flatter than an equivalent term bond. A combined portfolio of commercial mortgages, coupons and strips can extend the effective duration beyond 20 years. The principal advantage of this composite portfolio is that a plan sponsor is able to match the initial years, when flows are predictable almost exactly(horizon matching), while immunizing a portion of the portfolio from price risk through the use of long duration bonds. Cash flows from maturing 10+ year bonds contribute to the matching of long-term liabilities.
These strategies can and should be employed by plan sponsors to manage the risks associated with return volatility for mature or closed pension plans. Their actuary, in consultation with an investment manager skilled in these specialized techniques, can design an effective matched funding strategy employing commercial mortgages that can eliminate much of the plan’s cash flow risks. For most pension plans, stable monthly cash flows are just what the beneficiaries ordered.
Greg Dwyer is vice-president of mortgages at Co-operators Investment Counseling in Regina, Sask. Judith Lowes is vice-president of investment services at Co-operators Investment Counseling in Guelph, Ont. gjdwyer@cooperators.ca; Judith_Lowes@cooperators.ca
