Considerations for LIBOR transition and U.S. Variable Annuity Guarantee Valuations
This paper discusses risk-free curve selection and setting of the discounting spread (over the risk-free rate) for variable annuity fair valuation.
The California Public Employees’ Retirement System (CalPERS) announced on September 15 that it would divest its entire $4.5 billion hedge fund investment. With a market value of $298 billion, a move by CalPERS may be a bellwether for the industry. The decision comes at a time when many pensions are reconsidering hedge fund investments as a risk management tool.1
Over the last decade, several pension funds have allocated a portion of their portfolios to hedge funds in an effort to gain downside protection, thereby increasing risk-adjusted returns over the long term. CalPERS has stated that the objective with its hedge fund program was “to provide a moderate level of return with significantly less volatility and correlation to the global equity markets.”2 An additional goal of the program was to provide “an additional means of diversification to the Total Fund by prudently taking exposure to risks distinct from those currently within the Total Fund.”3
Conventional wisdom assumes that hedge funds’ returns are weakly correlated with equity markets. As such, a diversified portfolio that includes an investment in hedge funds would likely reduce risk. This is not often the case.
The global financial crisis is one example of the systematic risk hedge funds (and most other asset classes) may have trouble addressing. This type of risk is inherent to the entire market or market segment (e.g., global economic crisis, large interest rate movements, recessions, wars, etc.). Systematic risk events have a low probability of occurrence but can have a significant negative impact on portfolio value if they occur. These broad market events are responsible for some of the largest upswings in portfolio volatility on record. During the financial crisis, for example, many hedge funds performed poorly, falling in lockstep with nearly every major asset class. The Wall Street Journal reports that during 2008 a composite hedge fund index lost 19%, only slightly better than the passive Vanguard Balanced Index Fund, which lost 22.2%.4
We believe one way to address systematic risk is through the combination of a diversified portfolio, with the addition of a risk management overlay that is not dependent on the inter-connectedness of asset classes in down markets.
CalPERS’ CIO Ted Eliopolous denied that the firm’s divestiture from hedge funds is related to performance,5 instead citing complexity, high fees, and the inability to scale its hedge fund program to a strategically useful size. The hedge fund universe employs widely different and often intentionally shrouded strategies. This makes it difficult to classify the group as one asset class with a specific allocation target. In February, CalPERS took note of this and revised the hedge fund space within its portfolio from an asset class with a target allocation to a “program.”
At 1.5% of CalPERS’ total portfolio, the hedge funds’ effect on CalPERS’ overall performance was negligible. CalPERS stated that, to have an impact, the hedge fund program would need to be scaled to $30 billion or $40 billion. In the fiscal year ending in June, CalPERS spent $135 million in hedge fund fees, or about 4% of its investment. Scaled to $40 billion, these fees would rise to a staggering $1.35 billion.6 CalPERS spokesman Joe DeAnda has more recently stated that the hedge fund returns have not justified the costs.7
Worldwide, there are now more than 10,000 hedge funds holding $2.8 trillion dollars of assets. The need to stand out in a crowded space has caused many hedge fund managers to take on more leverage. As reported in the New York Times, CalPERS spokesman DeAnda explained, “We’re willing to take risk when we have a strong belief we’ll be rewarded. With hedge funds, we couldn’t get there.”8
Milliman Financial Risk Management LLC (Milliman FRM)—a global leader in financial risk management—provides investment advisory, hedging, and consulting services on $150 billion of global assets (as of September 30, 2014). Milliman FRM is a subsidiary of Milliman, Inc.—one of the world’s largest independent actuarial and consulting firms.