Is the Risk-Matching Precision of SMAs Worth the Cost and Complexity?

Recent Vanguard research explores the defined benefit (DB) plan risk-matching precision behind separately managed accounts (SMAs) and whether other investment vehicles, including collective investment trusts (CITs) and mutual funds, can equate that effectiveness.  

According to Brett Dutton, lead investment actuary and head of Vanguard’s Pension Strategy and Analysis team, there are common misconceptions with how SMAs are viewed. Considered as the “premier choice for liability hedging” because of its specific cash-flow timing, pension sponsors typically believe this precision will garner palpable results to funding status volatility. Yet, Dutton says these benefits are lower than sponsors anticipate, even marginal.   

“One reason for this is that segments of the yield curve don’t act independently of nearby segments,” he says. “Rather, the curve tends to transition smoothly between maturities. For this reason, we often find that matching key rate durations with pinpoint precision isn’t necessary for effective control of yield curve risk.”

The research adds figures clarifying parallels among strategies, including yield/discount rate and durations. Benchmark A (a blend of multiple credit and treasury indices that could implement mutual funds, CITs and an SMA) and Benchmark B (solely using an SMA), had a matching yield/discount rate at 3.7%. Additionally, Benchmark A had a duration of 11.9 years, while Benchmark B had a duration of 11.8 years. The only difference between the two was the key rate duration match by maturity bucket, which found Benchmark B considerably tighter.

When measuring the value at risk (VaR) between both models, the downside risk for all portfolios was less than 1% of total pension liability—0.58% for Benchmark A and 0.44% for Benchmark B. While the VaR model excludes risk factors such as demographic and actuarial changes, discount curve measurement risk, and payment of expenses from plan assets—resulting in a greater risk than 1% for each benchmark—Dutton says the payoff from using CITs and mutual funds remains significant.

“However, the important point remains true—the difference in risk between the portfolios would remain modest,” he says. “Furthermore, getting the overall risk level much closer to zero is practically impossible, regardless of the investment vehicle used, because the liability itself is not directly investable.”

Dutton notes that SMAs cost more and are more complex than CITs and mutual funds. According to the research, dealing certain bonds for “thinly-traded” issues with 10-to-20-year maturities can signify high transaction costs, not to mention overseeing “hundreds of individual holdings for each client.”

“In my experience, many plan sponsors would view a marginal loss in precision as a perfectly acceptable exchange for the diversification, flexibility, and lower costs of using mutual funds to hedge pension liabilities,” Dutton concludes.

More information about Vanguard’s research can be found here.