With the continued low interest rate environment and wide volatility in the stock market, defined benefit (DB) plan sponsors are trying to figure out how to invest to keep their liability-driven investing (LDI) strategies successful.
During Insight Investment’s expert roundtable, “A 2021 Roadmap for Institutional Investors,” Kevin McLaughlin, head of liability risk management, North America, noted that the goal of an LDI strategy is to have assets track liabilities, and, with so much uncertainty in the markets, DB plan sponsors are focused on funded status volatility.
There is also a growing focus on liquidity, he said. Especially for frozen DB plans, there are more outflows than inflows. “Over the next 10 years, DB plans could see outflows between 50% to 80% of assets,” McLaughlin said. “In the public DB plan space, some of those numbers are even more stark.”
Alex Veroude, chief investment officer (CIO), North America, said investors are wondering whether the 10-year Treasury note will break the 1% mark since it’s close to doing so now. However, he said Insight Investment’s view is that the world is in a state of financial repression, so it thinks real yields will be low, zero or negative in 2021. “If inflation is high, we’ll see a negative rate situation,” Veroude said.
Shivin Kwatra, head of LDI portfolio management, North America, said it is tempting in the current rate environment to take off hedges in a portfolio, but DB plan sponsors are resisting the temptation, and Insight Investment agrees with that decision. “Hedges should be part of a plan’s risk management program. We are suggesting plans think about increasing hedges,” he said.
Kwatra said, currently, most fixed income investments are in government bonds and STRIPS [Separate Trading of Registered Interest and Principal of Securities], and some of that could be achieved more efficiently with overlays. For fixed income investments that are in corporate vehicles, he said, the big theme has been to diversify away from corporate allocation both in public and private markets for better protection diversification and yield.
“Should you take off hedges and hope interest rates rise, or should you the stay course and increase your hedge ratio?” McLaughlin queried. “We think that despite rates being low, plan sponsors should hedge liabilities. The more they can hedge, the more they can lock down investment goals they seek to achieve.” He added that many plan sponsors—both corporate and public—are in decumulation mode, so the second reason to focus on hedging is the need to build a buffer to shocks on funded status.
McLaughlin said there is more sensitivity to a fall in interest rates than a rise in interest rates. “If rates decline further, the value of liabilities will increase 20% to 40%, but if rates rise, plan sponsors will only see a decrease in liabilities of 12% to 14%,” he explained. With this in mind, plan sponsors might be thinking about the risk of regret if they hedge too soon and rates rise—they’ll feel they lost out. But, McLaughlin said, it is better to be cautious in case rates fall.
“We see more focus on trying to make fixed income do more work. Plan sponsors are also more cash-flow aware to be able to pay for benefits,” he said. “Better hedges can free up liquidity.” McLaughlin added that before plan sponsors make investment decisions, they should ask if they are in a position to take on more risk.
Veroude said there will be a continued search for yield in the government bond space, and investors will find more yield in emerging markets and currencies tied to that, not in traditional bonds.
If DB plans can replicate Treasuries and STRIPS synthetically to free up capital, that should be a strategy, McLaughlin said. He also recommended that plan sponsors have three to five years of planned liquidity on hand.
Search for Growth
Going into 2021, DB plan sponsors are also asking where to turn for growth. “They are wondering if a large allocation to fixed income is still the best thing,” Veroude said. “We expect, and have already started to see, a rotation of investments in portfolios out of lower yielding assets and into other areas. Different asset managers have different answers for the best place to find growth.”
Veroude said there are fixed income vehicles that can provide diversification, negative correlation and yield/growth. “The next best thing might not be one single investment, but one to protect and one for growth,” he said.
In fixed income, growth will come from vehicles that don’t have a high propensity for default, Veroude said. Otherwise, investors should go straight to equities. “It would be nice to find investment vehicles that are not super crowded, but that’s easier said than done,” he said. “Investors can find some that are not over-crowded, but those vehicles are not widely advertised.”
There are two areas Insight Investment favors in the current market crisis: securitized investments and those with a liquidity premium—for example, private assets, particularly with lower default risk. “We think investors will increasingly skew their portfolios toward those,” Veroude said. “I think in five or so years, we will see DB plans’ fixed income allocations more in illiquid assets and less in government bonds. Intellectually, moving assets into private investments makes sense.”
In the search for yield, as plans allocate more assets to higher yielding securities, they will have to take on more risk, McLaughlin noted. Plan sponsors should ask if they can do that in a way to hedge liabilities. In the past, U.S. Treasuries were a hedge against equity risk, but diversification from Treasuries is now a theme, he said.
An equity with downside protection is fixed income-like, McLaughlin said. The challenge is the cost, but he said a “tremendous amount of work has been done to provide downside protection more efficiently than in the past.” Veroude said this is why he likes convertible bonds; they offer the upside of equity but if things go wrong, there is still the floor of an outright bond on hand. “They are coming back in vogue; 2020 has been a record year for the issuance of convertible bonds,” he said.
McLaughlin noted that there is hope for additional funding relief for DB plans. The Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act, which passed through the House in May, if passed in its current form, would extend the amortization period plan sponsors have for covering funding deficits. “It would mean lots of corporate plans can extend the time horizon for closing their funding deficit, so they could take on less risk and wouldn’t have to re-risk into equities,” he said.
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