Tom McCartan, vice president of liability-driven strategies for PGIM Fixed Income, spends a lot of time talking with pension plan sponsors about swings in funded status.
According to McCartan, U.S. pension plans have benefited from rising interest rates and strong equity markets following a long period of easy monetary policy after the Great Recession. He also points to the influence of the 2016 presidential election and the resultant corporate tax cuts as drivers of improved pension plan funded status.
While market performance in December wiped out all funded status gains for defined benefit (DB) plans last year, firms that track funded status estimate 2% to 3% improvement for the first month of 2019. The estimated aggregate funding level of pension plans sponsored by Standard & Poor’s (S&P) 1500 companies increased by 3% last month to 88%, as a result of an increase in U.S. equity markets, according to Mercer. As of January 31, the estimated aggregate deficit of $262 billion decreased by $50 billion as compared with $312 billion measured at the end of December. So far February has also been kind to pension plan funded status.
While many pension are still some distance away from being fully funded, McCartan says most plans are in much better shape today than they were a decade ago, during the doldrums of the Great Recession. In his opinion, the current state of affairs begs the question, “Should you stay on the funded status rollercoaster or move toward a recession-ready liability-driven investing [LDI] strategy?”
The Case for LDI
McCartan recently published a white paper that dives deep into the questions surrounding pension plan risk tolerance, titled “Is Your LDI Strategy Recession Ready?”
He says “adopting LDI” in basic terms means changing the investing objective from maximizing returns to instead focus on meeting a specific funding goal over a specific time period. Setting such guidelines can allow a pension plan sponsor to better tailor the risk exposure to avoid large losses in the case of recession. This safety may potentially come at the expense of missing some of the upside, but that is not really significant if the pension plan is remaining more stable and is able to smoothly and surely pay out the benefits owed to beneficiaries.
McCartan says LDI is growing even more important as pension plans broadly move into a phase where they are not growing but instead need to be focused on meeting their benefit obligations. He warns that, when there is eventually another downturn, it is going to be harder for market authorities and governments around the world to revive the economy. As a result, employers with large pension funding deficits could find themselves in a very difficult situation.
“This is because of all the easing that has happened since the Great Recession,” McCartan says. “Debt levels remain incredibly high around the world, so there is very little room for governments to stimulate the global economy quickly through some of the traditional means if/when the next recession occurs.”
When it comes to implementing LDI, McCartan outlines the basics of the approach as raising the pension plan’s interest rate liability hedge ratio to help mitigate interest rate risk; reducing spread duration and/or risk asset exposure to help lower funded status drawdown risk; moving from a market benchmark to a liability cash flow benchmark to help manage credit migration risk; and treating risk allocations and interest rate hedge ratios as distinct decisions to help achieve a high interest rate hedge ratio with desired risk asset exposure.
Many Plans Carry Growing Risks Unwittingly
According to McCartan, in recent years, both the percentage of BBB-rated bonds in the Bloomberg Barclays U.S. Long Corporate Bond Index and the duration of that index have increased meaningfully.
“At the same time, the durations of closed and frozen pension liabilities have been shortening as plans mature,” he explains. “Pension liabilities have AA-rated corporate spread risk, while the long corporate index is a mixture of all investment grade ratings. This combination of higher duration and lower quality means that the corporate spread risk of the long corporate bond index has been increasing relative to the corporate spread risk of pension liabilities.”
He points to Figure 6 in his white paper as demonstrating this divergence, using data from the long corporate index and a representative sample pension plan.
“Plan sponsors need to be aware of both the elevated level of spread beta in the hedging portfolio and, more importantly, the interaction with their risk assets,” he says. “These exposures are positively correlated and, as seen in past stressed market conditions, those correlations can increase.”
McCartan further observes how credit rating downgrades tend to be concentrated during recessions.
“Managing credit migration is important because there is an unhedgeable basis risk between a defined benefit plan’s corporate bond hedging portfolio and its liabilities,” he says. “Downgraded and defaulted bonds just vanish from the actuarial discount curves. There is no such good fortune in the hedging portfolio. Downgraded bonds do not vanish. They underperform and lower the plan’s funded status. This basis mismatch gives a plan’s funded status an acute sensitivity to negative credit migration.”
With all this in mind, McCartan strongly urges pension plan sponsors to consider the potential benefits of moving from a market benchmark to a liability cash flow benchmark.
“Liability benchmarks make the LDI manager responsible for all credit risk in the portfolio—not just active positions relative to an index,” he explains. “This greater awareness of the downgrade cost faced by the plan may incent some changes in portfolio construction. This style of benchmarking works best when combined with an investment process that emphasizes bottom-up security selection. Additionally, this benchmarking approach can encourage and enable sector diversification and allow the portfolio manager to include other non-corporate sectors (such as AAA-rated structured products) that have structurally lower downgrade risk.”
McCartan concludes by emphasizing how risk asset allocation decisions should be distinct from the interest rate hedge ratio decision.
“Given the very deep and liquid interest rate and equity derivative markets, there is no reason that a plan’s interest rate hedge ratio must be linked to the size of the risk asset exposure,” he says. “Many plan sponsors want to maintain some portion of risk assets for the long term for a variety of both economic and accounting reasons. Treating the interest rate decision as distinct to this risk asset allocation can help to avoid the plan’s funded status risk being long risk assets and short duration. That combination hurt funded status the most in the past two recessions.”
Learning Lessons From 2018
Another recent report, this one published by Goldman Sachs Asset Management and titled “U.S. Corporate Pension Review and Preview: The Return of Volatility,” looks back over 2018 for lessons pension plan sponsors can take away from the volatility seen during the year.
According to Goldman analysts, volatility is “a reminder of the importance of a strong governance structure and the need to be nimble.” As the report recalls, leading into October 2018, “notable contribution activity,” combined with rising interest rates and market returns had led to a significant rise in funded levels. The Goldman analysts say this provided a strong incentive for defined benefit (DB) plans to engage in de-risking activities, and while some plan sponsors did move down the path towards LDI at just the right time, many seem to have missed their chance.
“By our estimate, at the end of September 2018, corporate DB funded levels had risen to 91%, a 10 percentage point improvement from the end of 2016 and the highest level since the financial crisis,” the report says. “The opportunity to lock in such gains is often fleeting, and unfortunately the volatility in the fourth quarter demonstrated just how fleeting it can be.”
The Goldman analysts say the funded status of the aggregate U.S. corporate DB system fell “precipitously” at the end of 2018, finishing slightly below where it began the year.
“This demonstrates the importance of having a strong governance structure in place to be nimble and to take de-risking actions when the opportunity presents itself,” the report suggests. “We do believe some plans increased fixed-income allocations last year, potentially in response to the intra-year rise in funded levels. However, others may not have been able to effectuate changes to asset allocation and hedge ratios before the fall in equity prices and interest rates in the fourth quarter.”
The Goldman analysts say they will be watching closely as DB plan sponsors file their annual reports with the Securities and Exchange Commission, in order to get a more exact sense of what the bouts of market volatility have done to the health of private pension plans.
The analyst go on to offer some practical suggestions pension plan sponsors may consider during 2019, noting that some considerations may be more relevant than others contingent upon what the equity markets do and what unique circumstances a plan sponsor faces. Under the subtitle “Construction Ahead: Putting Together the LDI Portfolio May Become More Challenging,” the analysts recommend plan sponsors think deeply about their plan’s hedge ratio and the quality of the fixed-income portfolio.
“While many corporate DB plan sponsors will continue to focus on building out their fixed income portfolio and increasing their plan’s hedge ratio, actually putting together that portfolio may become more challenging going forward,” they warn.
The analysts cite several reasons why this may be the case. These include “a potentially lower investment grade corporate bond supply, in particular at the long end, after a multi-year period of robust issuance; supply that is not well diversified through the economy, leading to industry concentration; a greater percentage of investment grade bonds rated BBB than in the past, meaning sponsors may need to hold a lower quality portfolio than they may have had to previously; and the fact that we are likely closer to the end of the credit cycle than the beginning, potentially contributing to increased downgrade activity.”
The Goldman report says these factors suggest a more challenging environment to construct an LDI portfolio and highlight “the potential benefits of engaging an active LDI manager with experience in constructing appropriate portfolios.” The analysts suggest these factors may also lead some DB plan sponsors to contemplate other asset classes outside of corporate credit that may be utilized as part of a liability hedging program.
The Goldman report also says DB plan sponsors should think about “de-risking more than just bonds.”
“Many plans have put in place the strategy for the fixed-income side of their de-risking program, and are set to execute on it over the next several years,” the report says. “But as these programs become more developed, sponsors are starting to focus on what the return generating side of their portfolio should look like. This has been further spurred by the recent market volatility and has contributed to increased interest in strategies such as defensive equity, low volatility equity, alternative risk premia, and hedge fund replication. We have also seen more sponsors consider the use of derivative overlays for the hedging portfolio, which allows more capital to be allocated to the return generating portfolio, potentially increasing returns at a similar level of risk. We suspect more sponsors will take a closer look at this side of their de-risking programs in 2019.”